Framing Financial
Structure in an Information Environment
Thomas J. Courchene and Edwin H. Neave (eds.),
2003 (Paper ISBN: 0-88911-950-3
$29.95) (Cloth ISBN: 0-88911-948-1 $65.00)
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| Contents | |
| Introduction | |
| Acknowledgement | . . . | v |
| Introduction | . . . |
1 |
| Overview Perspectives | ||
| Financial Regulation in a Changing Environment Douglas Gale |
|
|
| Bankers and Risk Charles Goodhart |
. . . |
|
| Theoretical Underpinnings | ||
| Financial Governance and Financial Regulation Lewis D. Johnson and Edwin H. Neave |
. . . |
47 |
| Financial Governance and Financial Regulation: Comments Robert Jones |
. . . |
66 |
| Effects of Financial Restructuring | ||
| To What Extent Will the Banking Industry be Globalized? A Study of Bank Nationality and Reach in 20 European Nations Allen N. Berger, Qinglei Dai, Steven Ongena and David C. Smith |
. . . | 73 |
| Banking and Globalization: Comments Ron Giammarino |
. . . | 117 |
| Competition: National or International? | ||
| Revisiting Main and Bay Streets John F. Chant |
. . . |
123 |
| Revisiting Main and Bay Streets: Comments Frank Mathewson |
. . . |
151 |
| Bancassurance: Merging Banks and Insurance | ||
| Citicorp-Travelers Group Merger: Challenging Barriers Between Banking and Insurance Kenneth A. Carow |
. . . |
157 |
| Citicorp-Travelers Group Merger: Comments Paul Halpern |
. . . |
180 |
| Looking Forward | ||
| System Stability Charles Freedman |
. . . |
189 |
| Looking Forward: Three Challenges Tim O'Neill |
. . . |
199 |
| On the Future of International Financial Intermediation Stephen S. Poloz |
. . . |
203 |
| Contributors |
| Return to Top |
INTRODUCTION
Technology and the information revolution are progressively blurring
the
line between banks and near banks, between loans and securities, and
between domestic and international forms of financial business. These
changes create challenges for financial institutions, for regulators and
for financial system clients, wholesale and retail alike. Financial
managers strive to find efficient and effective organizational
structures
that offer sufficient flexibility in response to this changing
environment. For their part, financial regulators attempt to find
effective ways of monitoring institutional and system risk in response
to
the changing dynamics of financial sector structure. Individuals
complicate the lives of financial managers and regulators alike by
utilizing their new-found informatics power to demand state-of-the-art
financial instruments, and by placing their faith in regulators whose
task
is to ensure that the financial sector will respond to these demands in
ways that are transparent on the one hand, secure on the other. Partly
in
response to this rapidly changing environment, the Office of the
Superintendent of Financial Institutions (OSFI) is lending its support
and
encouragement to a series of national conferences on financial
regulation.
Framing Financial Structure in an Information Environment
presents the
proceedings of the second of these conferences, held at Queen's
University
in late 2001. The conference was hosted by the John Deutsch Institute
for
the Study of Economic Policy and by Queen's Financial Economics (a joint
venture of the School of Business and the Department of Economics).
The role of this introduction is to present a capsule summary of the
principal papers presented at the conference and reproduced in this
volume. Several of the papers are followed by commentaries, which we do
not summarize in this introduction.
We begin with the two overview perspectives by Douglas Gale and by
Charles
Goodhart.
Gale on Regulation Without Theory
In the first of the two framework papers, "Financial Regulation in a
Changing Environment", Douglas Gale wrestles with the reality that,
despite the presence of substantial and growing regulation of the
financial sector, there is no theory of optimal financial regulation.
Indeed, Gale notes that the development of central banking and financial
regulation has been an essentially empirical process driven by the
exigencies of history rather than by formal theory. For example, the
Great
Depression led to the Glass-Steagall Act's provisions that separated
banking from investment, to the creation of the Securities and Exchange
Commission (SEC) to regulate financial markets, and to the provision for
deposit insurance for banks and savings and loan institutions through
the
FDIC and the FSLIC. Europe, on the other hand, never instituted a ban
against allowing the same institutions to engage in both banking and
investment/underwriting activities.
Gale begins his analysis with a simple model of risk sharing with
complete
markets, within which a laissez faire financial system achieves
a
constrained-efficient allocation of risk and resources, and where
financial crises may actually be necessary in order to achieve this
constrained efficiency. One obvious implication of the model is that the
avoidance of crises should not be taken as axiomatic on the part of
regulators: "if regulation is required to minimize or obviate the costs
of
financial crises, it needs to be justified by a microeconomic welfare
analysis based on standard assumptions".
In order to provide an opportunity for welfare-improving
intervention,
Gale next develops an incomplete-markets model. The result is a market
failure (because the banks face the wrong "prices") which in turn
suggests
two ways in which prudential regulation can improve economic welfare.
First, the regulatory agency could execute the intertemporal trades that
banks, investors and depositors cannot achieve, effectively replacing
the
"missing" markets. The problem here is that it is not obvious what
technological advantage the authorities have over the market when it
comes
to executing intertemporal trades. Second, and more interesting, the
authorities could alter the allocation of resources in a way that
changes
prices and causes economic decisionmakers to change their own
intertemporal decisions. Under further assumptions Gale goes on to note
that "only if there is a pecuniary externality and markets are
incomplete
will there be an argument for regulation". He then adds:
It is not clear that any of these considerations are actually
the
ones that motivate the regulators who set capital adequacy requirements.
But what-ever the motivation, the onus seems to be on the regulator to
identify the pecuniary externality so that we can assess the importance
of
the market failure and the effectiveness of capital adequacy
requirements
as a solution. Financial fragility, the idea that one bank failure may
trigger others and bring down the whole financial system, would be an
example of a pecuniary externality on a very large scale. Perhaps this
is
what motivates the system of capital adequacy requirements. If so, we
need
better models of financial fragility before we can provide a theoretical
basis for the current system.
Gale's brief and optimistic conclusion merits quotation in its
entirety:
I began by noting the lack of theory in the practice of
financial
regulation. These notes have raised questions rather than answered them,
so this lacuna remains to be filled. I close with the economist's
familiar
lament that further research is needed. Our understanding of financial
institutions and their interaction with financial markets is growing and
we are near the point where we will have the tools to address questions
of
policy in a more systematic and theoretically sophisticated way. The
questions before us are fascinating in their own right and deserve to be
addressed by the brightest minds in the field.
Goodhart on Bankers and Risk
Charles Goodhart's delightful luncheon address, "Bankers and Risk",
might
well have been entitled "regulation and the law of unintended
consequences". Goodhart emphasizes, via a series of apt vignettes, that
one cannot in general reduce risk without at the same time having
deleterious implications for other social forces or functions. This
proposition may well be viewed as the mirror image of Goodhart's own law
-
that whenever authorities seek to make use of a statistical regularity
for
control purposes, that regularity will collapse.
At the level where risk, regulation, and banking interact, Goodhart
expresses surprise that "those responsible for trying to regulate
risk-taking within the banking system feel empowered to intrude upon,
and
to constrain, the chosen capital structure and base of the banking
system,
but shy away from any similar controls over the direct reward system,
bonuses, option payments, etc., for bankers". The use of subordinated
debt
to act as an early warning signal for excessive risk and, therefore, as
an
indirect constraint on bankers' risk-taking is a case in point, since
this
once-popular analytical approach is progressively attracting problems.
Much better, Goodhart argues, to act upon incentives that
directly face
bank managers. Along these lines, the appropriate lesson from Enron
might
well be "preventing ordinary workers from having their pensions
invested
in their own companies, whilst at the same time requiring that senior
managers are forced into the position of having their pension
invested in
their own company".
Goodhart also addresses a challenge emanating from the intertemporal
nature of risk. Since risk is typically "assumed" during boom times but
becomes "realized" during recessions, at a micro level it makes sense
for
capital adequacy requirements to be pro-cyclical, that is, they should
bite harder in a recession than in a boom. But from a macro or
stabilization standpoint, one would want to encourage banks to lend more
in a recession and less in a boom. One approach to reconciling these
objectives would be to ensure that risk is measured, for regulatory
purposes, over as long a period as possible so as to average over the
cycle of both good and bad times. Another of Goodhart's proposals here
is
to try to condition capital requirements on the relative growth of
lending
so that the faster a bank expands its portfolio the tighter the
requirements become.
Goodhart ends with "but fortunately, unlike regulation, luncheon
speeches
do have a closure". In this case, closure came all too quickly.
Neave and Johnson on Financial Governance and
Financial Regulation
Edwin Neave and Lewis Johnson develop a transactions-based analytical
framework for addressing governance and regulatory issues in a rapidly
evolving financial system. The authors take the financial transaction or
"deal" as their basic unit of analysis. They classify deals according to
their attributes, along a spectrum from standard/risky/liquid to
non-standard/ uncertain/illiquid. An analogous spectrum of governance
mechanisms runs from markets, to intermediaries, and to
hierarchies/internal financing, while the spectrum of governance
capabilities runs from monitoring through control (e.g., auditing), and
finally to approaches that may require ongoing adjustments to the deals.
With this taxonomy in place, Neave and Johnson then focus on
"alignment",
that is, the appropriate matching of deal attributes and governance
regimes. For example, deals that are non-standard (few in number,
uncertain, incomplete contracts) cannot be handled via decentralized
markets. Rather, they will require the expertise associated with
intermediaries or, in the most difficult cases, the degree of hands-on
management associated with internal financing arrangements like those of
financial conglomerates.
Neave and Johnson then apply this framework to mergers and
acquisitions
(M&As) to draw implications for regulation. M&As can increase either or
both of "concentration" or "convergence", where the former means
consolidation of companies within a given segment of the financial
sector
(e.g., banking) while convergence implies the combining of different
kinds
of business within the same enterprise. Because increasing concentration
will imply more or larger deals with the same attributes, it is likely
to
be a lesser regulatory challenge than a merger that increases
convergence,
since combinations of different business forms will likely generate
deals
with attribute combinations that are unfamiliar to the pre-existing
management regimes. Hence, regulators face a more challenging task when
overseeing convergence mergers. Indeed, Neave and Johnson argue that
convergence across institutional or market types may best be met by
convergence at the regulatory levels, that is, an integrated regulator
replacing the outdated regulation-by-pillar approach.
Berger et al. and the Limits to Globalization
In their paper, "To What Extent Will the Banking Industry be
Globalized? A
Study of Bank Nationality and Reach in 20 European Nations", Allen
Berger,
Qinglei Dai, Steven Ongena and David Smith (henceforth referred to as
Berger et al.) focus on over 2,000 foreign affiliates of
multinationals
and how these affiliates select a bank to handle their cash management
services (lending, deposit-taking, liquidity management, foreign
exchange). The paper, presented at the conference by David Smith,
identifies two dimensions of globalization - bank nationality and bank
reach. Nationality refers to the location of the bank's headquarters: a
host bank is located in the country where the multinational
affiliate
operates; a home bank is headquartered in the nation where the
multinational itself is headquartered; and a third-nation bank
has its
head offices in a nation other than the home or host nation. Reach
relates
to the scope and size of the bank - global banks,
local
banks that operate
in only one nation, and regional banks that have intermediate
scope and
size.
The raw data indicate that in large-banking-sector nations two-thirds
of
the foreign affiliates use host-country banks, with the remaining third
split evenly between home-country and third-country banks. However, in
the
former socialist nations (Poland, Hungary, Czech Republic), only 26% of
the firms operating there choose a host bank, with 43% of them selecting
a
third-country bank. In terms of the raw data on "reach", in
large-banking-sector nations, the foreign affiliates select local banks
only 10% of the time, while favouring global and regional banks equally
-
roughly 45% of each. The econometric analysis provides some additional
insights. Setting aside the affiliates of US firms, the estimates
indicate
that coming from a more distant home nation or one that does not share a
language with the host nation increases the probability of selecting a
host nation bank. Beyond this Berger et al. note that
firms that use host
nation banks for cash management services are
less likely to use a global bank and more likely to use a local or
regional bank. Moreover, corporations that use host nation banks also
tend
to use regional banks as they expand internationally, whereas those that
use home nation banks tend to rely on global banks as they expand. These
findings together suggest that local and regional banks may be better at
delivering concierge services [services that reflect the local market,
culture, language and regulatory conditions] than global banks, and
large
multinational corporations need more concierge services as they expand
further from their home.
The authors interpret the finding that multinationals rely on host
nation
banks with limited reach to imply that the extent of globalization may
remain limited.
Chant on Bay Street vs. Main Street
The challenge John Chant sets for himself in "Revisiting Main and Bay
Streets" is how to ensure that the Canadian banking sector remains both
domestically and internationally competitive. "Bay Street" characterizes
an internationally competitive banking system comprised of a few larger
banks that may lack vigorous domestic competition, while "Main Street"
characterizes a domestically competitive banking system that may leave
individual banks too small to compete globally. Is there a middle road?
Chant begins addressing alternative futures by focusing on avenues
other
than mergers through which banks could increase their size. Internal
growth is one route, although all the world's largest banks have relied
on
mergers for their growth. Strategic alliances are possible, but Canada's
20% ownership ceiling could be viewed as a constraint and, in any event,
alliances are few and far between in the banking sector.
Chant then turns to his preferred option: Reciprocal Entry Agreements
in
the context of a single North American banking market, especially now
that
the United States has passed legislation that allows their banks to
acquire powers similar to those available to Canadian banks. Based on
principles of the European Union banking environment, Canada would
simply
invite other countries to join in bilateral agreements for reciprocal
entry. Such a declaration would:
Among other things, reciprocal agreements should both encourage more
entry
and mean that new foreign firms may become interested in purchasing any
assets that merging Canadian banks are required to divest. Chant's
proposition could be a win-win one, leading both to bigger banks that
can
compete internationally and to a more competitive domestic financial
market.
Bancassurance: Merging Banks and
Insurance Companies
The time is surely nigh for the merger of a major bank and a major
insurance company in Canada. Because there is little Canadian evidence
as
to the likely implications of such a merger, we invited Kenneth Carow to
present his Journal of Banking and Finance paper,
"Citicorp-Travelers
Group Merger: Challenging Barriers Between Banking and Insurance". On
April 6, 1998 Citicorp and Travelers surprised the financial community
by
announcing a merger which significantly and immediately increased their
share prices (by 26% and 18% respectively). Intriguingly, there was no
legislation to allow such a cross-pillar merger: "Either federal policy
towards financial institutions needed to adapt to incorporate the
strategic vision of Citigroup (the new name of the merged firm) or
Citigroup would be forced to abandon a large portion of its global
product
strategy." In the event, Congress passed the Financial Services
Modernization Act of 1999.
Ken Carow drew on financial data from banks, life insurance
companies,
health insurance companies, and casualty insurance companies to sort out
what investors expected to gain from the removal of regulatory barriers.
The results indicate that large banks (but not small banks) and life
insurance companies experienced a significant net positive impact on
their stock prices. The fact that the other insurance companies (health
and casualty) did not exhibit negative returns suggests that this is not
a
wealth transfer from one segment of the insurance industry to another.
Among the several interpretations of these results, Carow observes
that
the former regulatory regime prevented the most efficient method of
providing financial services to the US economy and that the increased
prospects for future deregulation will allow banks and insurance
companies
to take advantage of economies of scope. "These benefits will arise from
the combined management of bank and life insurance risks, cross-product
sales revenues, and/or lower distribution costs."
Presumably Canadian mergers could generate similar gains.
Looking Forward
In lieu of a summary assessment of the conference proceedings we
invited
Charles Freedman, Tim O'Neill, and Stephen Poloz to "look forward", as
it
were, to selected implications for the financial sector and for
regulators.
Freedman on System Stability
The Bank of Canada's Charles Freedman focuses on three areas of
concerns
relating to system stability. The first relates to clearings and
settlement issues. Here, there is good news: on the payments side,
Canada's Large Value Transfer System is up and running and provides
intra-day payment certainty; the risk-control features of the
debt-clearing services of the Canadian Depository for Securities can
withstand the failure of even the largest participant; and the
Continuous
Linked Settlement Services (CLSS) system on the foreign exchange front
sharply reduces the counterparty risk.
The second relates to the prevention of financial crises. Here, Freedman
takes comfort in the increased deployment of inflation-targeting
strategies among central banks as well as from the increased use and
dissemination of codes of conduct, best practices and prudential
standards. Also important in this regard has been the striking of the
G20
group in the wake of the Asian currency crisis in order to promote both
financial transparency and financial stability for developing countries.
Among the initiatives relating to the third area - management of
financial
crises - Freedman is particularly encouraged by the IMF's "New Approach
to
Sovereign Debt Restructuring", patterned after earlier work undertaken
by
the Bank of Canada. It is built around four key features: first, changes
in national legislation would prevent creditors from disrupting
negotiations (leading to a restructuring agreement) by seeking repayment
through national courts. Second, the mechanism would have to provide
creditors with some guarantee that the debtor country would act
responsibly during the course of any standstill. Third, private lenders
would need encouragement to provide fresh money to help the debtor meet
its financing needs. Fourth, the mechanism would have to bind minority
creditors to a restructuring agreement once it has been agreed to by a
large enough majority.
Plaudits all around!
O'Neill on Three Future Challenges
Bank of Montreal's Tim O'Neill also directs his "looking forward"
comments
to three areas - the first is consolidation, where the driver here is
size/scale, but for specific product lines rather than for the
enterprise
itself. He presents data that suggest scale economies exist in areas
like
credit card issuing, discount brokerage, and mutual funds. Size or scale
of the enterprise itself becomes important if the enterprise wants to
focus on several product lines which themselves are scale-dependent.
O'Neill's second challenge relates to the "information asymmetries"
as
a
source of economic profit. The pace of the information revolution and
technology explosion is such that many erstwhile information asymmetries
(i.e., gaps in knowledge/understanding between financial services
provider
on the one hand and clients on the other) are eroding, with the result
that these financial services are becoming progressively commoditized.
Predictably, however, financial services providers will seek to create
new asymmetries, perhaps in areas such as market segmentation by
customer
type and location, improved micro analysis of pricing strategies, and
more
aggressive use of and change in branding.
O'Neill's final observation relates to information technology. The
dramatic reduction in information transactions costs in commodity-type
markets will make these markets volume-driven and contestable. However,
in
non-commodity markets, where trust and reputation are important assets,
new providers will likely have to link-up with established firms, at
least
initially.
Poloz on International Financial Intermediation
In light of Canada's remarkable export penetration, we asked Stephen
Poloz
to devote some of his commentary to international financial
intermediation
and the role of the Export Development Corporation (EDC) as a player in
this intermediation process. The riskier the foreign market a Canadian
company is selling into, or the smaller the company initiating the
transaction, the greater is the role for an intermediary like EDC for
ameliorating these risks. In 2000, EDC undertook transactions in 165
countries on behalf of Canadian companies and over 80% of its customers
were small companies.
Beyond this, Poloz sees four forces driving future change -
technology
is
facilitating larger scale; deregulation in the presence of significant
entry barriers in some markets may be leading to selective
specialization;
the events of 9/11 have served to enhance international risks; and the
trend towards the necessity of internalizing environmental and social
impacts/ risks into overall project finance which, in turn, provides
incentives for financial institutions to partner with entities like the
EDC which have expertise in these environmental/social assessments.
Poloz concludes by noting that one implication is that there will be
a
high degree of concentration in the international financial intermediary
sector - during 1994-96, roughly 40% of all global financing activity
was
done by the top five global institutions, and this rose to 54% in
2000-01.
Hence:
We appear to be headed for a world in which Canada will be
increasingly dependent on international financial intermediation for its
economic prosperity, but one in which the market for such services will
remain as imperfect as ever. Therefore, when considering regulatory
change, we should take great care not to make international financial
intermediation even more difficult or even less effective at the same
time.
* * *
We take this opportunity to express our sincerest thanks to the
authors
for their critical contributions to the success of the conference and
this
volume. We also extend our gratitude to the discussants - Robert Jones,
Ron Giammarino, Frank Mathewson, and Paul Halpern - whose contributions
follow the relevant paper. Finally, we are deeply grateful for those
institutions whose financial support made the conference possible: the
Office of the Superintendent of Financial Institutions, the National
Research Program in Financial Services and Public Policy, the Canadian
Bankers Association, and the Canadian Securities Institute.
All that now remains is for us to invite the readers to enjoy the
insightful offerings in Framing Financial Structure in an
Information
Environment.
. allow other country's banks to offer the same services
in
Canada
as Canadian banks;
. require home country authorities to look after deposit insurance
in Canada; and
. require adherence to the Basel Accord for capital-adequacy
standards.