PART II: OTHER ISSUES DISCUSSED WITH THE COMMITTEE
1. Size of Banks and Success
There are four separate issues with respect to size that the Committee heard during its meetings:
- Is being "big" in the domestic marketplace a precondition for success in the global marketplace?
- Is size necessary for success in the banking sector?
- Is it important for a country to have a domestically-owned bank that is a major player in the global marketplace?
- Is the size of banks an issue for public policy?
No one with whom the Committee spoke argued that a necessary condition for success in the global marketplace is to be big domestically.
With respect to size and success, the Committee was told that, while size is important, being big by itself does not make for a world class institution. For example, ten years ago, the big banks were all Japanese. Their size did not guarantee success. Nevertheless, size does provide the large capital base that is necessary for global success, even if it does not guarantee that success.
There have been numerous studies of the link between size and cost of banking services, but these studies have yielded no unambiguous conclusion. Some, with whom the Committee met, argued that the mergers taking place around the world are very large-scale mergers, that although scale economies exist, they are relatively small over long ranges. A bank will not benefit from these economies unless they become "mega-banks." But others with whom the Committee met argued the converse, namely that there are very specific cost efficiency gains from large scale institutions.
A specific cost efficiency argument was frequently made for investment in information technology (IT). The expenditures necessary to have "state of the art" IT systems, needed if a bank is to be successful in the modern marketplace, are basically fixed costs, which implies that the larger the bank the lower the unit costs.
While in-house development of proprietary IT systems was the route of choice in the past, this has clearly changed. The tendency now is to purchase in-house turnkey computer systems.
Being small is not a disadvantage. Technology is a must, and it has to be the best The good news is that if one shops wisely, even the smallest bank can have the best. The big guys are the ones in trouble.(1)
Further, Citibank, which was the model for the development of proprietary technologies, has changed its strategy.
Citibank is redirecting much of its technology spending to outside IT organizations who provide commercially available, nonproprietary software applications for specific business processes and manage systems for data distribution, transaction processing, voice, and imaging services freeing up the bank to focus on banking not technology competencies.(2)
The Committee did hear, from most people with whom it met, that medium-sized multiproduct financial institutions will face difficult and growing problems in obtaining operational efficiencies. Those that try to do everything will fail; those that focus on a small number of productive services may succeed. State Street Bank is an example of a bank with a global franchise (in the custody area) that is not a mega-bank.
Many products that in the past were operated by multiproduct financial institutions are becoming scale driven. Mortgages and credit cards, for example, are products that are being taken over by large single product financial institutions (often called category killers). Their size is important for multiproduct firms facing this kind of competition.
With respect to whether a country needs a domestic bank that is a "world-class player", those with whom the Committee met in the United States argued that this was important to multinational American firms. A large domestic bank is needed to finance the export business, and can facilitate the distribution of domestic debt. Further, when money is really tight, will a foreign bank service its domestic clients before it meets the demands of its foreign clients? Having a domestic bank that is a global player may ensure a reliable source of capital on a large scale for multinational companies based in Canada.
Views similar to those expressed in the United States were heard in the Netherlands and Switzerland, but not in the United Kingdom or New Zealand. The Australians are still debating this question.
Finally, how is public policy related to the size of financial institutions? The reorganisation of the financial services sector (mergers, the development of large single product institutions, the development of "boutique" financial service providers and so on) is a response to competition in the marketplace. Shareholders are looking for an increase in the value of their investments; consumers are looking for improved quality of service and better prices. What are the public policy issues related to these developments?
There are three issues of particular concern for public policy. First, will "big" banks mean a diminution of competition? Size and concentration are not the same concept. If size is accompanied by anticompetitive impacts in the marketplace, then the government has two options. It can prohibit large institutions or it can introduce ways of ensuring that the larger institutions face real competition.
Second, does size bring with it an unacceptable degree of political power, of influence on policymakers? Once again, if there are problems of this nature associated with size, the government can prohibit large institutions, or it can develop ways of counteracting this effect.
Finally, does size create a "too-big-to-fail" problem that was not previously there? If there is an implicit or explicit too-big-to-fail policy in effect, then increasing size will have no effect. If there is no such policy, then it will be important to ensure that mechanisms are put in place to counteract the impression that one will exist.
Most people with whom the Committee spoke indicated that, as long as there were no public policy problems with mergers, the decision to merge, to expand, to curtail some operations, and so forth, should be a business decision. The market will, and is the appropriate place to, pass judgement on business strategy.
2. Community Banks
The Committee heard a great deal about the strong second tier of financial institutions in the countries involved in the study that provide an effective level of competition for the "big" banks.
In the United States, for example, there are the community banks. These banks, when they are well run, know their credit risks well, because they are close to their customers (they are almost always run by a local citizen who knows the community well), and earn a high return on their assets. It takes relatively little equity capital, as little as three million dollars, a lot of paper work and considerable experience. Technology can be purchased; back room operations can be contracted out. Basically, the bank is selling a service. The problem with community banks is their vulnerability to exogenous shocks to the community in which they operate. National banks benefit from geographic diversification.
The Committee was told that if community banks are to be promoted in Canada, they should not be given special powers and their capital requirements should be adequate for safety and soundness. Further, the regulator must be given the resources to hire, train and deploy the staff to handle the increased number of regulated institutions. Regulation of small banks is a labour-intensive activity, particularly in bad times.
3. The Holding Company Structure
On the distinction between the holding company-affiliate model and the parent-subsidiary model, some argued that there is not much of a difference.
While some claimed that the holding company model protects affiliates if one fails (and permits insulation of the safety net from all the other operations of the holding company), others argued that, as long as there is effective regulation in the parent-subsidiary model (that is, not allowing double counting of capital), then the failure of one operating subsidiary should not bring down other subsidiaries.
The argument over the appropriateness of the holding company model versus the parent-subsidiary model appears to be a "turf battle" among American regulators. It was not a concern elsewhere.
One person with whom the Committee met did suggest that the use of subsidiaries can lead to confusion with respect to the appropriate regulator. He cited the case of Japan`s Daiwa Bank. In 1995, this bank absorbed losses of $1.1 billion (US) after 11 years of concealment of losses by its New York bond trader. Daiwa was examined by bank regulators, when in fact the problem was one that would have been more appropriately handled by securities regulators.
Most people with whom the Committee spoke indicated that, in the absence of a public policy case against a specific form of corporate structure, the decision to use the holding company model or the parent-subsidiary model should be a business decision. The market will, and is the appropriate place to, pass judgement on business strategy.
4. International Co-operation Among Regulators and Regulation of Foreign Banks and Non-Banks
It was the view of most with whom the Committee spoke that every major global financial player whose demise would affect the stability of the financial system should be subject to some "overall" supervision.
Many have suggested that the appropriate way to proceed is to agree upon a lead regulator for each multinational financial institution for which regulation is appropriate. This lead regulator would co-ordinate the activities of the national regulators dealing with a specific company and ensure that the financial institution is being comprehensively regulated.
With respect to international co-operation among regulators, the US will not accept another countrys regulator as the lead regulator. In fact, regulators in the US argued that the lead regulator approach may reduce flexibility, particularly if those who are not the lead regulators are reticent to share information about problems within their jurisdictions. If too much structure is imposed, it may be difficult to resolve problems in an emergency. Further, whatever the degree of co-operation, the enforcement authority of the lead regulator stops at its national borders. The American focus on the international stage is national treatment, on ensuring that American institutions operating abroad have the same powers, and are treated the same, as foreign financial institutions operating in the US have.
International firms such as GE Capital and Merrill Lynch present a challenge to the international financial system. Depending on the activities these types of firms engage in they may deal with numerous regulators. There is, however, no regulator looking at the firm as a whole; that is, there is no consolidated regulator. There should be. The regulated financial institutions, with whom the Committee met, also argued that these large relatively unregulated international financial firms have a competitive advantage over the more regulated financial institutions; there is a non-level playing field which should not exist.
5. The Multiplicity or Regulators in the United States
How many regulators a country needs depends, among other things, on the degree of concentration in the financial services industry; the structure of government, that is, federal or unitary, and the constitutional assignment of powers; and the willingness to rely on market forces. Countries like the United Kingdom with its all encompassing Financial Services Authority and the United States with its multiplicity of regulators are at the opposite ends of the spectrum.
The preference of most, with whom the Committee met, was for a relatively centralised regulatory authority. In fact the Canadian system was often pointed to as a good model, with one key modification called for, the assumption of the responsibility for securities regulation by OSFI.
While most of the people with whom the Committee met acknowledged that if you were starting from scratch you would not create a regulatory system like the one which the U.S. has today, it does yield some definite benefits. Many argue that the American system, with all its regulators, does provide a flexibility for financial institutions that is lacking in more consolidated systems, like the British system.
Depending on what services they wish to provide, what corporate structure they wish to employ and where they want to operate, banks will choose their regulator. (In the Chase-Chemical merger, the former had a federal charter, the latter, a state charter, and the merged bank took a state charter. Most of the recently announced proposed mergers will result in federally chartered banks.)
This "jurisdiction shopping" has enabled considerable innovation to be undertaken.
A further value of multiple regulators is the different points of view that are brought to the table. With the FSA model in Great Britain, there is no open dialogue as exists in the US, where the supervisors challenge each other.
6. The Community Reinvestment Act
The Committee heard about the Community Reinvestment Act, a 1977 federal law which requires banks to affirmatively seek out lending opportunities in the local communities where they are located. It does not involve quotas or mandated credit allocation. No banks are required to lend money to bad credit risks. It relies on disclosure to "encourage" lending institutions to reach out to previously under served areas.
An institution is graded every 18 to 24 months, by whichever of four regulatory agencies is responsible for it, from "outstanding" to "substantial noncompliance". Further different assessment standards apply to small banks, wholesale or limited purpose banks, and large retail banks.
For example, for banks with assets over $250 million (US), there are five performance indicators:
- lending activity (the number and amount of the bank`s loans in the bank`s assessment area);
- geographic distribution (the distribution of the bank`s lending across geographic areas, within the assessment area and across income groups);
- borrower characteristics (distribution of loans among mortgages, small business loans, small farm loans, and consumer loans);
- community development lending (the number and amount of community development loans, their complexity and innovativeness); and,
- the bank`s use of innovativeness or flexible lending practices to meet the needs of low- and moderate-income individuals.
Regulators look at an institution`s CRA ratings when they are making decisions on merger applications, acquisitions, branch openings and closures, charter applications, deposit insurance applications, or other actions requiring regulatory approval. Further, community groups can enter protests against institutions that they feel are not providing satisfactory service to their local communities.
The Act`s greatest contribution, some argue, has been the change it has made in the psychology of lending. It has encouraged lenders to ask themselves, as a matter of routine business, whether they are serving all potential clients. There are customers who, while not being the simplest to service, still pose acceptably small risks and can yield solid profits. These potential customers require considerable effort to reach, but it is nevertheless profitable.
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