The Convenience Function

The convenience function for a financial-services firm can be described in terms of four elements:

• The organization's geographic reach (e.g., number of branches or ability to transfer funds electronically)

• The number of products and services offered (e.g., a ''universal" bank versus a "narrowly defined'' bank)

• The average cost of accessing the bank's facilities

• The quality of the product and services (e.g.. speed and reliability)

Although the cost and quality of an individual FSFs products and services are

mainly a function of its internal environment and operations, regulations indirectly affect the cost of doing business and contribute to shaping this component of the convenience function. In contrast, geographic and product restrictions directly affect user convenience by limiting the scope of an FSF's geographic reach and its product offerings. To the extent that these restrictions limit firms' ability to diversify, they increase (bank) riskiness. Nevertheless, because asset restrictions are among the tools for managing guarantees, the basic question is: What businesses should regulated firms (banks) be in and who should decide (bankers, regulators. or lawmakers) what those businesses are? Given prompt corrective action and other regulatory reforms, a freer market solution is to let bankers decide what their businesses should be.

The Confidence Function

If we abstract from government guarantees for the moment, confidence in a financial institution should be a function of its net worth or capital adequacy (capacity to absorb losses), stability of earnings (an indicator of its riskiness), liquidity, and the accessibility, reliability, and cost of information about its operations, management, and so on. In general, market participants will have less confidence in firms with low net worth, highly variable earnings, illiquid assets, and weak managers. In an efficient market, disclosure of the components of a firm's confidence function would permit market participants to judge the safety or riskiness of financial institutions.

Because banks administer the payments mechanism and provide transactions services, supply backup liquidity to the economy, and serve as a conduit for monetary policy, most governments provide some form of guarantee or safety net for banks (e.g., in the form of deposit insurance or as a lender of last resort or both).

A government guarantee then becomes a critical component in establishing public confidence in banks and the banking system. However, if the government guarantee is too strong (e.g., 100% deposit insurance), it can create its own set of problems in the form of moral hazard, being too big to fail and too reliant on regulatory discipline to the exclusion of market discipline.

Recapitulation and Lessons

Price, convenience, and confidence represent three key layers of financial-services competition. In trying to achieve a financial system that is safe, stable, and competitive (too safe and too stable mean less competitive), regulators play a major role in shaping these three aspects of bank competition. Countries trying to develop efficient and safe banking systems need to understand how regulation shapes these functions and what trade-offs are involved.

Chapter Summary

Financial systems perform six basic or core functions:

• Clearing and selling payments (a payments system)

• Aggregating (pooling) and disaggregating wealth and flows of funds so that both large-scale and small-scale projects can be financed

• Transferring economic resources over time, space, and industries

• Accumulating, processing, and disseminating information for decision-making purposes

• Providing ways for managing uncertainty and controlling risk

• Providing ways for dealing with incentive and asymmetric-information problems that arisein financial contracting

Because commercial banks perform all of the functions, they are vital to any financial system. This is not to deny, however, that other financial institutions also perform the same or similar functions. Commercial banks have been adapting their institutional forms, epitomized by the bank holding company, to follow the evolving functions of the financial system.

A U.S. financial system described as the financial-services industry (FSI) includes depository institutions such as commercial banks, savings and loans (S&Ls), savings banks, and credit unions and nondepository institutions including insurance companies, pension funds, finance companies, mutual funds, and subsidiaries of nonfinancial corporations such as General Motors Acceptance Corporation (GMAC) and General Electric Capital Services. All of these companies can be described as financial-services firms (FSFs) or financial intermediaries (Fls). In addition, because the industries in which these companies operate have become less compartmentalized, their fusion or coming together has marked the birth of the FSI, an industry marked by -ization (e.g., securitization). The view that commercial banks operate in the FSI means that their role will look diluted in this framework. Although discussions of the decline of banking and the end of banking as we know it have been topical recently, commercial banks are still the kingpins of the FSI in the United States.

When the intermediation function is disrupted, disintermediation occurs, or a shift from indirect finance to direct finance. Disintermediation has occurred on both sides of bank and S&L balance sheets as they have lost deposits to other FSFs, especially mutual funds, and they have lost loans to instruments of direct finance (e.g., commercial paper and corporate bonds).

Financial markets perform two basic economic functions: (1) They transfer funds from those economic units that have surplus funds to those that need them (usually to buy tangible assets); and (2) they transfer funds in such a way as to redistribute or shift risk among those seeking and those providing funds. In short, the two principal functions of financial markets are funds transfer and risk shifting. As intermediaries, banks perform these two functions, which create credit risk, interest- rate risk, and liquidity risk-the dilemmas of bank risk management.

In the process of transferring funds and distributing risk, financial markets and institutions provide three important services: (1) They determine the prices of financial assets through the interaction of buyers and sellers; (2) they provide liquidity by offering investors the opportunity to sell (liquidate) their financial assets; and (3) they reduce search and information costs of transacting or exchanging financial assets (transactions costs). In addition to providing funds transfer and risk shifting, banks justify their existence by providing liquidity and reducing search and information costs.

Strength in banking requires a balance of banking powers and firm supervision. In practice, bank regulators use combinations of monitoring, asset restrictions, and risk-based pricing to manage their guarantees (i.e. to achieve firm supervision). Freedom of exit based on "prompt corrective action" is an essential component of any system of bank regulation and supervision. Nevertheless, Schwartz [1987] suggests that stabilizing interest rates and prices will do more for financial stability than reforming deposit insurance or reregulation. Moreover, with advances in monitoring technology and increases in the liquidity of bank assets through securitization, market discipline will increasingly supplant the need for regulatory discipline.

The inability of lenders, regulators, and deposit insurers (as principals) to adequately monitor the actions and information of agent borrowers (including banks) captures the central principal-agent problem of a regulated financial system.

Although market discipline is an alternative to regulatory discipline, most market economies rely on both forms to control bank risk taking. Ideally, market and regulatory discipline should complement each other to promote a safe-and-sound banking system.

Countries striving to develop efficient banking and financial systems should learn from the mistakes of the United States. To attempt to avoid these problems, developing countries need to maintain a stable economic and financial environment, to regulate banks in a way that does not restrict their diversification opportunities, and if they provide deposit insurance, to price it properly (e.g., based on risk exposure).

MODELS OF BANK-INDUSTRY LINKAGES

The bank-industry linkages in the United States, Japan, and Germany represent three alternative ways of relating financial economics and real economics (i.e., banks and industry). The Japanese keiretsu and German Hausenbanken(universal bank) foster closer relations between banks and industry, while the U.S. approach relies on capital markets and a well-developed banking system but one that is separated from commerce (i.e., nonbanking businesses cannot own a bank in the United States).