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Perspectives on safe & sound banking: Past, present, and future
Journal of Banking and Finance 12 (1988) 603-614. North-Holland
George J. Benston, Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane and George G. Kaufman, Perspectives on Safe & Sound Banking: Past, Present, and Future (The MIT Press, Cambridge, MA, 1986) pp. xxi+-358, $19.95. The Depository Institution Deregulation and Monetary Control Act, which metho&cally reduced the interest-rate and product restrictions on banking firms, was the first attempt at banking reform in the 1980s. However, since an increasing number of banks have failed in this decade, perhaps the policy makers and regulators are not aw of the need for compkts reform of the banking system. Specifically,complete reform calls for a restructuring of processes which insure, examine, and regulate financial institutions. If the yardstick used to gauge performance is the number of bank failures since 1980, existing reforms have been piecemeal and inadequate. Short of abandoning the current processes, the reform movement needs to view the larger effects of these partial reforms on the performance of the financial system. In a study commissioned by the American Bankers Association, five academic consultants (Benston of the University of Rochester, Eisenbeis of the University of North Carolina, Horvitz of the University of Houston, Kane of Ohio State University, and Kaufman of Loyola University of Chicago) present a treatise on the past, present, and future of the financial-services industry and on needed reforms. This collection, entitled Perspectives on Sufk & Sound Bunking, provides a comprehensive view of the management and regulatory blunders, and reforms of the past. Perspectives looks at the changing risk characteristics of the banking system .and the present regulatorgl inadequacies for dealing with these new facets. Finally, the authors offer alternatives for restructur@ the processes of insuring, examining, and regulating financial in~‘i.~!.Yr;r~~, and they appraise the effect of each on the structure and operation c,F.::Z?W?i,~.x;zcial system. Perspectives begins by exali>initlq %~#%g: risks and the effects on the banking system of bank failures. “lhs; ;:tur%:eof these risks, namely insufficient diversification, insufficient liquidity, ano the propensity of bank owners and managers to accept risks, work in concert to frame the probability of bank failure. Banks manage the% probabilities by diversifying activities and portfolios and by instituting better control and monitoring systems. However, when bankers are unwilling to use these tools because they seek risks, or are unable to do so because regulations limit diversification, they often manage theiLlbanks into failure. When banks fail in an uninsured system the @3751c266/88j$3.50@ 1988, Elsevier Science Publishers B.V. (North-Holland)
Book reviews
605
penalties accrue first to the stockholders and then to the depositors. However, when "'le ~anking system is supported by deposit insurance, the penalties for .,lure accrue first to the stockholders and then to uninsured depositors (in the case of less than 100 percent insurance) and the insuring party. Failures also can result in a contagion effect for the financial system with either a flight to currency, if the financial system is suspected of weakness, or to quality, if many institutions within the system are suspected of weakness but the system is sound. Perspectives then puts the historic bank runs and failures in proper focus. Banking difficulties are popularly believed to exert greater effects on the financial woes of the nation than difficulties in other industries. However, the adverse effects of these events in U.S. history have not 'been much greater than the effects of financial difficulties of most other business firms...'. For example, the great depression of the 1930s is believed to have caused thousands of bank depositors to lose their life savings in the absence of deposit insurance. The truth of the matter is that depositors lost some fraction of their savings during this period but the losses were typically less than 5 percent. However, legislators Carter Glass and Henry Steag~ used this popular myth to create the Federal Deposit Insurance Corporation under the Banking Act of 1933. What has happened since the great depression and the creation of federal deposit insurance? Mainly, the propensity for bank managers and owners to take risks, given the FDIC safety net, has increased. Often these managers and owners take excessive risk and the result is bank failure. When these banks fail what constitutes the most efficacious method of the FDIC for handling the insolvencies? The FDIC has several options at this point: (1) pay off insured depositors, (2) arrange for the purchase and assumption by a healthy institution (either in whole or in part), or (3) loan funds to the failed entity in hopes of reviving it. However, since the choices for handiing bank failures have been neither uniform across similar failures nor always prudent in terms of FDIC cost, a suggested reform includes allowing the FDIC to take over, and temporarily run, failed institutibns until a decision on the disposition of assets and liabilities is reached. Such a procedure would increase the available time for decision-making. What about the actions of the Federal Reserve, lender ot last resort to troubled institutions? When should Fed:ral money, via the discount window, be made available to failing banks and at what rate? Without the lender of last resort, the probability increases for the distress sale of failing-bank assets to cover liabilities. On the other hand, the need for 'fi~:e sales' of bank assets is reduced with a lender of last resort whose lending rate is sensitive to the maturity of the loan and to the problem-bank's other borrowing possibilities. Perspectives" view of the future for financial institutions provides important coverage of policy issues in banking. For example, regulators have always
606
Book reviews
justified bank regulatory policies by claiming that banks are the unique transmitters of monetary policy. However, with the growing number of nonbank financial intermediaries, banks no longer appear to be unique. Consequently, the banking regulations developed under the 'real bills' doctrine of the early 1900s must be changed. New activities for banks impact the safety of the financial system as does the new banking structure that carries out new activities. These new undertakings, however, should not threaten the safety of the insured bank but should pro~,ide for greater competition betweer kanking and non-banking firms for financial services. By instituting risk-r~ .ed capital standards, or repricing deposit insurance, banks could be alloy into other activities without adverse depositor effects. However, the actJ ,es which banks can undertake should be limited to those with readily assessable risks. Perspectives introduces the popular academic concept of market discipline as the correct determinant of financial safety and soundness. What are the benefits and costs of market-value reporting? By allowing banks to increase their market-related activities, we can explore the benefits of increased market-based asset pricing and of risk-based insurance prem;ums. These benefits include the correct pricing of risk in an assesslne,nt of the market value of assets and liabilities. The costs include determining the appropriate market values for assets with heterogeneous characteristics. For small institutions, the costs of determining market values are extremely high but Perspectives provides a primer for initiating such market-value reporting. The emphasis is still on the market as the best-known ratings agent for safety and soundness. Of course, only a few hundred banks (out of almost 15,000) presently have market data available. Nevertheless, these banks (and their holding companies) control the bulk of the industry's assets and deposits, and present the greatest threat to the ability of the financial system. Perspectives next covers one of the most widely debated financial topics of the banking discipline, risk-related premiums for deposit insurance. The authors examine the inequities of the present system of deposit insurance in which 'safe-and-sound' institutions pay premiums that compensate for the riskier institutions in the system. Acknowledging that informational inadequacies, administrative lags, and political protections limit needed changes in the present deposit insurance system, the authors thoroughly explore the a~ency theory implications of deposit insurance on the relatiop.~hip between the owner/maJiagers of the bank and the insuring agent. The authors also review the theory and empirical work in pricing deposit insurance and in predicting bank failure. How do deposit-insurance administrators design a better system for adjusting insurance premiums? The authors suggest a self-regulating commission of insmed banks. The healthy institutions would have the incentive to
Book reviews
607
report the risk excesses of other member institutions in order to avoid underwriting the insurance fund's exposure to these excesses. How do administrators improve the quality of information in the reporting system? The authors suggest the use of market-value reporting to more clearly assess the riskiness of insured institutions. One final measure suggested to more closely align the interests of the firm with those of the insurer is extended stockholder liability. The authors suggest a penalty for stockholders in the event of bank failure. Putting the personal wealth of stockholders at risk would increase the d~gree of menagement monitoring by the board of directors and decrease the benefits of risk-taking to stockholders. On balance, it appears that the only tool missing from this section on risk and markets is a chapter on the securitization of financial assets. This addition would have b~n a useful bridge between new bank'ng activities and the discipline of markets where buyers and sellers of financial assets (or pools of assets) determine price. Perspectives ~,ffers some alternatives to the present regulatory :ystem of on-site examination and off-site supervision. Even the agents of the FDIC and the Fed will admit that bank failures are in part due to inadequate and ill-timed monitoring. Second, the structure ~f the system itself can be part of the monitoring problem. One alternative would be to augment the statistical data on banks with market value data drawn from empirical studies which reveal significant factors iv. predicting bank failure. Finally, Perspectives y;overs the debate over centralization or decentralization of regulation, supervision, and examination. The authors see three major flaws with the cu~:ent regulatory framework: (1) regulatory agencies do not ~ooperate in th~'~oversight of the banking system; (2) regulators from different agencies fre~aently do not pool information on examined banks; and (3) regulators ofter~ try to avoid the examination of supervised problem banks by rela'fing the regulations. Some of these we_~knessescould be eliminated by con.~'lidating examination and chartering activities in one agency. After evaluating the FDIC and FHLBB proposals for change in the regulatory framework, the authors present options for change and a blueprint for implementing these changes in a comprehensive prol~osal of their own. The au.thors argue that despite the inherent problems with the present system the competitive benefits in maintaining multiple agencies for regulation, supervision, and examination must be acknowledged. In conclusion, Perspectives on Safe & Sound Banking provides a comprehensive review of the past, and a strong call for reform in the present banking system. This commissioned study is the result of ABA and academic cooperation that yields a thorough analysis of the effects of partial solutions on the larger picture of banking reform. To the authors' credit, no stop-gap measures are proposed as they argue for industry reform and a reshaping of the regulatory and insurance functions.
608
Book reviews 1
Per.~/pectives thoroughly covers the development of our banking system by focusZng on the events which changed the industry and on the alternatives for/mproving the system. It provides a clear understanding of banking's bi~/~est problems. This reviewer recommends Perspectives for academicians, b~/akers, and regulators (with an eye toward improving the safety and s]Jundness of the banking industry), and for both graduate and undergraduate students with career interests in financial management or regulation. /
/
M. Cary Collins University of Georgia, Athens, GA
Ernest Bloch, Inside Investment Banking (Dew Jones-Irwin, Homewood, IL, 1986) pp. XIV + 321, $35.63. According to the author, 'this book grew out of necessity and opportunity'. The necessity came when Bloch was teaching a course on investmentbanking and could not find a suitable text on the subject. The opportunity came from his good fortune to team teach an undergraduate course on investment-banking with Gustave L. Levy, senior partner with Goldman, Sachs and Co. This is one of the advantages of teaching at New York University and having large investment-banking houses right down the street. Apparently, the author is trying to span two markets with this book. Since the book was developed to teach a seminar course, Bloch apparently intends it to be used as a textbook, but the format of the book is much closer to that of a reference book for professionals. For example, there are no problems or questions at the end of the chapters, which is unusual for a textbook. The book covers four sections, (1) market making, (2) the new-issue process, (3) public policy issues regarding regulatory change in the new-issue process, and (4) issues raised by the institutionalization of security markets. Also, a glossary of technical terms is provided at the end of the book. This was adapted in part from the glossary in Managing Bank Assets and Liabilities by Marcia L. Stigum and Ren~ O. Branch, Jr. In the first section of the book, market making, which refers to placing capital at risk and carrying financial inventories, the reader is given a short introduction to investment banking and followed by a brief historical synopsis of the important regulatory and technological changes that have affected the investment-banking process since the great depression of the 1930s. The author then gives an overview of the investment-banking industry as it exists today. Here Bloch pinpoints investment-banking firms; who investment bankers are and how they make money. He thoroughly explains financial innovations and their effects on investmevt banking.
George J. Benston, Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane and George G. Kaufman, Perspectives on Safe & Sound Banking: Past, Present, and Future (The MIT Press, Cambridge, MA, 1986) pp. xxi+-358, $19.95. The Depository Institution Deregulation and Monetary Control Act, which metho&cally reduced the interest-rate and product restrictions on banking firms, was the first attempt at banking reform in the 1980s. However, since an increasing number of banks have failed in this decade, perhaps the policy makers and regulators are not aw of the need for compkts reform of the banking system. Specifically,complete reform calls for a restructuring of processes which insure, examine, and regulate financial institutions. If the yardstick used to gauge performance is the number of bank failures since 1980, existing reforms have been piecemeal and inadequate. Short of abandoning the current processes, the reform movement needs to view the larger effects of these partial reforms on the performance of the financial system. In a study commissioned by the American Bankers Association, five academic consultants (Benston of the University of Rochester, Eisenbeis of the University of North Carolina, Horvitz of the University of Houston, Kane of Ohio State University, and Kaufman of Loyola University of Chicago) present a treatise on the past, present, and future of the financial-services industry and on needed reforms. This collection, entitled Perspectives on Sufk & Sound Bunking, provides a comprehensive view of the management and regulatory blunders, and reforms of the past. Perspectives looks at the changing risk characteristics of the banking system .and the present regulatorgl inadequacies for dealing with these new facets. Finally, the authors offer alternatives for restructur@ the processes of insuring, examining, and regulating financial in~‘i.~!.Yr;r~~, and they appraise the effect of each on the structure and operation c,F.::Z?W?i,~.x;zcial system. Perspectives begins by exali>initlq %~#%g: risks and the effects on the banking system of bank failures. “lhs; ;:tur%:eof these risks, namely insufficient diversification, insufficient liquidity, ano the propensity of bank owners and managers to accept risks, work in concert to frame the probability of bank failure. Banks manage the% probabilities by diversifying activities and portfolios and by instituting better control and monitoring systems. However, when bankers are unwilling to use these tools because they seek risks, or are unable to do so because regulations limit diversification, they often manage theiLlbanks into failure. When banks fail in an uninsured system the @3751c266/88j$3.50@ 1988, Elsevier Science Publishers B.V. (North-Holland)
Book reviews
605
penalties accrue first to the stockholders and then to the depositors. However, when "'le ~anking system is supported by deposit insurance, the penalties for .,lure accrue first to the stockholders and then to uninsured depositors (in the case of less than 100 percent insurance) and the insuring party. Failures also can result in a contagion effect for the financial system with either a flight to currency, if the financial system is suspected of weakness, or to quality, if many institutions within the system are suspected of weakness but the system is sound. Perspectives then puts the historic bank runs and failures in proper focus. Banking difficulties are popularly believed to exert greater effects on the financial woes of the nation than difficulties in other industries. However, the adverse effects of these events in U.S. history have not 'been much greater than the effects of financial difficulties of most other business firms...'. For example, the great depression of the 1930s is believed to have caused thousands of bank depositors to lose their life savings in the absence of deposit insurance. The truth of the matter is that depositors lost some fraction of their savings during this period but the losses were typically less than 5 percent. However, legislators Carter Glass and Henry Steag~ used this popular myth to create the Federal Deposit Insurance Corporation under the Banking Act of 1933. What has happened since the great depression and the creation of federal deposit insurance? Mainly, the propensity for bank managers and owners to take risks, given the FDIC safety net, has increased. Often these managers and owners take excessive risk and the result is bank failure. When these banks fail what constitutes the most efficacious method of the FDIC for handling the insolvencies? The FDIC has several options at this point: (1) pay off insured depositors, (2) arrange for the purchase and assumption by a healthy institution (either in whole or in part), or (3) loan funds to the failed entity in hopes of reviving it. However, since the choices for handiing bank failures have been neither uniform across similar failures nor always prudent in terms of FDIC cost, a suggested reform includes allowing the FDIC to take over, and temporarily run, failed institutibns until a decision on the disposition of assets and liabilities is reached. Such a procedure would increase the available time for decision-making. What about the actions of the Federal Reserve, lender ot last resort to troubled institutions? When should Fed:ral money, via the discount window, be made available to failing banks and at what rate? Without the lender of last resort, the probability increases for the distress sale of failing-bank assets to cover liabilities. On the other hand, the need for 'fi~:e sales' of bank assets is reduced with a lender of last resort whose lending rate is sensitive to the maturity of the loan and to the problem-bank's other borrowing possibilities. Perspectives" view of the future for financial institutions provides important coverage of policy issues in banking. For example, regulators have always
606
Book reviews
justified bank regulatory policies by claiming that banks are the unique transmitters of monetary policy. However, with the growing number of nonbank financial intermediaries, banks no longer appear to be unique. Consequently, the banking regulations developed under the 'real bills' doctrine of the early 1900s must be changed. New activities for banks impact the safety of the financial system as does the new banking structure that carries out new activities. These new undertakings, however, should not threaten the safety of the insured bank but should pro~,ide for greater competition betweer kanking and non-banking firms for financial services. By instituting risk-r~ .ed capital standards, or repricing deposit insurance, banks could be alloy into other activities without adverse depositor effects. However, the actJ ,es which banks can undertake should be limited to those with readily assessable risks. Perspectives introduces the popular academic concept of market discipline as the correct determinant of financial safety and soundness. What are the benefits and costs of market-value reporting? By allowing banks to increase their market-related activities, we can explore the benefits of increased market-based asset pricing and of risk-based insurance prem;ums. These benefits include the correct pricing of risk in an assesslne,nt of the market value of assets and liabilities. The costs include determining the appropriate market values for assets with heterogeneous characteristics. For small institutions, the costs of determining market values are extremely high but Perspectives provides a primer for initiating such market-value reporting. The emphasis is still on the market as the best-known ratings agent for safety and soundness. Of course, only a few hundred banks (out of almost 15,000) presently have market data available. Nevertheless, these banks (and their holding companies) control the bulk of the industry's assets and deposits, and present the greatest threat to the ability of the financial system. Perspectives next covers one of the most widely debated financial topics of the banking discipline, risk-related premiums for deposit insurance. The authors examine the inequities of the present system of deposit insurance in which 'safe-and-sound' institutions pay premiums that compensate for the riskier institutions in the system. Acknowledging that informational inadequacies, administrative lags, and political protections limit needed changes in the present deposit insurance system, the authors thoroughly explore the a~ency theory implications of deposit insurance on the relatiop.~hip between the owner/maJiagers of the bank and the insuring agent. The authors also review the theory and empirical work in pricing deposit insurance and in predicting bank failure. How do deposit-insurance administrators design a better system for adjusting insurance premiums? The authors suggest a self-regulating commission of insmed banks. The healthy institutions would have the incentive to
Book reviews
607
report the risk excesses of other member institutions in order to avoid underwriting the insurance fund's exposure to these excesses. How do administrators improve the quality of information in the reporting system? The authors suggest the use of market-value reporting to more clearly assess the riskiness of insured institutions. One final measure suggested to more closely align the interests of the firm with those of the insurer is extended stockholder liability. The authors suggest a penalty for stockholders in the event of bank failure. Putting the personal wealth of stockholders at risk would increase the d~gree of menagement monitoring by the board of directors and decrease the benefits of risk-taking to stockholders. On balance, it appears that the only tool missing from this section on risk and markets is a chapter on the securitization of financial assets. This addition would have b~n a useful bridge between new bank'ng activities and the discipline of markets where buyers and sellers of financial assets (or pools of assets) determine price. Perspectives ~,ffers some alternatives to the present regulatory :ystem of on-site examination and off-site supervision. Even the agents of the FDIC and the Fed will admit that bank failures are in part due to inadequate and ill-timed monitoring. Second, the structure ~f the system itself can be part of the monitoring problem. One alternative would be to augment the statistical data on banks with market value data drawn from empirical studies which reveal significant factors iv. predicting bank failure. Finally, Perspectives y;overs the debate over centralization or decentralization of regulation, supervision, and examination. The authors see three major flaws with the cu~:ent regulatory framework: (1) regulatory agencies do not ~ooperate in th~'~oversight of the banking system; (2) regulators from different agencies fre~aently do not pool information on examined banks; and (3) regulators ofter~ try to avoid the examination of supervised problem banks by rela'fing the regulations. Some of these we_~knessescould be eliminated by con.~'lidating examination and chartering activities in one agency. After evaluating the FDIC and FHLBB proposals for change in the regulatory framework, the authors present options for change and a blueprint for implementing these changes in a comprehensive prol~osal of their own. The au.thors argue that despite the inherent problems with the present system the competitive benefits in maintaining multiple agencies for regulation, supervision, and examination must be acknowledged. In conclusion, Perspectives on Safe & Sound Banking provides a comprehensive review of the past, and a strong call for reform in the present banking system. This commissioned study is the result of ABA and academic cooperation that yields a thorough analysis of the effects of partial solutions on the larger picture of banking reform. To the authors' credit, no stop-gap measures are proposed as they argue for industry reform and a reshaping of the regulatory and insurance functions.
608
Book reviews 1
Per.~/pectives thoroughly covers the development of our banking system by focusZng on the events which changed the industry and on the alternatives for/mproving the system. It provides a clear understanding of banking's bi~/~est problems. This reviewer recommends Perspectives for academicians, b~/akers, and regulators (with an eye toward improving the safety and s]Jundness of the banking industry), and for both graduate and undergraduate students with career interests in financial management or regulation. /
/
M. Cary Collins University of Georgia, Athens, GA
Ernest Bloch, Inside Investment Banking (Dew Jones-Irwin, Homewood, IL, 1986) pp. XIV + 321, $35.63. According to the author, 'this book grew out of necessity and opportunity'. The necessity came when Bloch was teaching a course on investmentbanking and could not find a suitable text on the subject. The opportunity came from his good fortune to team teach an undergraduate course on investment-banking with Gustave L. Levy, senior partner with Goldman, Sachs and Co. This is one of the advantages of teaching at New York University and having large investment-banking houses right down the street. Apparently, the author is trying to span two markets with this book. Since the book was developed to teach a seminar course, Bloch apparently intends it to be used as a textbook, but the format of the book is much closer to that of a reference book for professionals. For example, there are no problems or questions at the end of the chapters, which is unusual for a textbook. The book covers four sections, (1) market making, (2) the new-issue process, (3) public policy issues regarding regulatory change in the new-issue process, and (4) issues raised by the institutionalization of security markets. Also, a glossary of technical terms is provided at the end of the book. This was adapted in part from the glossary in Managing Bank Assets and Liabilities by Marcia L. Stigum and Ren~ O. Branch, Jr. In the first section of the book, market making, which refers to placing capital at risk and carrying financial inventories, the reader is given a short introduction to investment banking and followed by a brief historical synopsis of the important regulatory and technological changes that have affected the investment-banking process since the great depression of the 1930s. The author then gives an overview of the investment-banking industry as it exists today. Here Bloch pinpoints investment-banking firms; who investment bankers are and how they make money. He thoroughly explains financial innovations and their effects on investmevt banking.