Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Choices in Banking Policy

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Choices in Banking Policy

Article excerpt

It is a great pleasure to have the opportunity to meet all of you and to share with you some of my thoughts on issues related to banking--what I like to refer to as "banking policy" as distinct from monetary policy. When I first joined the Federal Reserve way back in 1970, I did research on banking issues, and in fact my doctoral thesis had to do with banking policy. As time passed I was drawn ever more heavily into the monetary policy area. But I have never lost interest in banking issues, and my new role at our Bank obviously gives me ample reason, to put it gently, once again to give this broad and challenging area a very high priority in my personal work schedule.

My remarks this afternoon will summarize some of the conclusions I've reached regarding major issues currently facing banks, bankers, and regulators. First, I will say a little about the efficiency of bank regulation as it exists today, how it should be evaluated, and how it might be improved. Second, I will look at some of the trade-offs between the regulatory burden we'd all like to reduce, on the one hand, and the scope of the federal safety net, on the other. Finally, I will comment briefly on consumer and community reinvestment issues, which are receiving especially intense attention presently.

I begin with the fundamental idea that financial system arrangements are generally most efficient if left to private choice. This is merely a corollary to the well-known presumption in favor of unfettered competition in unconstrained markets. The unique characteristics of banking and finance sometimes cause people to lose sight of the applicability of this principle to these industries, but the extraordinary recent innovations in banking and financial markets should convince skeptics of the power of a competitive financial system, given the chance, to seek and find the most cost-effective means of intermediating between borrowers and lenders.


Banking is one of the most heavily regulated of all industries. To determine the principles that ought to guide the design of banking regulation, we need first to ask why that regulation exists.

In my view, the strongest rationale for bank regulation derives from federal deposit insurance, discount window lending, and the Fed's involvement in the payments system. Together, these three activities are often referred to as the "federal safety net," but I find it most useful to think of them as credit enhancements provided by the federal government to the banking system. Deposit insurance is a third-party guaranty, analogous to standby letters of credit, private mortgage insurance, and other forms of credit insurance. Discount window lending is similar in many respects to a collateralized line of credit, and the credit extension inherent in the Fed's participation in the payments system is basically a clearinghouse overdraft facility.

Private providers of similar credit enhancements generally restrict the portfolio choice and risk-taking activities of recipients, since they recognize that third-party commitments often give rise to problems of "moral hazard"--to use a term coined in the insurance industry--which refers to the tendency of insured entities to take greater risks than they otherwise would. So, too, I think most people would agree that the government needs to constrain the portfolio choice and risk-taking activities of banks in order to protect the federal safety net from moral hazard.

A key point here, however, is that competition among private credit enhancement providers forces them to minimize the burden of the restrictions they impose. If one provider offers a guaranty with significantly more restrictive covenants than competitors offering the same guaranty, business is likely to be slow. On the other hand, a provider offering a guaranty with insufficient restrictions on borrower activity is likely to lose money steadily over time due to excessive risk taking by its customers. …

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