Rethinking Financial Regulation

By Hoenig, Thomas M. | Economic Review - Federal Reserve Bank of Kansas City, Second Quarter 1996 | Go to article overview

Rethinking Financial Regulation


Hoenig, Thomas M., Economic Review - Federal Reserve Bank of Kansas City


In recent years, revolutionary changes in financial markets, combined with incidents such as Barings and Daiwa, have revived concerns about the adequacy of financial regulation. Historically, financial regulatory policy has been driven by the view that to maintain the health of the financial system you must maintain the health of individual institutions. Accordingly, if institutions are protected from failure through regulation of capital and prudential supervision, the viability of the system is ensured and the risks to the explicit or implied government safety nets that protect financial institutions are minimized. Indeed, recent discussions about how to deal with incidents such as Barings and Daiwa have centered on ways to extend the traditional safety and soundness regulation of individual institutions to incorporate an increased emphasis on risk management policies and procedures.

In light of ongoing changes in financial markets, however, extending the traditional approach to financial market regulation may not work. Extending the traditional approach may be too costly and difficult, especially for large, globally active institutions, because of the complexities of many new activities and financial instruments. Given these difficulties, it seems appropriate to ask whether there is an alternative regulatory approach to promoting financial stability and protecting government safety nets without sacrificing efficiency or stifling innovation.

My comments today are designed to provide some thoughts on possible alternatives. Two changes in emphasis to the regulatory system are discussed. First, instead of regulating to make institutions fail-safe, an alternative approach is to strengthen the stability of the financial system by designing procedures that prevent large interbank exposures in the payments system and interbank deposits. Second, although moral hazard problems can be contained through traditional regulatory approaches, an alternative is to require those institutions that engage in an expanding array of complex activities to give up direct access to government safety nets in return for reduced regulation and oversight. By further emphasizing these elements within the regulatory system over expanded micromanagement, individual institutions could be permitted to engage in new activities and sometimes to fail because financial stability would be less threatened by the failure of an individual bank-large or small, global or domestic. At the same time, the cost of protecting the safety nets would be better confined because traditional regulation would focus on traditional banks that choose to have access to the safety nets.

THE CHANGING FINANCIAL SYSTEM

In recent years, financial markets around the world have experienced significant structural changes. Some of the more important changes are the growing importance of capital markets in credit intermediation, the emergence of markets for intermediating risks, changes in the activities and risk profiles of financial institutions, and the increasingly global nature of financial intermediation. These changes have been spurred largely by a technological revolution that has reduced the costs of information gathering, processing, and transmission. As this information revolution continues, there is little doubt that the changes in financial markets will also continue.

More than ever before, banks face greater competition from other financial institutions. Many businesses are turning away from banks and other depository institutions and directly toward capital markets and nonbank intermediaries for their funding needs. In the United States, for example, banks have lost market share in the short-term lending market to commercial paper and finance company loans. Over the past 25 years, bank loans as a share of short-term debt on the books of nonfinancial corporations have fallen from about 80 percent to about 50 percent. In addition, corporations have greater access to other sources of finance, such as medium-term note facilities and junk bonds. …

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