Safety and Soundness of Financial Intermediaries: Capital Requirements, Deposit Insurance, and Monetary Policy

By Kopcke, Richard W. | New England Economic Review, November-December 1995 | Go to article overview

Safety and Soundness of Financial Intermediaries: Capital Requirements, Deposit Insurance, and Monetary Policy


Kopcke, Richard W., New England Economic Review


More than two-thirds of the $25 trillion of financial assets held in the United States is managed on behalf of investors by financial intermediaries, ranging from trusts, mutual funds, and mortgage pools to insurance companies, pension funds, and banks. Since the inception of financial markets in industrial economies, savers have entrusted much of their wealth to intermediaries that, in turn, finance the projects of investors. Because of their importance, governments have long regulated the activities of these intermediaries to ensure sound financial markets, a foundation of secure economic development. The form of this regulation has changed often over the centuries as intermediaries and financial markets have changed with economic conditions and the demands placed on them. Currently, regulators both here and abroad are considering reforms that not only might foster more efficient domestic financial markets but also might prepare the way for more equitable global markets.

The current discussions, like those past, engage views of financial markets that are often difficult to reconcile. Some, who believe that these markets potentially are relatively efficient, advocate minimal interference. Regulations that require more than the necessary disclosure of investments and risks might introduce burdens that exceed their benefits. Others, who believe that the prominence of intermediaries reflects the limits of savers' information, advocate regulations to insure the safety and soundness of intermediaries. At the very least, regulations may diminish the force of "credit cycles" and the threat of widespread insolvency among intermediaries.

The first section of this article considers the role of financial intermediaries within competitive financial markets wherein all investors view the prospects for each asset much the same. In these circumstances, the prices of assets and the allocation of resources do not depend greatly on the activities of intermediaries. Accordingly, the regulation of these intermediaries does not diminish the risks that fully informed investors are willing and able to assume. At worst, regulations such as mispriced deposit insurance or various taxes, which force intermediaries to price risk and returns differently than other investors, would influence the volume and form of intermediation, but they would little disturb the uniform pricing of assets and risks.

The second section reconsiders the role of financial intermediaries when not all investors are fully informed about the prospective returns on all assets. In this case, the activities of intermediaries can influence both the prices of assets and the volume of investment. Intermediaries that enjoy the confidence of savers foster more efficient financial markets by acquiring and managing proprietary information about assets that are not very familiar in public markets. Intermediaries' cost of funds rises with their leverage, in these circumstances, and this cost rises most slowly for those with the best reputations. If savers' confidence in intermediaries' investments varies with business conditions, financial institutions may be "fragile" and markets may be prone to occasional "crunches."

The third section discusses the role of regulation when not all investors are fully informed. When the cost of funds for intermediaries depends on savers' state of confidence, public policy can influence the risk premiums embedded in credit market yields by designing capital requirements, accounting rules, and liability insurance coverage in order to foster the prudent valuation of assets and the efficient flow of funds from savers to investors. Because the consequences of these regulations vary with economic conditions, the actions of regulators, like those of the monetary authority, may need to adjust with circumstances, so that they shift returns and risks during business cycles in ways that dampen, rather than exaggerate, attendant credit cycles. …

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