Dimensions: 6.5'' x 9.5'' 221 pages AEI Press  (Washington) Publication Date: October 1996 Paperback ISBN: 0844739898 Price: $ 14.95 Add to Cart   Examination Copies

The author is the Arthur F. Burns Professor of Free and Competitive Enterprise at the Graduate School of Business of Columbia University.

Dramatic changes in information and telecommunications technologies have transformed U.S. financial markets in the 1980s and 1990s. Traditional financial intermediaries, such as banks, have had to change what they do and how they do it in response to a steady stream of new financial products and instruments that have crumpled the competitive barriers that historically separated financial institutions in the United States.

The New Finance examines the changes in financial markets and explores the implications of those changes for financial intermediaries and public policy. One of the book's central conclusions is that the current system of bank regulation is out of step with today's financial realities and needs to be substantially changed. The challenge is to redesign regulation in a way that increases the freedom of financial institutions to compete, while at the same time making the financial system less vulnerable to reckless action by individual financial institutions. Edwards's analysis leads him to conclude that the best way to achieve such seemingly incompatible goals is to adopt a system of collateralized banking. The book discusses how adopting such a system will result in a more stable financial system, both by reducing our reliance on government to maintain financial soundness and by enhancing the effectiveness of private markets in controlling institutional risk-taking.

The Transformation of Financial Markets 

The sweeping changes that have occurred in financial markets have affected banks (or depository institutions) more than any other financial intermediary. Traditional commercial banking--making long-dated loans with funds raised by issuing short-dated deposits--is in rapid decline. Traditional bank borrowers are increasingly bypassing banks in favor of going directly to capital markets, and households are shifting funds from bank deposits to competing nonbank intermediaries, like mutual funds. In an effort to maintain profitability, banks have increased their risk-taking and have sought to expand into more volatile, nontraditional financial activities. That is accomplished either by circumventing existing regulations or by getting those regulations changed. Banking also is undergoing a massive consolidation, as banks either exit the market or seek to bolster their competitive position though mergers with other banks. In the future, the face of banking in the United States will be far different from what it was in the past.

Some simple statistics make evident the transformation that has occurred in U.S. financial markets. In 1980 depository institutions (commercial banks and thrifts) held more than 58 percent of the assets of all financial intermediaries; in 1994 they held less than 38 percent of those assets--a 20 percentage point decline in market share. During that period more than 4,000 banking organizations disappeared.

The decline of traditional banking is connected to the stupendous growth of nonbank financial intermediaries. The growth of pension funds and investment (or mutual) funds has been nothing short of phenomenal. The share of total intermediary assets held by those two nonbank intermediaries grew from 20 percent in 1980 to almost 40 percent in 1994, and that growth shows no sign of abating. Further, from 1982 to 1994 pension and mutual funds accounted for 67 percent of the net growth of households' total financial assets, compared with only 19 percent for depository institutions. Clearly, pension funds and mutual funds are providing a more attractive way for households and businesses to hold financial assets than are banks. Through those institutions, households and businesses now hold huge diversified portfolios of stocks, bonds, real estate, and even commodities.

The Growth of Mutual Funds 

The tremendous growth of mutual funds shows the increased willingness of households to hold liquid assets whose values change on a daily basis, depending on the performance of the assets backing their investments. Shares in mutual funds are backed by portfolios of specified types of financial assets, which are designated in a fund's prospectus. For example, a high-growth equity mutual fund holds a portfolio of high-growth stocks. Those collateral assets are marked to the market on a daily basis, so that the value of investors' shares changes in accordance with the performances of the underlying assets. Mutual fund investors can choose to have their investments collateralized with assets ranging from the virtually riskless (such as money market mutual funds) to high-risk equity and bond instruments (such as long-dated, mortgage-backed, bond funds).

Those collateralized investments stand in sharp contrast to bank deposits, which carry the bank's promise to repay at par value. Depositors depend primarily on the creditworthiness of the bank and on explicit and implicit government guarantees, rather than on the value of the assets that the bank holds. The value of deposits does not vary on a daily basis in accordance with the performance of the bank's assets. Rather, depositors rely solely on the bank's promise to repay their funds at par value and are largely indifferent about what happens to the bank's assets. In addition, notwithstanding some constraining regulations, banks can invest their deposit funds in assets of virtually any risk level, and that process is for all practical purposes opaque to bank depositors. Only regulators and government guarantees stand between depositors and financial catastrophe. Despite government assurances and guarantees, however, in recent years households have steadily reduced their holdings of government-insured bank deposits in favor of competing collateralized investments such as mutual funds that provide higher yields. In 1982 deposits constituted 51 percent of households' liquid assets, compared with 30 percent in 1994.

The Response of Banks to Changes in Investors' Preferences 

In response to those developments, banks have sought to change what they do and how they operate. Since 1980 they have more than doubled the amount of their funding obtained from nondeposit sources--to 40 percent of their total liabilities. Banks have also increased their holdings of risky loans such as commercial real estate and have substantially expanded their reliance on off-balance-sheet activities--doubling the share of their income generated by such activities since 1978, from 17 percent to 34 percent. Competitive pressures also have quickly become political pressures, as banks have pushed for legislation that would liberalize their powers and enable them to expand rapidly into nontraditional financial activities, such as securities and insurance activities. Only archaic laws and regulations have kept them from fully expanding such activities. Thus, whether or not the importance of banks as financial intermediaries has diminished, it is clear that both banks and financial markets have changed in important ways and that those changes have weighty implications for how financial markets and institutions should be regulated in the future.

A critical problem for banks is that they are severely constrained in what they are allowed to do by regulations written more than a half-century ago, when financial technologies and the competitive environment were vastly different from what they are today. It should surprise no one, therefore, that an important goal of bankers is to find ways either to circumvent or to eliminate entirely the regulatory obstacles that constrain them. Bank regulators as well are struggling to find ways to free banks to compete that do not jeopardize either the ability of institutions to make good on explicit and implicit government guarantees or their ability to maintain the soundness and stability of financial markets. But while the need to modernize financial regulation to make it compatible with current financial realities is obvious to all who care to look, there is no consensus on how to do it. Reform proposals typically founder on the shoals of unending controversy and self-interested political maneuverings.

The Need to Modernize the Financial System 

Neither the U.S. Congress nor regulators anticipated or planned for the changes that have occurred. Charged with the responsibility of maintaining the stability and integrity of financial markets, U.S. banking regulators are saddled with an outdated regulatory structure forged mainly during the 1930s in response to stresses on the financial system created by the Great Depression. But the current regulatory system is not only inefficient because it is out of step with today's technologies and market realities; it is also dangerous, because it is deceptive. It lulls us into believing that it is adequate to cope with the financial risks that now exist, while in reality it is not.

The New Finance brings what is happening in financial markets to a wider audience and informs and stimulates critical discussion of how to modernize the financial system. To make progress, discussion must be informed enough to cut through the political rhetoric and posturing that now prevents serious financial reform. In addition, past criticism of the changes that are taking place in financial markets has all too often focused on the wrong issues.

In particular, there are those who believe that the ascendancy of nonbank financial intermediaries such as mutual funds and the concomitant decline of traditional banking have in effect "deinsurancized" the financial system and thus increased its susceptibility to a systemic meltdown. They fear that mutual fund shareholders, unlike government-insured bank depositors, can be stampeded into running on mutual funds, a move that would precipitate a financial "meltdown." Others fear that the proliferation and growth of unregulated financial instruments and markets, such as derivatives and off-exchange derivatives markets, have become the "Achilles heel" of financial markets. They argue that unless those markets are restrained by additional government regulation, they will eventually collapse--with dire consequences for the entire financial system. Still others believe that the structural changes in financial intermediation have undercut the ability of the Federal Reserve to identify and control key monetary aggregates and thus have diminished the effectiveness of monetary policy.

This book analyzes and evaluates those concerns. After examining them, Edwards concludes that they do not constitute major threats to the financial system and most likely spring from a misunderstanding of the changes that have occurred. The primary threat to financial stability in the future, Edwards asserts, will come from the banking industry, where an outdated system continues to regulate institutional risk-taking.

The current regulatory system is inappropriate for today's financial system and the one that will exist in the twenty-first century. It will have to be substantially restructured if we are to avoid an escalation of the kind of institutional recklessness that caused the U.S. thrift debacle in the 1980s and the Japanese banking crisis of the 1990s. We must find a way to enhance the role of private markets in controlling institutional risk-taking and increasing market efficiency, and we must reduce our reliance on government guarantees and government regulators to maintain financial stability. Government regulators are no longer in a position to monitor and control institutional risk-taking effectively, however much we may want them to be. Further, all financial history, in the United States and in other countries, points to the unstable and potentially explosive compound that results from the mixing of government guarantees and politics.

A Restructured Financial System 

The New Finance lays out a plan for restructuring regulation to enhance the stability of financial markets while reducing our reliance on government regulators. The regulatory regime proposed will expand the freedom of all financial institutions to compete and to better serve their customers. The key to that regime is protecting the payments system by collateralizing or backing it with private assets sufficient to ensure that participating institutions will always be able meet their payment obligations. In particular, financial institutions that choose to provide liquid transaction balances or deposits (and the associated payment and clearing services) would be required to collateralize those liabilities with low-risk, liquid assets--much as member organizations in futures clearing associations now collateralize their obligations to other clearing members.

Collateralizing and custodializing the payments system would reduce the need for government regulators to monitor and control risk-taking and would free banks and other financial firms to compete more effectively with each other and with foreign banks. To put it differently, collateralization of payments is a way of privatizing the clearing and payments system. It eliminates the need for government to provide guarantees and subsidies that in turn require it to oversee the investment practices of financial institutions.

Whether the recommendations contained in The New Finance are adopted, however, is of secondary importance to the book's overriding objective of stimulating informed debate about the public policy implications of the revolution that is overtaking financial markets. According to Edwards, we have been far too complacent about the changes sweeping over financial markets and about the inadequacies of the current regulatory system. Those who read this book will come away with a better understanding of what is happening in financial markets and why it is necessary to change how we regulate our financial industries.