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The Role of Financial Regulation in a World of Deregulation and Market Forces
Lawrence J. White
Stern School of Business
New York University
November 1, 1999

To be presented at the IMF Conference on Second Generation Reforms,
Washington, DC,
November 8–9, 1999

Contents

  1. Introduction

    1. A Brief Vocabulary

  2. The Specialness of Finance, and the Implications

    1. Implications for the Structure of Finance

    2. The Vulnerabilities, and the Role for Regulation

  3. Understanding Financial Regulation

    1. A Typology of Regulation

    2. Uses of the Typology

  4. Framework for Financial Regulation

    1. Economic Regulation

    2. Safety Regulation

    3. Information Regulation

  5. Conclusion

References

Figures (Use the free Adobe Acrobat Reader to view these files.)



I.  Introduction

The 1990s have been the decade of the spread of market-based economic policies and of the deregulation/privatization experience that began in the United States in the 1970s. But it has also been a decade of failed banks and banking policies and of major economic crises, especially in Asia, that had their roots in financial failures.

The latter events should not be interpreted as a reason for wholesale repudiation of the former. The net effects of the experience of market-based policies and deregulation surely has been and will continue to be positive.1 But the banking and financial failures should serve as a strong signal that, even in a world that relies much more on markets and less on governmental intervention, there is a substantial and important role for sensible financial regulation—as an enhancement for the operations of those markets. This principle applies as forcefully to the world of developing and transition economies as to the world of industrial and post-industrial economies.

The remainder of this paper will expand on that theme. In Section II we will discuss the aspects of finance that make it important and special and the implications of that specialness for the structure of finance and of the financial sector in an economy and for the regulation of the financial sector. Section III will develop a framework for understanding and categorizing regulation in general and apply it specifically to financial regulation. Section IV will develop a list of the components of sensible financial regulatory system. Section V will offer a brief conclusion.

A.  A Brief Vocabulary

In the remainder of this section we will establish a brief vocabulary, since the terms, institutions, and structures of finance are somewhat specialized and may be unfamiliar.

By a financial intermediary, we mean an enterprise or institution that holds (invests in) financial assets (such as loans, mortgages, shares of stock, etc.) and that obtains the funds for these investments by issuing liabilities (such as deposits, mutual fund shares, insurance obligations, pension fund obligations, short-term debt obligations, etc.). Included in this category would be banks and other depository institutions, insurance companies, pension funds, mutual funds (unit trusts), commercial finance companies, and consumer finance companies.

By a financial facilitator, we mean an enterprise or institution that facilitates financial transactions but that is not primarily a financial intermediary itself. Included in this category would be stock brokers, dealers, market makers, financial advisors, accountants, auditors, rating agencies, analysts, publishers of financial newsletters, etc.

Finally, because banks and similar depository institutions loom large in financial regulation, we offer in Figure 1 a stylized portrayal of the essential features of a bank, as represented by its balance sheet. Its assets are the loans that it makes, since it expects to be paid back, with interest. Its liabilities are the deposits that it has accepted (which provide the funding for the loans), since it owes that amount (is liable) to the depositors. The arithmetic difference between the value of the loan assets and the value of the deposit liabilities is the net worth of the bank—its owners' equity—or, as the phrase is commonly used in finance, its capital. So long as the value of the bank's assets exceeds the value of its liabilities—i.e., so long as its capital is positive—the bank is solvent. In much of the discussion of banks, it will be important to remember that the depositors essentially stand as lenders to the bank.

II.  The Specialness of Finance, and the Implications

Finance is special, for at least three reasons. First, finance is ubiquitous. Every individual, enterprise, organization, or government requires finance, even if it is self finance, to smooth out income and expenditure flows and to provide the basis for investments.

Second, finance is central to the development of any economy.2 The financial sector is primarily the means for transforming and transferring the savings of an economy into its investments. An efficient financial sector will do this task well and encourage more saving as well as more and more efficient investment. Faster growth and higher levels of income and of well being will be the end result. Also, the financial sector is the provider of the transactions medium (money) and the payments mechanism/system that facilitates the exchange of goods and services in the economy. Again, a more efficient financial sector will encourage more rapid growth in the rest of the economy.

The operation of an efficient financial sector is dependent, however, on efficient financial regulation, because of a third feature: Finance involves an unavoidable time sequencing that creates special problems. Finance always involves an initial conveyance of funds—a loan, an investment—and then a later reversal of the flow of funds-the loan repayment (plus interest), a stream of dividends, etc.3

Because of this time sequencing, the lender or investor has to be concerned about being repaid.4 But information asymmetries between the borrower and the lender will adversely affect the lender's ability to determine the prospects of repayment. First, before the lender grants the loan, the borrower is likely to know more about its own risk characteristics and prospects for repayment than does the lender, which can create the problems of adverse selection: If there are no sanctions (or weak sanctions) for non-repayment, risky borrowers are likely to be more eager to borrow (and to be more willing to pay higher interest rates to borrow) than are less risky borrowers.5 Second, after the borrower has received the funds, moral hazard problems arise: In the absence of sanctions for non-repayment, the borrower's behavior will become more risk-prone, since the borrower will receive all of the "upside" benefits from undertaking greater risks but will not bear the "downside" costs of the losses.

Lenders' recognition of these potential problems in turn causes the lenders to become information gatherers:6 Before the granting of a loan, lenders will want to gather information about the prospective borrowers' likelihoods of repayment; and during the term of the loan the borrower will continue to monitor the borrower's behavior and financial condition, so as to be reassured that the borrower's likelihood of repayment has not diminished.

A.  Implications for the Structure of Finance

Differing characteristics among prospective borrowers and differing information-gathering skills among prospective lenders have logical consequences for the structure of finance. These implications are portrayed in Figures 2 and 3.

In Figure 2 we array potential borrowers along a spectrum of their informational opaqueness or transparency.7 At the left-hand side of Figure 2, the most opaque potential borrowers will have the most difficulties in arranging for finance and will have to rely on self-finance or on "friends and family" and other informal sources for their finance. Such informal sources are likely to have special information about the borrowers' abilities to repay and/or to have special means of extracting repayment (or to be more willing to forgo repayment). At the right-hand side of Figure 2, the most transparent borrowers will have the most ease in obtaining loans and will be able to access the securities markets, where the lenders (bond buyers/investors) are less able to scrutinize borrowers beforehand or to monitor borrowers during the term of the loan.

Borrowers of intermediate opaqueness/transparency are likely to rely on lenders that are information specialists—lenders with special information gathering expertise and monitoring capabilities—for their finance. These specialists include financial intermediaries (such as banks, etc.), supplier firms that provide short-term trade credit, and the special finance subsidiaries of equipment suppliers that provide, in essence, longer-term trade credit. Further, the structure of the lending/borrowing arrangement will be sensitive to the opaqueness of the borrower: More opaque borrowers are likely to receive shorter (and/or more callable) loans on which they pay higher interest rates and for which they are more likely to be asked to post collateral.8

The boundaries that separate the types of borrowers (and where they get their finance) are not rigid and will be affected by prevailing legal arrangements, by the transparency of accounting conventions, and by the current state of data gathering and processing technologies. To the extent that lenders have greater legal reassurance that they will be repaid (e.g., greater ability to seize collateral and repossess assets and greater certainty about priorities in bankruptcy arrangements), they will be more willing to lend to borrowers that would be otherwise too opaque.9 Further, greater transparency in accounting (on the part of enterprises) will make the lender's task of determining the riskiness of the borrower easier, while opaque accounting will make these determinations more difficult and will likely cause the lender to "fear the worst", thereby discouraging lending; uniformity of accounting treatment across enterprises will make comparisons easier.

Improvements in the technologies of data collection and assessment make the lenders' information gathering and monitoring tasks easier and tend to push to the left the boundaries portrayed in Figure 2. Thus, as the technologies of telecommunications and data processing have improved dramatically in the past few decades in the U.S., more types of borrowings have tended to be "securitized" and thus the securities markets have encompassed more borrowers (e.g., junk bonds, mortgage-backed securities, other types of asset-backed securities), while banks and other intermediaries have been able to penetrate more deeply into the area of opaque borrowers, making credit card loans to households and small enterprises and even making more small business loans that were previously considered too risky. Also, as technology has improved, the securities markets have extended their reach across national boundaries, while banks and other lenders have extended loans to borrowers abroad that previously were too opaque for those lenders.

Accordingly, in Figure 2 we portray the boundaries between the various types of borrowers and their prospective lenders with a wavy line, which is meant to convey the concept of fuzzy boundaries that vary according to the legal, accounting, and technological conditions that are present.

In Figure 3 we provide two important characteristics of informational opaqueness/transparency for enterprise borrowers—their size and their age—and show how borrowers with these characteristics will tend to be matched with the various types of lenders. Young firms tend to be opaque; they have a limited "track record" from which lenders can make judgments. Small firms require small amounts of financing, which would not justify the fixed-cost expenses of information gathering and assessment that a specialized lender would require. Accordingly, very young, small enterprises are likely to have to rely on "friends and family" and informal finance. As firms grow older and larger, they may be able to obtain trade credit and to attract the attention of banks or other financial intermediaries. Finally, when they are sufficiently large and mature, they can directly access the securities markets. Again, in Figure 3 we have drawn the boundaries as wavy (fuzzy) lines, since these boundaries will depend on legal, accounting, and technological arrangements.

Though not portrayed in Figure 3, geographic distance (or physical proximity) is another dimension that has similar properties: Enterprises that are physically farther away from potential lenders tend to be more opaque (less familiar) and therefore have more difficulty in accessing those distant lenders; instead, enterprises tend to obtain their finance from local lenders (and lenders tend to favor local borrowers). But greater informational transparency by a borrower can more readily attract lenders from afar, whether in the securities realm or the intermediary realm. And, again, improvements in technology are reducing the "frictions" of distance, allowing borrowers and lenders to transact across greater distances.

This asymmetric-information based approach to the structure of finance thus indicates that there is an important role for securities markets and for banks in any economy, although their relative importance may vary with the state of technology, the structure of an economy, and the legal and accounting frameworks of the economy. Securities markets are largely the preserve of transparent borrowers: relatively large enterprises or governments, with track records, who can attract investors who have intermediate information capabilities but are not information specialists10 These markets will work best (most efficiently) when accounting frameworks are standardized and transparent, where the opinions of rating agencies and analysts are widely available, where the rights of lenders and investors are well specified, and where bankruptcy procedures are clear.

Banks and bank-like entities are information specialists and tend to focus on borrowers that are in the intermediate range of informational transparency/opacity.11 Small and medium-size enterprises with modest "track records" are clearly in this latter intermediate category. Banks have historically held this role of lender to borrowers in the intermediate category, since banks' relative sizes have given them advantages of expertise, scale, and diversification in dealing with borrowers, which individual lenders would be unlikely to have. In addition, since borrowers (especially enterprise borrowers) are likely also to maintain their checking accounts with the lending bank, that bank may be able to use this information so as to be able to monitor its borrowers more effectively.12

B.  The Vulnerabilities, and the Role for Regulation

The unavoidable information orientation of finance creates potential problems and vulnerabilities. First, as was mentioned in the Introduction, depositors stand in the position of lenders to banks. But depositors generally are not informational specialists; they are therefore vulnerable to the asymmetric information problems of banks that are borrowing from them.

To illustrate this point, in Figure 4A we reproduce the bank balance sheet of Figure 1. If the bank experiences losses and the value of its assets declines to, say, $80 (because some borrowers cannot repay their loans), the bank has become insolvent, as is portrayed in Figure 4B. The bank's owners' stake has been eliminated, and, under a legal system of limited liability for owners, they cannot be held liable for any losses beyond the elimination of their equity. Thus, the only other absorbers of the insufficient value of the assets must be the depositors. In the absence of any other arrangement, the bank of Figure 4B would have to close, its assets would be liquidated (for their $80 value), and the depositors would somehow allocate the $80 among themselves to satisfy their $92 in claims.13

The limited liability arrangement thus creates moral hazard behavior incentives for bank owners (or bank managers on the owners' behalf) to engage in excessively risky lending.14 The bank owners will capture the benefits from the "upside" outcomes of risky ventures; but their losses from the "downside" outcomes are limited to their equity stake. Such excessively risky lending will have negative expected values and thus imply inefficient investments.15

If depositors were information specialists who could readily assess the riskiness of their bank's activities, they could monitor their bank's activities and protect themselves (in the same way that the bank protects itself in its role as lender). But, for the most part, depositors are not information specialists and are unlikely to be able to protect themselves adequately as lenders to banks. Thus, the potential for moral hazard behavior by banks is ever-present.16

These problems of bank insolvency are exacerbated by the maturity and liquidity mis-match of the typical bank's assets and liabilities. The bank's loan assets tend to be of longer maturity and less liquid than its deposit liabilities, most of which can be withdrawn at relatively short notice. No bank can meet the simultaneous demand of all of its depositors for their funds.

This mis-match thus creates the potential for depositor runs, which can force the closure of even solvent banks.17 If depositors fear—correctly or incorrectly—that their bank's assets have declined substantially in value, they will rush to the bank to withdraw their funds, so as to avoid bearing some of the losses of the feared insolvency. Even if their fears are baseless, the withdrawals by enough poorly informed depositors could cause the bank to be unable to honor its liquidity commitments to those depositors. As a consequence, even well-informed depositors who know that the bank's assets have not lost value will also rush to withdraw their deposits, in fear that the former group's withdrawals may impede the latter's access to their funds. Their rush to the bank will exacerbate the bank's liquidity problems. And if its inability to meet its depositors' withdrawal requests causes the bank to close and liquidate its assets—i.e., call in its loans-then even an originally solvent bank may become insolvent as its loans cannot be repaid in full on short notice.

Further, if poorly informed depositors in neighboring banks fear that similar problems could affect their banks, and depositor runs could be contagious. Alternatively, a run on one bank might impair the claims of other banks, creating a cascade of failed banks.18

A second vulnerability in the financial sector arises in the securities markets. Since those markets are the domain of investors/lenders that are of intermediate expertise with respect to information (more than depositors, less than the specialists) and since these markets rely extensively on widespread information availability, they are vulnerable to the frictions and instabilities that fraud, misrepresentation, or even just non-uniformity of presentation can create. The efficiency and efficacy of these markets relies heavily on the widespread availability of good information.

These problems and vulnerabilities create a potential role for carefully crafted efficiency-enhancing regulation. In the next Section we will provide an organizing framework for understanding regulation. We will then outline a scheme of efficiency-enhancing financial regulation.

III.  Understanding Financial Regulation

At first glance, the web of regulation that surrounds enterprises in any economy seems to be an impenetrable mass of restrictions and requirements. And efforts to understand regulation are usually not aided by a multiplicity of agencies and methods and by actions that sometimes involve formal legislation, that sometimes involve administrative regulations, and that sometimes involve formal or informal implementation. This confusion applies equally forcefully to financial regulation considered by itself. In the U.S., for example, there are a multitude of agencies, at the state and federal levels, that have separate but overlapping and sometimes duplicative regulatory authority in the financial arena. The printed volumes of laws and regulations that apply to the financial sector would occupy many linear feet on any legal library bookshelf.

Nevertheless, there is a way of making sense out of this apparent jumble.19 To do so, we will employ a general three-way classification scheme for regulatory interventions.

A.  A Typology of Regulation
Economic regulation

This category of regulation broadly involves governmental controls with respect to prices, profits, and/or conditions of entry and exit, including must-serve obligations.20 With respect to finance, such regulation would apply to any limits on interest rates that can be charged on loans or paid on deposits; limits on fees for other financial services; limits on entry by domestic or foreign enterprises; limits on the establishment of branch locations by incumbents; limits on the fields and activities into which financial institutions can enter; and requirements that financial institutions provide services to specific industry sectors and/or specific geographic areas.

It is important to note that this is the category of regulation that has been most affected by the wave of deregulation that has occurred in a number of sectors in the U.S. and in other countries over the past 25 years. The financial sectors of many countries have also experienced deregulation of this type.21

Health-safety-environment (HSE) regulation22

This category of regulation broadly encompasses restrictions on the types of products that a firm can offer and the types of production processes in which it can engage.23 For finance, one version of this form of regulation focuses on "prudential" (or "safety and soundness") considerations that are aimed primarily at preventing the insolvency of banks and other depositories, insurance companies, and certain kinds of pension funds.24 The instruments of prudential regulation are primarily minimum capital (net worth) requirements (so as to provide a financial buffer against potential insolvency), limitations on financial institutions' activities (so as to limit the riskiness of their activities), and the monitoring of the honesty and competency of their managements and operations (so as to avoid the insolvencies that might follow from dishonest or incompetent management).

Regulatory provisions with respect to corporate governance for publicly traded companies could be considered to be a form of safety regulation, as are restrictions as to the forms and methods of securities issuance and trading.

Information regulation

This form of regulation involves the requirements that specific types of information, often in a standardized format, that must be provided with the product or service.25 In finance, examples of information regulation include: requirements that publicly traded enterprises provide information to their stockholders and creditors at stated intervals (e.g., quarterly) and in a standardized fashion; that banks provide standardized information on deposit rates and loan rates to their customers; that insurance companies provide standardized information as to terms and coverage to their insureds, etc.

B.  Uses of the Typology

This three-way typology of regulation does not eliminate all ambiguities. Activities limitations on financial institutions might be considered to be a barrier to entry (economic regulation) or a risk-restraining effort (prudential regulation); indeed, many economic regulation measures, which are often intended primarily to protect incumbents or favor other special interests, are frequently "dressed up" as efforts to enhance safety. The requirement that publicly traded corporations periodically issue financial statements that have been prepared according to a standardized accounting framework ("generally accepted accounting principles", or GAAP) is part of almost any corporate governance structure (safety regulation); but it is also inherently a form of information regulation.

Despite these ambiguities, however, this classification scheme is broadly useful for linking the types of regulatory actions with the likely motives for regulation. In principle, economic regulation could be used for restraining the exercise of market power, information regulation could be used for dealing with problems of informational deficiencies, and H-S-E regulation could be used for dealing with problems of negative externalities (spillover effects) as well as severe problems of informational deficiencies (where the required provision of the information alone might not be sufficient to deal with the problem). In practice, of course, political forces come into play, and parties that are affected by regulation often try to influence outcomes in their favor, so that (for example) much economic regulation has come to represent efforts to protect incumbents and thus exacerbate problems of market power rather than alleviating them.26 Nevertheless, the ability to link types and motives of regulation helps clarify the role of regulation.

IV.  Framework for Financial Regulation

The three-way classification of regulation used in Section III will also serve as the basis for our framework of financial regulation.

A.  Economic Regulation

The design aphorism of Ludwig Mies van der Roh—"Less is more"—applies forcefully to this category of regulation. Though this category has a genuine role to play when major and otherwise unfixable monopolies loom, the dangers of extensive protectionism for incumbents—the creation and protection of monopoly power—and other inefficiencies are so great that governments ought to retreat rapidly and broadly from this category.27 The retreat should envelop artificial barriers to entry and forced credit allocation as well as direct price restrictions. The result should be a financial sector that is open to entrants, foreign as well as domestic; to new ideas about products and services; and to a competitive process that permits the better ideas and the more efficient organizations to flourish and spread their benefits throughout the economy. Concerns about safety and about information adequacy should be addressed directly through safety/prudential regulation and information regulation, and not through inefficient economic regulation.

B.  Safety Rgulation

As was discussed in Section III, safety regulation has two distinct forms for the financial sector. We will address both.

Prudential regulation

Prudential regulation with respect to banks and other depository institutions, insurance companies, and defined-benefit pension plans should be vigorous, since widespread insolvencies among these institutions can be disruptive and undermine the confidence of savers and investors in an economy.28

The components of a vigorous and sensible prudential regulatory system are many but important:

Minimum capital requirements

Capital is both a direct buffer against insolvency and an indirect protection, since higher capital levels mean that the owners have more to lose from risk taking and should thereby be less inclined to undertake it. Minimum capital requirements should be commensurate with the risks undertaken by the bank and should be forward looking. They should be based on an accounting framework that emphasizes current values for assets and liabilities rather than the historical values that are the basis for existing accounting frameworks. Where possible, a layer of subordinated debt should be part of the capital requirement. This will bring supplementary market discipline and scrutiny to aid the regulatory process, since the holders of the subordinated debt will have similar interests in curbing the excessive risk taking of the owners.29

Restrictions on activities

All activities that are "examinable and supervisable"—that regulators can comprehend sufficiently to be able to set appropriate capital requirements and to judge the competency with which they are being conducted—should be permitted within the bank. Any activities that are not examinable and supervisable should not be allowed to be conducted by the bank but should be permitted for a separately capitalized affiliate, so long as transactions (e.g., loans) between the bank and the affiliate are tightly scrutinized.30

Honesty and competency

The honesty and competency of a bank's principal owners and senior management must be continuously scrutinized.

Prompt corrective action

When a bank's capital level drops below the regulatory minimum level, regulatory scrutiny should increase and restrictions should tighten. When a bank becomes insolvent, it should be promptly disposed of: The former owners' rights should be eliminated and senior managers removed, and new owners should be found or the bank should be liquidated.

Market value accounting

Since adequate capital is crucial for safety regulation, it must be measured appropriately. As was mentioned above, the standard measurement frameworks that apply to banks are inadequate, since they are backward looking and are slow to recognize current values. The necessary accounting framework must rely on current—i.e., market-based—values.31

Lender of last resort

A reliable lender of last resort, that is prepared to lend to otherwise solvent banks that are subject to depositor runs, is an important means of dealing with the instability problems of banks discussed in Section III. In order to reassure itself that it is lending to solvent institutions, the lender of last resort (most likely the central bank) will need the same information that is available to bank regulators.

Deposit insurance

Recall that the major reason for prudential regulation is the inability of the bank's depositors adequately to monitor the bank's behavior. Deposit insurance provides an extra layer of assurance for depositors, against regulatory failures. In addition, during the past few decades, whenever they have faced bank insolvencies, governments have invariably kept depositors whole, regardless of whether formal deposit insurance arrangements were in place. A better policy would be to make such arrangements explicit beforehand, rather than creating ex ante uncertainty and ex post "bailouts". Like all efficiently priced insurance, of course, the premiums should be risk-based.32

Personnel

Good laws and regulations are not by themselves adequate. They need to be interpreted and enforced. They require a regulatory cadre that is well staffed, well trained, and well paid.

Corporate governance and securities regulation

These forms of regulation are properly considered to be a form of safety regulation. Though they do not affect the basic economic/financial risks that are inherently part of securities markets, they do provide a basic framework of reliance and assurance for creditors and investors. These provisions ought to include the specification of creditor and stockholder rights, including minority stockholder protections, and a bankruptcy code. The important long-run considerations—that lenders will be more willing to lend when they have greater information and greater assurances that they will be repaid—should be kept in focus in the design of such systems.

This also include a system of fiduciary obligations on the part of stock brokers and dealers (and other financial facilitators) and limits on manipulation in thin markets.

C.  Information Regulation

Requirements for timely, periodic issuances of information by publicly traded companies are an important "lubricant" for securities markets. Though such issuances are inherent part of a corporate governance system, they are also an essential form of information regulation. The issuance of financial information must be standardized (so that lenders and investors can more easily make comparisons among enterprises), through the use of an accounting system that stresses standardization and transparency.33

Again, as is true for prudential regulation, the enforcement of information regulation (as well as corporate governance, bankruptcy, and securities regulation) must be a regulatory cadre that is well staffed, well trained, and well paid.

V.  Conclusion

The "triumph of markets" is a well deserved achievement. But less appreciated has been the vital role of the government-based undergirding—infrastructure—that has supported this success. And one vital piece of this infrastructure has been financial regulation.

In this paper we have outlined a sensible structure for financial regulation. Using a three-way classification of regulation, we argued that "economic regulation"—controls on prices, profits, entry/exit, and must-serve obligations—should be abandoned rapidly and broadly. Indeed, it has been this form of regulation that has sometimes weakened financial sectors and made them more vulnerable to changes in the economic environment, and it is in this general area that deregulation has achieved its greatest successes.

Instead, financial regulation should focus primarily on prudential regulation for banks and similar institutions, on the development of corporate governance and bankruptcy systems, on safeguards in securities markets, and on information regulation for securities markets.

For countries with weak traditions in these areas, these tasks will not be easy. But an efficient financial sector is important for economic growth and development, and efficient financial regulation is crucial for an efficient financial sector. The beneficial results make the effort worthwhile.

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1For a review of the U.S. experience, for example, see Winston (1993).
2See King and Levine (1993a, 1993b), Levine (1996, 1997, 1998, 1999), Levine and Zervos (1998), and Rajan and Zingales (1998).
3Insurance involves a similar time sequencing, where the initial event is the commitment to provide insurance and the later event is the payout if/when the insured-against event occurs.
4In the following discussion, for linguistic convenience we will describe the problem in terms of a "lender" and a "borrower"; but the problems apply equally forcefully to an investor and an enterprise, or to an insurer and its insureds.
5See Stiglitz and Weiss (1981).
6Even if there are no inherent informational asymmetries between borrowers and lenders but there are differences among prospective borrowers with respect to their abilities/proclivities to repay, the lenders will have the same incentives to gather information about the borrowers.
7See Berger and Udell (1993).
8See Strahan (1999).
9See Laporta et al. (1997, 1998) and Levine (1998, 1999).
10Technology gains have, however, also permitted the aggregation and securitization of standardized consumer loans—residential mortgages, credit card loans, automobile loans, etc.
11See also Gorton and Winton (1998).
12See Nakamura (1993).
13If, instead, an acquiror were considering taking over the insolvent bank, it would insist that the depositors relinquish $12 of their claims, so as to bring the liabilities into equality with the (diminished) level of assets.
14This problem of moral hazard arising from limited liability is, of course, a general one and applies to all corporations vis--vis their creditors; it underlay much of the discussion above.
15Equally important, bank owners have insufficient incentives to avoid being careless or inattentive in their lending.
16Insured parties stand in the same relationship to their insurance companies, as do pension claimants to defined-benefit pension funds (those pension funds in which employers promise retirement payments to employees that are usually geared to a percentage of the latter's salaries during their last few years of employment prior to retirement).
17See Diamond and Dybvig (1983), Postlewaite and Vives (1987), and Chen (1999).
18The problem of runs is likely to be less severe for insurance companies and pension funds.
19See White (1996a).
20In the U.S. such regulation was typified generally by the blanket control over airline fares, routes, and entry and exit that the former Civil Aeronautics Board exercised prior to the late 1970s. It is still found in the area of local electricity, telephone, water, and gas rates, local taxicab regulation in many ares, etc.
21Nevertheless, in the U.S. some important pieces of economic regulation remain: e.g., the federal ban on the payment of interest on commercial checking account deposits, some states' restrictions on credit card fees, a few states' restrictions on branching, the federal restrictions on the entry of banks into areas outside of traditional commercial banking, the federal requirement that banks "meet the needs" of their local communities, etc.
22This is sometimes described as "social regulation."
23This form of regulation is manifested outside the financial sector in aviation safety requirements, environmental regulations, workplace safety requirements, pharmaceutical safety requirements, etc.
24I.e., "defined benefit" pension funds.
25The labels that accompany pharmaceuticals, the labels on packaged foods, and the labels on many manufactured items requiring disclosure of the country of origin are typical examples outside the financial sector.
26See Stigler (1971), Posner (1974), and Peltzman (1976). It was the political recognition that, in many instances, this type of regulation was impeding competition that contributed to the wave of deregulation of the 1970s and 1980s.
27It is important to note that the "protections" that economic regulation has brought to financial institutions have sometimes caused them to be more exposed to the insolvencies that were supposed to be avoided; see White (1999).
28For the remainder of this discussion we will refer to "banks", but the discussion applies to the other regulated entities as well.
29See Benston and Kaufman (1988a, 1988b).
30See White (1996b) and Shull and White (1998). This principle of tight scrutiny should apply to any transactions between the bank and its owners (or affiliates or friends of the owners), since such transactions are otherwise an easy and obvious way of looting the bank.
31See White (1991a, 1991b, 1991c).
32A drawback to deposit insurance is that it reduces the incentives for depositors to monitor their bank. But, since depositors are unlikely to be adequate monitors anyway—again, this is the reason that prudential regulation is needed—this drawback is not a major one.
33Indeed, encouragement of good accounting generally is important throughout the financial sector, since even banks and other specialist lenders rely heavily on financial statements in assessing prospective borrowers and monitoring ongoing loans.