The Changing Banking Landscape
President and Chief Executive Officer
Federal Reserve Bank of Atlanta
Florida International Bankers Association
September 3, 1998
Good afternoon! Bill Estes and Sue Costello have been urging me to visit with FIBA since I was named President of the Federal Reserve Bank of Atlanta in 1996. I was able to meet with your directors over lunch that February, but this meeting with the full membership has been too long in coming. Pat Roth can attest to our difficulty in finding an open date, and somewhere, Im sure, an economic model can explain the inverse relationship between the desire to meet with a group and the time available to do it.
In addition to my schedule, Ive also been trying to keep an eye on what, in an earlier time, might have been a decades worth of financial and economic developments: We are now witnessing the formation of U.S. financial institutions whose combined assets will exceed the annual gross domestic product of entire nations. And in some regions around the world, economies that were previously considered miraculous are in serious need of divine (or IMF) intervention.
None of this is new for members of FIBA. Some of you work for what are already the worlds largest banks. Others have lived through crises in Latin America thatin some respectsbear an eerie resemblance to the crisis in Asia today. And all of you, by virtue of your position in Americas gateway to Latin America, are keenly aware of how U.S. policiesmonetary, financial, legal, regulatory and all the restare transmitted through the world and retransmitted back to the United States. In a way, then, its probably not such a bad thing that this meeting has been so long in coming. These last two years have brought a decades worth of insights.
My agenda for today is to tap into those insights. Ive brought along some concerns that have been weighing heavily on my mind recently, and whichI have to admitI simply dont know the answers to. But before I ask you to consider some of my questions, I suppose its only fair that I answer some of yours.
Im an engineer: by training, by temperament andfor the first few years of my career with the Atlanta Fedby profession. Most of my colleagues at the FOMC are economists, so my background makes me pretty unusual. But it also, I think, gives me a unique perspective on whats driving events in the financial services industry and in the economy.
Generally speaking, engineering seeks to give individuals some degree of controlover land, the elements, transportation, you name itthrough the development and application of technology. And in the financial services industry, communications, computing and data processing technologies have done just that. I need not explain this to members of FIBA: many of you service your customers through a variety of technologies. You market and approve loans with credit scoring software. You provide automated letters of credit facilities. Or you manage risks through derivatives portfolios and complex risk management models. The point is that financial institutions and their customers have a range of options and a degree of control that they havent had before. And its all been made possible by technology.
All of this is, without question, to the good. Taken together, the actions of individual businesses and consumerswhat economists generically call the marketis the most efficient way to distribute limited resources, and market efficiencies have much to do with the strength and duration of the current expansion. But for bankers, consumers and policymakers, the ascendancy of the market has additional implications that weve barely even begun to explore. The most important, however, is that economic policies must now, more than ever, be market based. For the next few minutes, Id like to consider the implications of this reordering for the Fed as regulator and as monetary policymaker.
In fact, the market began undermining the legalistic American financial regulatory structure more than two decades ago. Remember that the central objective of post-Depression financial policy wasand, strictly speaking, still ispreventing competition between financial sectors. Glass-Steagall erected legal firewalls between the sectors; regulators tried to keep the walls up by reducing competition within sectors. So fixed commissions on the New York Stock Exchange were tolerated with the understanding that brokerage houses wouldnt compete with banks. And interest on checking accounts was prohibited so that banks wouldnt be tempted to compete with brokerages.
All of this began to break down in May 1975, when trading among institutional investors and competition from regional exchanges forced the New York Stock Exchangeafter more than 200 yearsto abandon fixed commissions. But with the demise of fixed commissions, there was little incentive for brokerages not to compete with banks, Glass-Steagall notwithstanding. Three years later, of course, Merrill Lynch did just that with the introduction of its cash management account. Consumersespecially the most profitable consumersleft banks in droves, and it would become a matter of time before policymakers abandoned Regulation Q and permitted banks to offer interest on transaction accounts.
These were crucial developments: no longer did the market respond to policymakers. Now, policymakers responded to markets. It was a pattern that would be repeated over and over again, with the demise of interstate banking prohibitions, the end of interstate branching prohibitions and the expansion of Section 20 powers, to name just a few examples. Eventually, of course, it will culminate with repeal of Glass-Steagall itself. The point is, markets move first, we react later.
Its worth emphasizing that most of the developments I just mentioned took place before derivatives, credit scoring, mortgage backed securities, ATMs and other technology-driven innovations flooded the financial services industry. And those innovations came before 45 percent of American households owned personal computers, as they did last year. If two decades agoin a relatively low-tech environmentthe market undermined four decades of financial policy that quickly, how much faster will it move when PCs are as ubiquitous as televisions?
In this market-driven environment, it would be tempting to conclude that regulators are irrelevant. Tempting, but wrong. For one thing, the markets rules and incentives are not always aligned with the interests of taxpayers and consumers. For another, the markets corruption-prevention record is less than stellar (although in fairness it should be mentioned that regulators record is not much better).
But by far the most compelling reason for regulation is the one offered by Senator Glass and Congressman Steagall 65 years ago: the safety and soundness of the American financial system. Think about it: the sources of systemic risk today are basically the same as they were in 1933: transaction cascades (which generally refers to a breakdown of the payment and settlement system), financial contagion and asset value implosion. But technologythe same technology that gave life to the markethas exponentially increased the speed and consequences of a financial system meltdown. And, of course, the financial system is no longer confined to our borders; its now global.
So the first challenge for the Fed and other regulators is to redefine the term safety and soundness. The goal, I suspect, will always be the mitigation of systemic risk. But it may no longer be possible or desirable to mitigate systemic risk by preventing the failure of financial institutions. Containment, I believe, will be the preferred approach, but even thats easier said than done. Can a one trillion dollar institution really be contained?
The second challenge is how we work, or how we do the containing. The truth is that in todays financial services industry, regulations cannot keep up with innovations in the marketplace. For example, the Basle Accords risk-based capital modelwhich took so many years to gain broad acceptanceis already inadequate as a gauge for determining capital requirements for many very large institutions. Were making progress toward catching up (again) with work on modeling, and supervisors have also begun accepting, on a limited basis, internal models to determine capital requirements for market risk. Credit risk is now also a primary focus of modeling efforts, and I am optimistic that real progress is being made in that area. But were still, as ever, behind the market.
The evolution of the financial services industry has meant the movement and (in some cases) complete disappearance of long-established reference points. State boundaries and Federal Reserve Bank District lines, for example, are now poor indicators of where banks actually operate. The balance sheet is becoming far less meaningful as a gauge of an institutions financial condition. And the concept of legal entityalways the focus of examiner effortshas similarly become less relevant as bank management focuses on product lines with little regard for where those activities are officially housed.
The challenge for supervisors is to move beyond our historic but now myopic reference points and to begin to focus on the processes that deliver and manage those products and services. At the Fed, were trying. Risk-focused supervision, as Ive just mentioned, allows our examiners to assess risk with banks own processes. These vary widely, depending on the sophistication of the institution. For some, it is a loan review function that requires quality testing. For others, it is portfolio management strategies driven by the most complex formulas that the financial rocket scientists can dream up. Im aware that none of our initiatives have yet been perfectedfar from itbut we think they are a good start toward forging the bank-supervisor partnership that is so critical for protecting the U.S. financial system. Im interested in hearing what you think.
In addition to its regulatory responsibilities, the Fed is also the nations monetary policymaker. And just as were still pursuing an indispensable but six-and-a-half decade old goal on the supervision and regulation endsafety and soundnesswere also pursuing a time-honored public goal on the monetary side: national economic stability, as reflected by GDP growth, the unemployment rate and, most importantly, the inflation rate. But as with safety and soundness, the environment in which were expected to achieve economic stability has been completely transformed by markets.
The market is no longer domestic. Trillions of dollars change hands every day. But quite apart from allowing countries to pursue comparative advantages, this ebb and flow of resources also serves as a particularly vigilant enforcer of market discipline. Policies that defy or obstruct the operation of the market, or that obscure the true condition of an economy or business, are not tolerated. And when punishment comes, it is swift and painful.
The most recent demonstration of market discipline, of course, has been in Asia, where countries with exchange rates inconsistent with economic fundamentals have been punished with an overwhelming capital flight. (In this respect, the Asian crisis resembles the peso crisis a few years ago.) But the market has also become much more sensitive to weaknesses in property rights, accounting conventions and bankruptcy and commercial law. For countries on the receiving end of market discipline, the challenge is implementing reforms. Real reformthe kind rewarded by marketstakes time, but markets punish now. It reminds me of that bitter old labor saw: the beatings will continue until morale improves.
For the United States, the current seven-years-and-counting expansion can probably be viewed as a reward for the right kind of economic policies. But this doesnt mean our job is finished. As long as countries are vulnerable to exogenous shocks such as wars, oil production cuts (and year 2000 problems)which is to say, alwaysmonetary policymakers have got to be able to understand all of the markets signals. And in a global environment, thats incredibly difficult.
One of the more basic challenges we face is simply discerning the indirect effects of our policy choices. Whether we want it to or not, an action by the FOMC immediately affects the availability of credit around the world. Investment portfolios are reallocated and capital spending campaigns reassessed. As those decisions are made by counter-parties and trading partners, they influence again the very economy that U.S. monetary policymakers tried to influence in the first place. Understanding how these indirect effects work remains a very daunting challenge.
A related (and even more basic) challenge for monetary policymakers is modeling the economy. The standard econometric modelsthose with the longest historical track recordsare relics of a day when the U.S. economy was basically closed (at least compared to what it is now). Moreover, modeling an economy with more than two participantsespecially when one of them is the dominant global playeris an enormous technical challenge. Almost no factor can be considered external (exogenous), and the policy effects we observe in so much domestic data are nearly impossible to extract.
At the Atlanta Fed, were trying to understand all aspects of the global market. Economist Tao Zha is developing whats known as a dynamic multivariate model. Taos model accounts for the effects of monetary policy in a rigorous, transparent way that has been previously unavailable, and it seems to be demonstrating good potential as a forecasting tool.
Were also exploring some of the more important global policy issues of the day. Recent research by Atlanta Fed economist Marco Espinosa seems to indicate that in countries where the economic infrastructure is not well developed, completely open capital markets may not be ideal. In other words, under certain circumstances and at certain stages of economic development, some degree of financial capital restrictions may be beneficial in some countries.
Theoretical research by economist Roberto Changand recently tested with data from Latin America and Asiagoes a long way toward explaining recent crises by illuminating the connection between exchange rate regimes and banking crises. Among other things, Robertos work suggests that during a currency crisis, any intervention should begin with an injection of liquidity. Otherwise, a currency crisis can quickly become a banking crisis. Structural reform may be essential, but financial obligations must be honored first in order to prevent a problem from spreading. This observation has obvious implications for preventing and correcting future crises.
But this is your territory, and I told you I was here to listen. Before I stop, though, Id like to share one final observation. Much of the reason the Fed needs to change the way it reaches its goalsas a supervisor and as a monetary policymakerresults from its past success in achieving them. The soundness of the American financial system and the stability of the economy have made the American economy the envy of the world. But that very success has changed completely the way those goals will be pursued tomorrow. It is incumbent upon usconsumers, bankers and policymakersto continue to find a way to reach them.