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. regulators and supervisors must step in to ensure that banks are properly limiting There are clear-cut cases of bank regulations their risk positions. Therefore, it takes a combination of serving as payments that failed to achieve their intended goals. guarantor, lender of last resort, and bank regulator for the government to bring There are clear-cut cases of greater stability to the banking system, strong incentives to deliver at fair prices bank regulations that failed to achieve despite banks’ interdependence in a broad array of products and services their intended goals because regulators payments. that effectively meet the needs of their failed to take into account the market So, yes, bank regulation does diverse customer base. forces at work and the capacity of help bank customers — and in a way Historically, most people, bankers, and occasionally consumers, to that one does not always think about — including researchers, politicians, and innovate around a regulatory barrier by helping to ensure the stability of the policymakers, were not always of this when it is in their interest. banking system. opinion. During the1930s, in the midst Attempts to regulate market A stable banking system of the Great Depression, people leaned prices — or, in the case of banking, benefits more than just bank customers heavily in the other direction. The market interest rates — offer an — it is an essential element of a strong thinking was that there existed instructive example. Under Regulation economy. It helps gather people’s savings substantial need for rules and regula- Q, the Fed was authorized to set ceilings and channel them to the most produc- tions to protect bank customers from the on the interest rates that banks paid on tive investment opportunities available. unbridled workings of the marketplace, their deposits. The intention was to That kind of investment in new which included both monopoly and supply banks with funds at relatively low equipment and new technologies is an customer exploitation. cost and thereby hold down interest essential engine of growth and rising As you might imagine, the rates on bank loans, particularly standards of living. Indeed, improving truth lies somewhere in between these residential mortgages. But in the 1970s overall economic performance is govern- two views. Indeed, the history of market interest rates on other savings ment’s ultimate purpose in building the banking legislation and the regulation of instruments rose above the Reg Q banking infrastructure that it has over banks over the past 75 years has been ceilings, and the result was a reduced the past century. essentially a story about finding that supply of funds to banks and a harder www.phil.frb.org Business Review Q2 2002 3 time for mortgage borrowers. Savers This process of deregulation For any market to function withdrew their bank deposits to buy brought positive results. It intensified properly, those buying the good or higher yielding assets. Meanwhile, competition among banks, inducing service must fully understand their potential mortgage borrowers found them to expand product offerings, choices, what they are buying, and what their options reduced and their local increase efficiency, align prices with they are not. In the marketplace for bank in dire financial straits. production costs, and improve service to financial services, this is a challenge. Not long after, some state their target customers. Financial products and services have banking regulators tried to impose usury Recently, the string of pro- many complex features, and innovative ceilings, or interest rate caps, on market legislation culminated in the financial firms armed with the latest in consumer credit, including installment passage of the Gramm-Leach-Bliley Act, information technology are creating loans and credit cards issued by banks also known as the Financial Modern- more sophisticated products and services operating in their jurisdictions. The ization Act of 1999. This act repeals the all the time. intention was to make credit available to long-standing Glass-Steagall Act of 1933 To help consumers make more state residents at lower interest rates. that had prohibited banks from affili- informed choices, regulators have However, the providers of consumer ating with securities firms and insurance pushed for greater clarity in loan credit skirted the regulation. They companies. Under Gramm-Leach-Bliley, documents and financial disclosure simply ceased issuing credit in those banks, insurance companies, securities statements. The first step was to states and moved to states where usury firms, and other financial institutions standardize the information on ceilings were not in force. The financial can affiliate under common ownership disclosure forms. Truth-in-Lending and activity in Delaware is a testimony to and offer their customers a complete Truth-in-Saving regulations are two banks’ ability to shift operations to more range of financial services. classic examples. friendly terrain. Delaware is now home The ultimate impact of Truth-in-Lending establishes a to nearly half the credit cards issued in Gramm-Leach-Bliley is yet to be standard formula that lenders must the U.S. realized. Will people want one-stop follow in disclosing the interest rates and As these attempts to regulate shopping for financial services at a fees they will charge on a particular market prices and other examples of financial “supermarket”? Or do they loan. The regulators’ aim is to give restrictions on product features, prefer shopping in a financial services consumers the information they need to organizational structure, or market “mall,” purchasing services from a do some “comparison shopping” when geography show, regulation will not variety of different specialized providers? they look for a loan. Truth-in-Saving deliver the intended result unless that With the presence of both big institu- does the same thing for investment result serves the interests of those on tions and niche players, people have a products. both sides of the market: bankers and choice. Probably, both types of institu- Have these regulations their customers. tions will do well because consumers’ worked? The fact is that the required Over the past 20 years, in tastes and preferences are not uniform. disclosure forms have been attacked particular, we have acted vigorously to The virtue of the current structure is from both sides. Lenders claim the remove the rules and regulations that that the mix of suppliers in the financial disclosure statements are expensive to stifle competition and innovation. The services industry will be determined by produce. Consumer advocates argue Depository Institutions Deregulation consumer preferences. that they are imprecise and difficult to and Monetary Control Act of 1980 understand. Both sides have valid eliminated many restrictions on banks’ DEVISING REGULATION THAT points, but these are issues about pricing and product offerings. Next, OVERCOMES MARKET particulars. Such disclosures are steps in limitations on banks’ market area were FAILURES the right direction, and regulators set aside. The Garn-St. Germain Act of This is not to say that the should work to refine and improve 1982 allowed bank holding companies banking marketplace functions perfectly them. headquartered in one state to acquire and there is no need for regulations But we must go beyond banks in other states. The Riegle-Neal aimed at helping bank customers. improved disclosure statements for the Interstate Banking and Branching Regulators’ primary focus today has banking marketplace to function Efficiency Act of 1994 permitted banks shifted away from product and price smoothly and deliver maximum benefit headquartered in one state to open restrictions and toward improving the to all its potential customers. We must branches in other states if permitted by quality of market information available build consumers’ understanding of the state law. to consumers. workings of the financial system so that

4 Q2 2002 Business Review www.phil.frb.org their level of financial literacy is com- has been established. The initial services offered today, but it is an mensurate with the sophistication of impetus, which came from legislators’ exceptionally daunting challenge for today’s financial marketplace. and regulators’ imperative that banks those with limited financial experience In the burgeoning subprime expand access to credit, was largely or education to make such decisions. lending market, where concerns about successful. In addition, low-income people predatory lending have sprung up, we usually have limited access to long-term see some momentum toward increasing PREDATORY LENDING credit and can ill-afford to keep money financial literacy today. But along with these positive on hand. Consequently, they are recep- developments in subprime lending have tive to a sales pitch offering upfront cash REGULATION AND DEREGULA- come alarming incidents of abusive and a long payback period. And when TION GIVE RISE TO SUBPRIME practices by some lenders operating in an unexpected expense comes along, LENDING MARKET that market. These practices — often the need for immediate cash makes While the subprime lending targeted at elderly women and them easy prey for the predatory lender. market is relatively new, it has had a minorities — are commonly referred to I want to reiterate that fairly long gestation period. When the as predatory lending. subprime lending is by no means banking marketplace was heavily synonymous with predatory lending. regulated, banks allocated consumer Clearly, the best way Subprime loans carry a higher interest credit sparingly. Good or “prime” to eliminate predatory rate because they carry a higher risk of borrowers received credit; others did default. This makes perfect sense in a not. In the early 1970s, legislators and lending is to eliminate competitive market where expected loss regulators wanted to ensure that banks the information asym- and risk determine price. Predatory provided equal access to credit for all loans carry disproportionately high segments of their market area, including metry that gives rise interest rates or onerous terms not low- and moderate-income commun- to it. justified by higher risk. Rather, these ities. The Community Reinvestment rates or terms are imposed by lenders Act and associated regulations As the competition drove willing to exploit a borrower’s lack of encouraged banks to target bankable banks and other lenders to expand the financial knowledge, market access, or assets in these previously untapped subprime market, credit was made economic resources. market segments, essentially extending available to more people relatively It is important for regulators to credit availability down-market. unfamiliar with the financial make this distinction because we want Lending volumes grew rapidly in this marketplace. As research done by to put an end to predatory lending area, and bankers became more familiar groups like The Reinvestment Fund in without otherwise impeding the with the lending opportunities available. Philadelphia shows, the sad truth is that workings of the subprime lending Initially, banks were able to some unethical lenders take unfair market. How do we accomplish this? charge high interest rates to these new advantage of the situation, exploiting Tempting as it may seem, I borrowers. But, in recent years, as customers’ naivete and convincing them doubt that the solution lies in imposing deregulation and innovation have to take on mortgages with onerous, and interest rate ceilings or outlawing certain intensified competition among banks often unrealistic, terms, charging terms on loans, given our previous and other financial service providers, excessive fees or exorbitant interest experience with interest rate ceilings. those interest rates have declined rates, rolling in hidden costs or unneces- Our intention would be to get better substantially. sary insurance, or simply committing terms for victims of predatory lending. This is not to say that the outright fraud. Instead, we would likely shrink the pool interest rates on subprime loans were The root cause of predatory of funds now available to high-risk, low- driven to equality with the rate on prime lending is, of course, the differential income consumers in the subprime loans. However, the interest rates banks level of knowledge between the lender lending market. And the victims of charged and the amounts they were and borrower — an extreme case of predatory lending would likely be no willing to lend to subprime borrowers what economists call “information better off — their economic and reflected a reasonable assessment of the asymmetry.” It is difficult enough for financial circumstances would not higher loss rates and differential risk mainstream customers to understand change. involved. In short, a reasonably well and choose wisely from among the Clearly, the best way to functioning subprime lending market many complex financial products and eliminate predatory lending is to www.phil.frb.org Business Review Q2 2002 5 eliminate the information asymmetry the need for greater financial literacy tions of market participants — both that gives rise to it. Consumers who extends well beyond that of low-income bankers and bank customers — will not understand basic personal finance, are people or other relative neophytes to the serve bank customers or achieve any willing to explore their options, and financial marketplace. People generally other regulatory goal. At best they will know how to exercise their contract know relatively little about the financial have no effect; at worst they will rights are less likely to be victimized. marketplace. Even regular consumers of produce unintended and deleterious Efforts to advance financial various financial services do not really consequences. literacy are booming. In Philadelphia, for understand the costs and benefits of Finally, in some cases, my example, the Neighborhood their choices. answer is maybe. In principle, bank Reinvestment Corporation, a publicly regulations can help bank customers if funded organization with a solid CONCLUSION they increase the degree of competition reputation for its community informa- Let me conclude by returning or the flow of information in the tion and counseling programs, is starting to the question with which I began: marketplace and thus drive suppliers to on a new project to educate low-income Does bank regulation help bank do a better job of meeting their people about home mortgages. customers? In some cases, my answer is a customers’ demands. But in practice, Meanwhile, at the national level, the clear yes, though perhaps not in the way regulations designed to improve the American Bankers Association has one might at first think. For the nation quality of information, such as Truth-in- formed a working group to educate to have a sound and stable banking Lending or Truth-in-Saving, have met bankers and community leaders about system, the government must absorb with mixed success at best. predatory lending. some of the risks inherent in the system. Recent developments in the We at the Federal Reserve are In the United States, the government subprime lending market, particularly doing our part to foster greater financial does so by serving as deposit insurer, the egregious episodes of predatory literacy by providing materials and payment guarantor, and lender of last lending, deserve regulators’ serious supporting local efforts through our resort. Having absorbed these risks, the attention. I believe that the most Community and Consumer Affairs government must regulate and supervise effective and lasting solution to this Department. The Fed continues to banks to ensure they do not introduce problem lies not in regulation but in pursue basic research into the financial new ones. So bank regulation is part and education. Given today’s fast-growing, behavior of consumers at all income parcel of having the sound and stable complex, and sophisticated financial levels, so that we can better understand banking system that bank customers in marketplace, raising the general level of how and why they use the financial the U.S. enjoy. financial literacy among consumers may system as they do. In other cases, my answer is a be a more productive use of public My reading of the evidence clear no. Regulations that do not take resources than any new regulatory from Fed research and elsewhere is that into account the self-interested reac- initiative. BR

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