Question

Throughout the 20th and 21st centuries, the financial services industry has undergone major regulatory reform.Beginning with the early parts of the 20th century and extending through the present, describe the process through which regulation of the following sectors (banking, insurance, stocks, bonds, mutual funds, pension funds) of the financial services industry has evolved.In your discussion, be sure to include the major laws passed in each sector and any motivations for reforms.

Answer 1

Insurance System:

Banks also implicitly provide insurance services that insurance companies are unable to provide because the risks do not meet the standard characteristics of explicitly insurable risks: losses being observable by all (no asymmetric information); the absence of moral hazard inducing the insured to behave in a manner that is prejudicial to the interests of the insurer; and the diversifiability of risks.

Lenders face the risk that they may need funds before the maturity of an imperfectly marketable loan. Liquidity needs are unexpected but not highly correlated between transactors. By pooling risks (having a large number of depositors each with uncertain future liquidity needs) the bank is able to predict its own requirement to meet its depositors' liquidity needs. The greater the number of depositors the more predictable is the liquidity requirement and the bank is able to minimise its own holdings of liquid assets to meet this demand. Thus by pooling risks the bank is able to provide liquidity insurance to risk-averse depositors facing private liquidity risks. It is this that enables banks to hold non-marketable assets. ‘The bank thus transforms imperfectly marketable, longer term assets into fully marketable, short-term liabilities, and in the process provides its debt-holders with insurance against the contingency that they will be caught short by an unexpected liquidity shock’. The development of unit trusts and money market mutual funds has the effect of eroding the banks' traditional advantage as a supplier of liquidity insurance. Consumers who traditionally maintain liquidity in banks are now able to earn a higher rate of return in money market funds and at the same time secure the advantages of liquidity. This is especially the case in those funds which also offer payments facilities.

Regulatory subsidy

A further strand of analysis focuses not upon intrinsic advantages of banks but upon the implicit subsidies they receive through various forms of protective regulation; regulation which limits competition, deposit insurance, implicit lender-of-last-resort facilities and so on. Regulation may accentuate whatever economic advantages banks may possess and may create economic rents for them. There is a powerful strand in the history of regulation based upon the alleged dangers of ‘excessive competition’ (Llewellyn 1986). Regulation frequently has the effect of limiting competitive pressures and sustaining restrictive practices and cartels. However, the general trend of deregulation means that these protections have been gradually eroded. To the extent that regulation previously sustained excess capacity, the process of deregulation is likely to reveal the extent of such overcapacity. An industrial structure built up in a protected and uncompetitive environment is likely to be unsustainable in more competitive market conditions. In general, regulation has become less protective of the banking industry as public policy priorities have increasingly been given to enhancing competition and efficiency in the financial system.

Payments advantage

Some theories of the banking firm give emphasis to the advantage that banks have because they are an integral part of the payments system. However, banks are losing their monopolies in this sector of the financial system. The development of money market mutual funds and unit trusts with payments facilities offers a challenge to the banks' traditional monopoly in this area. Similarly, the development of credit cards and debit cards erodes this same monopoly, and an increasing proportion of transactions can now be executed without the need for even a temporary stock of funds in a traditional bank account. The development of electronic barter has enormous potential to undermine the banks' traditional monopoly in the payments system. In general, there is a challenge to banks based on a challenge to two traditional assumptions:

That transactions require money; and

That only banks can issue money.

Money is a convenient facility as it means that transactors do not need information about the standing of the payer, as would be the case if payments were made through the transfer of other assets. However, technology also facilitates the verification of the standing of transactors: a particular example is the development of smart cards. Information can now be easily stored in such cards which in turn can be issued by a variety of firms other than banks.

In various ways, therefore, the related pressures of competition, deregulation, financial innovation and technology have eroded some of the comparative advantages of banks in their traditional financial intermediation business. In addition, new information and trading technology has reduced information and transactions costs in capital markets relative to bank lending costs . Financial innovation and technology (together with the development of rating agencies) are eroding transactions and information costs and market imperfections which have been the basis of banks' efficiency and comparative advantage over capital markets.

Regulation to some extent exaggerated the comparative advantages possessed by banks because it created something of a protected market environment. In effect, banks in some countries are losing their predominant role as deposit-takers and lenders to companies. Market pressures are eroding the market imperfections which gave rise to the banks' comparative advantage over intermediation in capital markets. Financial innovation and technology are also eroding transactions and information costs and market imperfections which are the basis of financial institutions' efficiency over direct credit markets. In addition, banks' own cost structures (including the cost of capital) may also have eroded some of their comparative advantages. The recent loan-loss experience of banks in many countries suggest that banks are also subject to problems associated with asymmetric information and inefficient monitoring which some models of the banking firm highlight as the banks' potential major comparative advantage.