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Does Bank Regulation Help Bank Customers? Based on a Speech Given by President Santomero to the Frontiers in Services Conference, Bethesda, MD, October 26, 2001

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Does Bank Regulation Help Bank Customers? Based on a Speech Given by President Santomero to the Frontiers in Services Conference, Bethesda, MD, October 26, 2001 Does Bank Regulation Help Bank Customers? Based on a speech given by President Santomero to the Frontiers in Services Conference, Bethesda, MD, October 26, 2001 BY ANTHONY M. SANTOMERO he answer to the question posed in the title taste, he could take his deposit elsewhere. is yes, no, and maybe, according to President The reality, of course, is T Santomero. Yes: the government must absorb considerably different. Depositors some of the risks inherent in the banking cannot assess the risks in the bank’s loan portfolio very easily, since banks devote system in order to maintain the system’s stability. No: time and resources to developing an regulations that ignore the self-interested reactions of intimate understanding of the risk both bankers and their customers will not serve those characteristics of a particular lending opportunity. The assets banks put on customers well. And maybe: bank regulations, in their books reflect their case-by-case principle, can help if they increase competition or the judgments. Since depositors cannot see flow of information. In practice, however, some their bank’s risk profile clearly, they cannot accurately assess the risk to regulations designed to improve the quality of which their deposits are exposed. This information have met with mixed success. President uncertainty creates the potential for Santomero suggests that focusing on improving both instability in the banking system. A banking panic is the classic financial literacy and information disclosure might be manifestation of this instability. Some more productive. event, real or imagined, convinces depositors that their bank cannot meet its obligations to all of them, and so they Since becoming a central the risks in their portfolios and that they rush to the bank to get their money banker, I have been considering the maintain adequate capital against back before the bank fails. Of course, question: “Does bank regulation help unforeseen contingencies are part of a depositors at other banks are also bank customers?” As a long-time government infrastructure designed to economist, my answer is: “Sometimes bring stability to the overall financial yes. Sometimes no. It all depends.” system. For the U.S. banking sector, this infrastructure has evolved over the last BANKS CANNOT SERVE THEIR century. It includes prudential regu- CUSTOMERS WITHOUT SOME lation along with FDIC deposit insur- REGULATION ance, the Fed’s discount window, and One way in which bank the Fed’s bank-to-bank payment system, regulation and the associated process of called Fedwire. Each piece is necessary supervisory oversight help customers is to ensure a stable banking system. by keeping the banking system stable. The core business of a bank is At the most basic level, stability means to take in deposits and make loans. that banks can provide a safe place to Theoretically, depositors could look at make deposits, and one that gives ready the bank’s balance sheet, assess the and reliable access to them when riskiness of the loans and securities out- needed. standing, and determine the overall Bank regulations focused on riskiness of the institution. If the risk Anthony M. Santomero, President, ensuring that banks prudently manage level were too high for a depositor’s Federal Reserve Bank of Philadelphia www.phil.frb.org Business Review Q2 2002 1 uncertain about risk exposure of their stability into the banking system, despite to make a payment it owes to Bank C, deposits. The depositors at another depositors’ inevitable uncertainties about and so on. Again, problems at one bank institution observe the activity at the the risk profile of their bank. become contagious, and the entire troubled bank, which increases the Banks’ role in the payment banking system fails to deliver the basic uncertainty they have about their own system is a second feature of the bank- payments services its customers count institution. So, the run at one bank ing business that creates the potential for on. Worse, if the payments are large could easily upend their confidence in instability. Banks routinely make enough, the liquidity or solvency of the their bank. Thus, the run becomes payments for their depositors. Indeed, entire financial system is at risk. contagious, setting off a genuine banking panic. Through a combination of deposit insurance We think of banking panics as and bank regulation, the government has a thing of the past. You have to go back to the Great Depression to find a introduced greater stability into the banking banking panic in the United States. system, despite depositors’ inevitable One important reason is that, at that uncertainties about the risk profile of their time, the federal government created the FDIC insurance program to protect bank. the average depositor from losses, most consumers keep a bank account The Federal Reserve uses two regardless of the fate of his or her bank. primarily so that they can write checks, devices to contain the systemic risk Deposit insurance has been make and receive electronic payments, created by banks’ role in the payments proven successful, not only by the track and get cash to make purchases. system. First, the Fed guarantees that all record of the banking system in the U.S. But this role for banks creates a Fedwire payments are final. That is, if since its introduction but also by the fact strong interdependence among them, the Fed moves funds from Bank A’s that the governments of most industri- and because of this interdependence, a account into Bank B’s during the course alized countries have adopted deposit problem at one institution can quickly of the day, the Fed will not rescind that insurance schemes of one type or put the entire banking system at risk. A payment, even if Bank A is insolvent at another. In fact, explicit deposit insur- simple example will make the point. A the end of the day. Second, the Fed ance is required for all countries seeking check written by one of entry into the European Union. Bank A’s customers is Government insurance for the presented to Bank A by individual depositor eliminates one Bank B. Normally, Bank A potential source of instability to the pays Bank B by transferring banking system, but it creates another funds from its account at one. It gives banks the incentive to the Fed to Bank B’s overload their portfolios with risky assets. account at the Fed. It does Insured depositors do not bear any of the this over Fedwire, the Fed’s risk the bank takes on, so they don’t electronic payment demand a risk premium in the interest network for banks. rate they are paid on their deposits. And However, suppose since equity holders face limited liability, Bank A has insufficient they don’t bear the downside risk when funds in its Fed account. the bank takes a chance on a high- This could happen for any return, high-risk asset. number of reasons, from a With the natural market mismatch of inflows and mechanism disabled, the government outflows during the course must introduce its own regulation and of a busy day to an opera- supervision of banks to ensure that they tions disruption, as hap- are properly limiting their risk exposure. pened at some New York In short, through a combination of banks on September 11. If deposit insurance and bank regulation, Bank A cannot pay Bank the government has introduced greater B, Bank B may not be able 2 Q2 2002 Business Review www.phil.frb.org makes discount window loans available DO BANK CUSTOMERS NEED middle ground. Legislation passed in the to otherwise healthy banks that have SPECIAL PROTECTION? 1930s made banking arguably the most insufficient funds and no place else to So, we might pose the heavily regulated industry in the United borrow them at the end of the day. This following question. Suppose the banking States. Gradually, we have been dis- prevents our hypothetical Bank A from industry is operating with government- mantling the unnecessary, burdensome, closing out the day insolvent. provided deposit insurance, payments and even counterproductive regulations Serving as a guarantor of guarantees, and lending facilities. that have thwarted the legitimate payments and lender of last resort Further suppose that supervisory and workings of the marketplace. At the contains one threat to the stability of the regulatory mechanisms are in place to same time, we have been trying to banking system, but like deposit manage the risk exposures that these devise regulations to eliminate the insurance, it also creates the incentive programs create. Finally, suppose that genuine flaws in the marketplace that for individual banks to take on too within this environment, banks are free create opportunities for exploitation or much risk. Banks know that if, at the to offer any financial service, serve any abuse. end of the day, a bank does not have market segment, and charge any price. sufficient funds to make its payments, Would a “free market” serve bank ELIMINATING DYSFUNCTIONAL the Fed will step in and provide the customers’ interests best, or would such REGULATIONS necessary funds. So, banks do not a marketplace be inimical to the However, this middle ground is concern themselves as much as they interests of bank customers? hard to find and harder to tread. But we should about their reserve position or the This is not an easy question to can find some lessons in the mistakes positions of the banks from which they answer. Today, most people would lean and successes of the past. Perhaps the are collecting payments. toward the first view. Given that the clearest is that regulators can achieve Again, with marketplace market for financial services is an their goals only if they respect the power oversight of risks neutralized, bank intensely competitive one, banks have of the marketplace.
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