Financial Innovations and the Supervision of Financial Institutions

Article excerpt

The nation's central banker assesses innovations in banking in the context of their effect on supervision. He discusses the blurring of distinctions between financial intermediaries, legislative reform, functional regulation, risk management, and the potential for some type of umbrella supervision.

Innovations in data processing and telecommunications, advances in the science and art of risk measurement and management, the increasing globalization of financial markets, and deregulation at home and abroad have permitted and encouraged a blossoming of new financial products and activities. As a result of these changes, competition in the financial services industry has increased greatly, and millions of consumers of such services have been made better off. But the industry also has witnessed some spectacular failures, such as the collapse of Barings Bank and the financial crisis in Orange County, in which some of the new financial instruments have played highly visible roles.

I do not wish to downplay the controversies generated by these new instruments and activities. But in debates about the specifics, bankers often tend to lose sight of the larger picture. Thus, I intend to focus on four major implications of these new developments in financial markets:

1. Financial innovations have not changed the substance of banking. The core functions of banking remain the measurement, acceptance, and management of risk.

2. A critical result of the recent innovations is further blurring of distinctions between traditional forms of financial intermediaries, such as commercial banks, investment banks, insurance companies, and specialized finance companies.

3. With the blurring of distinctions between financial intermediaries, repeal of the Glass-Steagall Act, at least insofar as such repeal-permitted mergers between largely financial businesses, would not be a major innovation in itself. Rather, such legislation would constitute a recognition of evolving market reality, much as was true of the recent repeal of federal restrictions on interstate banking and branching.

4. On the assumption that Glass-Steagall will continue to be "repealed" by the marketplace and will be repealed by the Congress, a critical issue for supervisors is how to achieve ongoing and unchanged supervisory goals in an increasingly complex financial world, especially a world in which it is more and more difficult to make distinctions based on the functions of particular financial entities.

Blurring of Distinctions Between Financial Intermediaries

Last year, I argued that a crucial difference between the banks of today and those of the not too distant past is that risk information processing now lies closer to the core of the banking business. Yet the computer-driven risk management activities of today's banks do not differ in purpose from those of earlier banks. Then, credit officers made less formalized but equally critical judgments, and portfolio managers had far fewer types of financial instruments in which to invest and did so with less rigorous analysis. In substance, banks have always been measuring, taking, and managing risk.

I want to push this point a little further and argue that it is becoming increasingly difficult to distinguish the core functions of banking from the core functions of other financial intermediaries. Each of the various "types" of financial firms increasingly engages in activities traditionally the province of the others. And each of these types of financial businesses has as its core functions the measurement, acceptance, and management of risk.

Examples abound that demonstrate this blurring of distinctions. For instance, the economics of a typical loan syndication, including the types of risks inherent in such a syndication, do not differ essentially from the economics of a best-efforts securities underwriting. The expertise required to manage prudently the writing of over-the-counter derivatives is similar to that required for using exchange-traded futures and options. …