Structuring Finance to Enhance

Economic Growth and Stability

by Douglas J. Elliott
Brookings Institution Press 2013
getAbstract 2013
Rating (10 is best)
Overall: 7
Importance: 7
Innovation: 7
Style: 6
Take-Aways
Americas regulatory response to the 2008 crisis
ignored an opportunity to rethink the purpose and
structure of the financial sector.
The finance industrys purpose should be to serve
the real economy by providing liquidity, acting as
an intermediary and managing risk.
Before the crisis, many large banks benefitted from
an implicit government guarantee.
Risk occurs when these too-big-to-fail institutions
teeter, but the failure of a significant number of
small banks can also pose a danger to the financial
system.
Capping the size of banks could lead to a reduction
in overall economic benefits.
Preventing banks from proprietary trading may not
make practical economic sense.
Regulators are exploring ring fencing to isolate
deposit taking from riskier activities.
The Volcker rule, which bans US banks from
proprietary trading, could cause them to withdraw
from securities activities.
Regulators must understand the economics of
scale and scope in the financial industry.
If banks save money when they engage in both
banking and the securities industry, restricting them
from doing so could increase costs to society.
Relevance
What You Will Learn
In this summary, you will learn:
1.) How the structure of the financial industry and its
reform are intricately related,
2.) Why breaking up large banks and restricting their
activities may not benefit the economy or society,
and
3.) Why economic experts agree on the need for more
research.
Recommendation
Governments responded symptomatically to the 2008
financial crisis and spent little time examining the
structure and rationale of the financial system and its
relationship to regulatory reform. The Economic Studies
program at the Brookings Institution brought together
experts and analysts from the US Federal Reserve
System, universities and the financial industry to discuss
fundamental issues related to the structure of finance.
Among those participating were Daniel Tarullo, a member
of the Board of Governors of the Federal Reserve System
and the leader of the Feds financial reform efforts;
Martin Baily, former chairman of the Presidents Council
of Economic Advisers; and Donald Kohn, former vice
chairman of the Federal Reserve Board. Baily and Kohn
are senior fellows at Brookings. They and other speakers
expressed a variety of opinions but all agreed on the
need for more extensive research about a range of fiscal
issues. getAbstract recommends this informed discussion
to anyone who wants an overview of the debate about the
US financial industry and its reform.
Summary
Peculiarities and Purpose
Financial industry reform in the wake of the 2008 financial
crisis has centered on preventing what went wrong then
from happening again. But that response ignores an
opportunity to ask basic questions about the proper
purpose and structure of the financial sector. It fails to
delve into what benefits finance should seek to achieve
and how society can best organize the financial industry to
achieve those goals.
The financial industry is unique in the way its fortunes
affect the broader marketplace. Its purpose should be to
serve the real economy by providing liquidity, acting as an
intermediary between savers and borrowers, and helping
to manage risk. Most experts agree that it is not necessary
for the government to support the industry for its own sake
but that this sectors proper working is critical for overall
economic growth and activity.
Though no longer practiced widely, industrial
organization (IO) the study of how industry structures
achieve specific business or social objectives could
provide important ideas on how the financial sector can
better address socioeconomic needs. Organizing finance
more effectively could lead to regulatory changes that
would promote growth and stability while safeguarding the
interests of all members of society.
For regulators to design effective laws, they must
understand the financial systems economies of scale and
scope: Large banks can be more efficient than smaller
institutions and can provide individuals, households and
businesses with a wider range of cheaper products and
services. Take the question of whether it makes sense
to restrict deposit-taking institutions from participating in
securities markets: If banks gain significant economies
from engaging in both spheres of activity, restricting
them to one or the other could impose greater costs on
the public. On the other hand, if those economies exist
because large banks operate with the unfair advantage of
implicit government support, then constraints on size and
activity would be rational remedies.
In addition, IO would deal with the unseen dynamics
of the financial industry, such as the extent of the
cooperation necessary among banks to ensure credit
and market liquidity. The financial sectors actions have
unintended ripple effects that spread throughout an
economy. These externalities are another industry
dynamic. Mark-to-market accounting forces banks to
recognize losses on assets when prices are tumbling.
Banks interconnectedness with one another, with
other institutions and with markets in general promotes
contagion: When panic occurs, fear spreads quickly
among market participants, forcing selling that pushes
markets even lower.
Societal Objectives
Some financial sector parties have lost sight of the
industrys societal responsibility. The 2008 financial crisis
revealed many transactions and financial products with no
underlying commercial value; rather, they existed only to
enrich the participants. Yet it is hard to judge where value
ends and speculation begins: Virtually all speculative
transactions have at least the theoretical advantage of
increasing liquidity in markets by raising the volume and
frequency of activity.
Whether any single speculative deals ability to improve
market liquidity was worth the risk it brought to its
participants and to the marketplace is unknowable. What
is evident, however, is that individuals who transact for
their own gain eventually join with other participants
to produce an overall good for society, a concept that
goes back at least as far as Adam Smith. But if the
industrys structure promotes speculation at the expense
of economic stability, regulators and industry experts need
to investigate and change whats wrong with finance.
More Questions than Answers
Measuring the issues that affect financial institutions and
their impacts on the economy is mostly conjecture; for
instance, even experts have no way to determine how big
or how integrated financial firms need to be. For now, the
field lacks empirical evidence that proves the need for a
rigorous reworking of the financial industry. However, more
research that incorporates an IO emphasis could begin
to address what kind of and how much banking reform is
most effective.
Other issues that require further study include the question
of whether it makes sense to divide firms according to
their lines of business, and how reducing the size of larger
financial institutions would affect smaller ones. When
economists discuss financial sector structural reform, they
differ on whether banks are too big, but none think theyre
too small, although, in relative terms, banking in the US is
significantly smaller than in Europe and Japan.
Large banks contribute significant economic advantages.
A study by the Clearing House Association, an industry
body, suggests that big banks create national benefits
of between $50 billion to $110 billion annually through
economies of scale, product offerings and financial
innovation. A Federal Reserve Bank of St. Louis study
points out that capping the size of banks at $1 trillion, a
relatively high level, could lead to a reduction of $79 billion
in overall economic benefits.
But other experts argue that finance plays too big a role
in the modern economy. The number of global banking
positions more than tripled from 2000 to 2008. Some
studies point out that economic efficiency declines
with rapid financial growth and high levels of financial
activity. And new research also suggests that rapid
growth in financial intermediation is correlated with slower
productivity growth in the wider economy.
Too Big to Fail
Certain financial service activities for instance, deposit
taking are so vital to the future of the economy that
the government should protect them with guarantees
or a safety net. Firms and households need a place to
deposit their money safely without fearing bank insolvency.
That is why the Federal Reserve expanded its safety net
to include money market mutual funds during the 2008
crisis: Even though these funds are neither regulated nor
protected as deposit-taking institutions, consumers use
them like banks.
In the period leading up to the financial crisis, large
banks profited from the view that the federal government
implicitly guaranteed them against failure. Without that
implied faith, these too-big-to-fail institutions would not
have been able to borrow or would have had to borrow at
higher interest rates. But estimating the monetary value to
banks of such guarantees is impossible.
Debate continues on whether post-crisis financial reforms
and regulations, such as the Dodd-Frank Act, could
make government bailouts unnecessary. Title II of Dodd-
Frank authorizes the creation of an orderly liquidation
mechanism for systemically important financial
institutions. But Dodd-Frank might not go far enough.
Under pressure from the finance industry, legislators have
not addressed many of the core issues at the heart of the
crisis.
Because deposit-taking institutions might misuse the
advantages of a safety net, arguments abound for
breaking up the largest banks, through either compulsory
restrictions or a system of incentives that would encourage
massive institutions to shrink. Those who contest this
assertion say that supporters of disassembling big banks
often exaggerate its benefits, and contend that even if
larger banks had broken into 20 smaller pieces before
the financial crisis, the smaller units could have made the
same mistakes and incurred similar risks and failures.
The public presumes that letting smaller financial
institutions fail poses fewer risks for the system than
allowing large ones to collapse. History shows this may
not be true. Government policy makers may decide
that bailing out a significant number of small institutions
is necessary, even at considerable cost to taxpayers,
because their group failure presents a threat to the overall
security of the financial system, as demonstrated in the
US savings and loan crisis.
Limits
To mitigate the too-big-to-fail risk and keep the system
from crashing all at once, government policy makers
should focus on practical ways of limiting banks
interdependence on each other. Dodd-Frank regulations
stipulate and some Fed initiatives propose that banks
with assets of more than $500 billion (the largest banks)
should set limits on the exposure they have to each other
and to the rest of the financial sector. These Single
Counterparty Credit Limits (SCCLs) must balance efforts
to reduce the contagion risks against stifling useful
market activities.
Many proposals for restructuring the financial industry
suggest that regulators should prevent banking companies
from participating in the securities market or, at the very
minimum, restrict the scope of their activities. After the
Great Depression, the US Congress passed the Glass-
Steagall Act that forbade deposit-taking institutions from
conducting securities transactions, thereby removing the
conflict of interest that many then assumed was one of
the causes of the 1930s crisis. Some economic historians
today dispute that claim, and experts question whether the
simplistic remedy of limiting banks activities makes any
economic sense.
Ring Fencing
Constraining banks to conduct certain activities, like
deposit taking or derivatives trading, in separate legal
vehicles essentially shields federally insured deposits and
bank depositors from the losses or failures arising from
other riskier bank business. This ring fencing still exists in
the US, which never wholly repealed the Glass-Steagall
Act; instead, Congress revoked Glass-Steagall provisions
that prevented commercial banks from associating with
securities dealers under the same holding companys
control. The law still precludes deposit-taking banks from
engaging in securities activity, although their subsidiaries
can do so. Stringent rules govern the interactions between
the deposit-taking function and the securities affiliates of
bank holding companies.
In Europe, two regulatory initiatives are attempting to deal
with these issues of safety through ring fencing. In the UK,
the Independent Commission on Banking, also called the
Vickers Commission, proposed to ring fence banks core
deposit taking from their other financial activities.
The European Commissions High Level Expert Group
suggests that all securities trading whether proprietary
trading or the market-making activities necessary to
handle client needs should occur outside the ring-
fenced deposit taker, an admission that regulators cant
easily distinguish between proprietary trading and market-
making activities.
Part of the Dodd-Frank Act includes the Volcker Rule,
which abolishes proprietary trading by banks and their
affiliates. But commercial banks are central to US
financial markets, and loans and credit are synergistically
related to underwriting securities. Regulatory confusion
could lessen the liquidity that enables markets to provide
companies with well-priced equity and debt. Many
experts worry that strict adherence to the Volcker Rule
could cause market inefficiencies if large commercial
banks were to withdraw from market-making activities.
In addition, derivatives have become central to the risk
management practices of firms, financial institutions and
markets, so disentangling what are client-initiated trades
from bank proprietary trading is difficult, to say the least.
Finally, if regulations were to compel large commercial
banks to withdraw from securities activities or restrict their
involvement in these activities, the government should
provide a period of transition to allow smaller firms to
develop the necessary culture, risk management systems
and counterparties to expand their trading.
About the Author
Douglas J. Elliott is a fellow in economic studies at the
Brookings Institution, a nonprofit public policy organization
based in Washington, DC.