Financial Update (Second Quarter 2007)

Conference Presents 20 Years' Perspective on Safe and Sound Banking

Economic Review cover"Banking is now, and has always been, a risky business." This cautionary statement was the first sentence of the executive summary of Perspectives on Safe and Sound Banking: Past, Present, and Future, a book written in 1986, when the U.S. economy was suffering some turbulence and the bank regulatory framework was showing signs of strain. The book's five authors were commissioned by the American Bankers Association to assess and recommend policy options to improve the banking system's efficiency, performance, and safety. The five academic consultants came to a consensus on policy options and recommendations, which have in many ways served as a blueprint for the changes in banking's regulatory framework that have occurred in the 20 years since the book's publication.

A conference last year titled "Safe and Sound Banking: Past, Present, and Future," cosponsored by the Federal Reserve Banks of Atlanta and San Francisco and the founding editors of the Journal of Financial Services Research, paid homage to this seminal work. The purpose of the conference was to evaluate whether—and how—the 1986 report's recommendationshave been implemented, to assess the current state of the banking industry, and to update the menu of recommendations to address the challenges confronting banking during the coming years.

A recent issue of the Atlanta Fed's Economic Review presents the conference papers, commentaries, and discussions, which represent the views of experts, including the five economists who wrote the 1986 report.

Q1/Q2 Economic Review: A Special Focus on Safe and Sound Banking: Past, Present, and Future
Conference agenda: "Safe and Sound Banking: Past, Present, and Future" off-site image
Perspectives on Safe and Sound Banking: Past, Present, and Future off-site image
Federal Reserve Staff Study: Improving Public Disclosure in Banking off-site image pdf document
Basel II: Revised international capital framework off-site image

Looking at the road traveled
The paper by Frederick Furlong and Simon Kwan focuses on the principal recommendations made in Perspectives on Safe and Sound Banking and then discusses and analyzes subsequent related developments. Furlong and Kwan note that several of the legislative initiatives and bank regulatory and supervisory changes during the past two decades have been in keeping with the report's recommendations and analyses. But other recommendations in the book have not been followed, and some proposals the book rejected have been enacted through legislation or regulation.

Looking at risk challenges
Although the banking system appears to be safer and sounder today than it was two decades ago, new risk challenges have arisen that could not have been anticipated in the 1980s. A paper by Robert DeYoung outlines the fundamental structural changes in the U.S. commercial banking industry in the past 20 years.

DeYoung's strategic analysis of the current state of the industry compares the "transactions banking" business model practiced by large financial companies to the more traditional relationship-based banking business model. In particular, the author focuses on the different production technologies, product mixes, strategic behaviors, and risk-return trade-offs that characterize these two opposite approaches. In closing, he discusses what these new developments may mean for the industry's ongoing safety and soundness.

Looking at the overlooked
Mark Flannery's paper identifies underresearched and/or underappreciated issues that affect bank safety and soundness or financial system stability. The author first discusses the goals of safety and soundness supervision and then focuses on seven imperfectly understood, and often intertwined, issues: credit rating agencies; the combination of banking and commerce; nationwide depositor preference and the distribution of liability-holders' risk exposures; systemic risk; capital adequacy; market discipline; and credible resolution procedures for the failure of large financial firms. Many of these open issues are similar to those discussed in the 1986 report, and all deserve serious scholarly attention, Flannery notes.

Looking back—and ahead
In a roundtable discussion, the five economists who wrote Perspectives on Safe and Sound Banking assess how legislative and regulatory changes during the past two decades have reshaped the banking landscape, and they weigh in on what tasks remain to ensure that the banking system, and the larger financial system with which it has become so intertwined, remain healthy.

June 15, 2007