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Expansion of commercial banking powers … or, universal banking is the cart, not the horse
Journal of Banking & Finance 23 (1999) 655±662
Expansion of commercial banking powers . . . or, universal banking is the cart, not the horse John H. Boyd
*
Carlson School of Management, University of Minnesota, 271-19th Avenue, Minneapolis, MN 55455, USA
Abstract This short essay deals with universal banking in an environment in which a government safety net (for example deposit insurance) results in a moral hazard problem for banks. It argues that universal banking signi®cantly exacerbates the problem. Speci®cally, universal banking extends the distortion of incentives caused by moral hazard to other sectors of the economy. Ó 1999 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21 Keywords: Universal banking; Commercial banking; Bank regulation
1. Introduction The title of my essay is a paraphrase of the title of an earlier paper by my colleague, and dear friend, Jack Kareken. His much cited paper (Kareken, 1983) is rather famous because it essentially predicted the savings and loan crisis. Unfortunately, it was not so widely read in the early eighties. Whereas I am not predicting any impending crisis, I am making the same logical point as *
Corresponding author. Corresponding address: Kappell chair in Business and Government, Finance Department, Carlson School, Room 3-110, 321 19th Avenue South, Minneapolis, MN 55455, USA; e-mail: [email protected]. 0378-4266/99/$ ± see front matter Ó 1999 Elsevier Science B.V. All rights reserved. PII: S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 1 0 1 - 0
656
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Kareken regarding the importance of sequence. In this essay, universal banking is the ``cart'', and reform of the bank safety net (deposit insurance, the Discount Window, etc.) is the ``horse''. My punch line is this: if a universal banking system is implemented in the US without, ®rst, eliminating moral hazard due to the safety net, the consequences could be most undesirable. Since, in my view, the safety net issue is the deepest and thorniest issue in the prudential regulation of banks, I am not optimistic about a quick ®x. 1 Let me anticipate for a moment. An argument I expect to hear is that we have already ``solved'' the moral hazard problem in banking due to recent regulatory innovations such as the BIS capital standards and other provisions of FDICIA, etc. Critics of this essay will also surely note that the US banking industry is remarkably healthy and well capitalized at present, as is the FDIC. In response to such anticipated arguments, I would ®rst observe that the US is not the only country in the world. Many other nations ± including several which also employ the BIS capital standards ± have experienced severe banking problems in the last ®ve years or so. The list of nations with banking crises runs from much of South America and Mexico to some of Europe and most of Asia. It includes nations with isolated banking problems such as England and France, and others such as Japan with crises involving, essentially, the entire system. Do we really think our banking system is so unique that it is immune to such forces? In so far as the recent US banking experience is concerned, we have bene®ted from a superb macroeconomic environment in recent years. To be sure, US banks have done well recently ± but, they have done well during one of the longest and strongest economic recoveries in post-war history. Recall that in just the last macroeconomic downturn (roughly 1989±1991) US banks did so miserably that the Congress felt it necessary to authorize bailout funding for the FDIC. Although a bailout proved unnecessary, I submit it is too soon and too risky to declare victory. The new regulatory regime has not been put to the test in anything except a benign environment. Next, I turn to a brief description of universal banking. 2. Universal banking A universal banking system is one in which banks are permitted to make equity investments in ®rms rather than, or in addition to, extending them loans. In practice, the best example of such a system is in present-day Germany where banks hold large blocks of equities, vote their shares and serve as directors of
1 Many of the arguments contained in this essay are put more formally in Boyd et al. (forthcoming). My coauthors are responsible for none of the errors, if any, in this essay.
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corporations. Through the policy of ``Auftragsstimmrecht'' they can also vote the shares of other parties (Gorton and Schmid, 1996). Fundamentally, under universal banking, banks can own and control other ®rms, including commercial and industrial enterprises. 2 This topic is of more than theoretical interest. Variants of such a system have been, and continue to be, proposed for the US: by the US Treasury (1991), the so-called Shadow Financial Regulatory Committee (American Banker, 1997) and some members of Congress. Indeed, universal banking legislation is under active debate in Washington today. Now, at face value, such proposals might appear innocuous; ``Just let banks buy some stocks, in addition to their loan portfolio holdings''. But things are not always what they seem, and these proposals could have profound eects on our ®nancial markets. For example, universal banking is not at all ``friendly'' to markets; indeed, these two arrangements, markets and universal banks, are to a considerable extent substitutes. In Germany, the universal banking system does not exist alongside large and active stock and corporate bond markets as we have in the US. There, securities markets are narrow, trading volumes are low, and it is quite uncommon for individuals to hold stocks and corporate bonds for their own accounts. (Gorton and Schmid, 1996). This sort of ``crowding out eect'' is not the main point of my essay ± but it is worth thinking about. 3 Next let us talk about moral hazard in banking. 3. Government-induced moral hazard in banking: What is it? The problem of government induced moral hazard in banking (GIMHIB) has been recognized by theorists at least since the seminal works of Merton (1977) and Kareken and Wallace (1978). Industry practitioners and regulators were slower to recognize the problem (or at least to admit its practical signi®cance) ± that is, until the savings and loan crisis in the US. At that time, GIMHIB was publicly and ¯agrantly displayed in extremis, and no one could deny its importance. For a time, bankrupt (or ``Zombie'') S&Ls were permitted to continue operating by the FSLIC even though they were economically broke. Having nothing to lose and much to gain, many of the Zombies took huge portfolio risks and/or were looted by their managers. The resulting losses were large and caused an angry Congress to disband the S&L regulators, and
2
Another feature of universal banking systems is that banks are permitted to engage in the full range of intermediation services including brokerage and investment banking. Although important, that dimension of universal banking is not the focus of this essay. 3 Also worth thinking about is the concentration of ownership which might occur under universal banking.
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to pass legislation (most notably the FDICIA legislation of 1991) which is quite explicit in its recognition of GIMHIB. 4 I next turn to a simple but illustrative example of what GIMHIB is and how it works. 3.1. An example of GIMHIB Many scholarly studies have been written about GIMHIB, and I cannot begin to do justice to that large literature here. However, a simple example will help to set out the principles involved, and to illustrate why GIMHIB so badly distorts market-based incentives. I note that the points I am about to demonstrate by example have been rigorously proved elsewhere. Here, I employ the theoristÕs ploy of reducing a problem to its purest form, so that nothing but the essential features remain. In particular, GIMHIB induces an incentive to gamble ± so I discuss this phenomenon in a gambling framework. The most important point is to show that under GIMHIB, bankers will quite rationally seek out gambling opportunities, even when they are naturally averse to risk-taking. The example: An entrepreneur is endowed with $4 million in personal wealth. She opens a new bank, putting $2 million in equity and raising $18 million in insured deposits, which are the only bank liabilities. Bank assets will be ``invested'' using the roulette wheel. Speci®cally, the full $20 million will be placed on the color black, which pays two-for-one for a win. The entrepreneur is, by assumption, averse to risk-taking with her own wealth. To hedge her bank bet, she places her other (personal) $2 million on red. For now, I ignore the zero on the roulette wheel; this comes up only 1/36 of the time and ignoring the zero does not aect my calculations very much. (Conceptually, if not quantitatively, this is however an important assumption. But I will get to that in a moment.) With this simpli®cation, the only possible outcomes are red and black. Now, if red comes up the bank is broke, but the owner wins. She takes away $4 million and has just broken even, personally, since her initial endowment was $4 million. Alternatively, if black comes up, the owner loses on her own account. But the bank, which she also owns, wins $20 million, net. She can pay o the depositorsÕ $18 million (plus interest, which I ignore) and walk with $22 million. Before the fact, her expected net rate of return on this ``investment'' is (($22 ) $4) / $4) ´ (1/2) 225%. 5 And, of course, from the entrepreneurÕs perspective there was never a risk of loss. I submit, a 225% expected rate of return on a one day investment, with no risk
4 For example, the provisions which make it more dicult to invoke the ``too big to fail'' policy are explicitly an attempt to contain GIMHIB. So is the policy of ``prompt closure''. 5 In words, a $4 million investment results in a ®fty±®fty chance of winning an $18 million net pro®t, or breaking even.
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of loss, is pretty tempting. That is the main point of the example, because GIMHIB creates this situation. 6 The example can be pushed a bit further, to illustrate three additional features of GIMHIB. For brevity, I will not present the calculations but the reader can easily do that for himself. First point: If I did allow for the zero on the roulette wheel, both red and black would lose 1/36th of the time. 7 With this change, roulette would become a negative net present value ``investment''. However, the expected return to the entrepreneur would only be slightly reduced and it would still be possible to create a perfect hedge. 8 Thus playing roulette would still remain a very attractive proposition. WhatÕs the point? GIMHIB induces banks to willingly invest in negative NPV projects, if they are suciently risky. Obviously, from an economic eciency perspective, this is a particularly undesirable eect since negative NPV investments are socially wasteful. Second point: The second point is that the entrepreneur has an unlimited appetite for ®nancial leverage. In the original example, if the bank doubled its asset/equity ratio, from 10:1 to 20:1, the expected rate of return to the entrepreneur would rise dramatically, from 225% to 475%. More generally, the expected rate of return to the entrepreneur is increasing in leverage, without limit. Third point: The converse of the second point is also of some interest. In the original example (e.g. no zero on the roulette wheel) suppose that there were a 50% capital requirement so that the bank could only raise $2 in deposits to match its $2 in equity. Then, the expected rate of return to the entrepreneur would fall to 25%; but that is still a positive expected return on a risk-free bet. Indeed, in the example, capital regulation, no matter how severe, can never render gambling unpro®table. Or, to put the point another way, capital regulation by itself cannot overcoming the moral hazard problem. 9
6 Readers may think that this example is ``unrealistic'' and that my extreme assumptions drive the results. I of course disagree. In contemporary ®nancial markets, bankers have access to an unlimited array of risky investments. (Just consider the recent Barings incident.) The roulette example does provide for access to a costless, perfect hedge which admittedly may be a bit farfetched. However, in principle the bank owner could just as well eliminate risk of loss by diversi®cation; that is, by chartering a large number of independent banks. 7 Assuming there is only one zero on the roulette wheel, as in many European casinos. 8 This requires betting a small amount on the zero(s). 9 This statement is only true if the gamble has a non-negative expected return. If the expected return is negative, there will always exist a capital ratio which renders gambling unpro®table. It also requires that asset values be bounded from below at zero (Karaken et al., 1978).
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3.2. Summary What is going on in this example, obviously, is that gambling is enormously pro®table for the bank (on average) only because it is enormously unpro®table for the FDIC. When the gamble pays o, the gain goes to the bank; when it fails most of the loss goes to the deposit insurer. The clear implication is that whenever such incentives are created by GIMHIB, they must be somehow controlled. Otherwise, there will be an expected value wealth transfer of unknown magnitude from the government to the banks. (The S&L crisis was an excellent example of such forces being allowed to play out in real life.) As we shall see next, the distortions caused by GIMHIB are especially troubling in the context of universal banking. 4. Now, what about universal banking? I again employ the theoristÕs trick of reducing the problem to its fundamentals. The simplest universal bank possible is one whose only asset is a controlling equity investment in a single non-®nancial corporation; its only liability, insured deposits. Now, for exactly the same reasons as above, the bank has the incentive to choose a risky investment ± but now it will be, by construction, an investment in the non-®nancial sector. Too, the universal bank will ®nd it perfectly rational to invest in a negative NPV project, if risky enough. And ®nally, it will employ as much ®nancial leverage as permitted. It should be clear that the distortion of incentives caused by GIMHIB transmits directly to the non-®nancial ®rm because it is owned by a bank. And as sole owner the bank has control rights, meaning it can implement its distorted objectives. There are a host of complications which obviously need to be taken into account here. Examples include: allowing for other owners of the ®rm besides the universal bank; allowing the universal bank to hold a diversi®ed asset portfolio; and permitting it to make loans as well as equity investments. Such complications are beyond the scope of this essay but in any case do not alter the basic logic: GIMHIB induces banks to make risky investments and to ®nance them in a risky manner. This distortion of incentives extends to non-®nancial ®rms, and potentially to all sectors of the economy, when non-®nancial ®rms can be owned by universal banks. 10 I next turn to the question of how, and at what cost, GIMHIB can be kept in check.
10
It should also be noted that a universal banking system expands the potential liabilities of the FDIC to include losses occurring in the non-®nancial sector. This is a common argument (Saunders and Walter, 1994), and not the main point of this essay.
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5. Controlling or eliminating GIMHIB There is a large literature on controlling GIMHIB. However, there are realistically just two general classes of policies for this purpose. As we shall see, either class of policy can control moral hazard due to GIMHIB if applied with sucient vigor. Unfortunately, both classes of policies are very costly in terms of economic eciency. The ®rst tactic is to regulate, audit and supervise banks so as to limit their ability to take risk. In eect, GIMHIB is left in place, but is contained by direct governmental intervention. That approach, of course, is exactly what is done now with commercial banks, and in principle the policy could be extended to the operations of universal banks. To me at least, this raises several questions. First, ``Does one really want that degree of governmental intervention in the non-®nancial sectors of the US economy?'' Recall that we presently regulate and examine virtually every aspect of commercial banking operations: asset allocation, liability allocation, capital structure, control rights, entry and even exit. A second and related question is, ``Are the banking authorities prepared to regulate, supervise and examine the activities of non-®nancial ®rms at the same level of eectiveness that they now do commercial banks?'' Based on my years in the Federal Reserve System, the answer to this question is clearly ``No''. This probably explains why the US bank regulators are not in general among the advocates of universal banking. The second widely-discussed way to control GIMHIB is, essentially, to bribe the banks into behaving. The idea is that if banking franchises are made suf®ciently valuable, their owners become unwilling to gamble because they have too much at stake (Benveniste et al., 1991). The logic of this proposition is undoubtedly correct, and Keeley (1990) has presented persuasive empirical evidence of an inverse relationship between bank charter values and banksÕ risk-taking. The conclusion of KeeleyÕs important study is that, as the banking industry became increasingly competitive over the last several decades, increased risk-taking was an important side-eect. We cannot now return to the 1950Õs when banking was simple, not very competitive, and almost failure-free. But we surely could increase charter values of commercial or universal banks to the point where the forces of GIMHIB were oset. This could be done (for example) by implementing a policy of restricted entry and binding deposit and loan rate regulation. If pursued with sucient vigor, such a policy would undoubtedly ``work''. To me, however, (and I suspect to most free market advocates), this solution is no more appealing than the ®rst one. Finally, let me brie¯y mention the ultimate ``wunder waen'' in dealing with GIMHIB, which is simply to eliminate it by eliminating the banking safety net. Obviously this would require getting rid of deposit insurance which is politically unthinkable in the US. But even if that could be done, eliminating deposit
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insurance would not eliminate GIMHIB. The policy of ``too big to fail'' would also have to be dealt with. This would require that the government credibly commit to allow banks to fail, even the largest banks, and then actually allow that to happen. Ex-ante policy statements are not sucient if the market views them as incredible. And as recent events around the world have forcefully demonstrated, it is extremely dicult for policy-makers to allow such market forces to play out. In this respect, there is no reason to believe the US is different from other nations. In sum, I submit that controlling GIMHIB in an economically ecient manner is a daunting task for policy-makers. Getting rid of GIMHIB is, most likely, even harder. But, until one or the other is accomplished, universal banking remains the cart. And to put it before the horse of GIMHIB reform would be a risky business.
References American Banker, 1997. Criticism of Financial Reform Overblow, Shadow Panel Says, May 6. Benveniste, L., Boyd, J.H., Greenbaum, S., 1991. Bank capital regulation. Osaka Economic Papers. Boyd, J.H., Chang, C., Smith, B., Moral hazard under commercial and universal banking. Journal of Money, Credit and Banking, forthcoming. Gorton, G., Schmid, F.A., 1996. Universal Banking and the Performance of German Firms. Working Paper, University of Pennsylvania, Philadelphia, PA. Kareken, J., 1983. Deposit insurance reform or deregulation is the cart, not the horse. Minneapolis Federal Reserve Bank Quarterly Review 7, 1±9. Kareken, J., Wallace, N., 1978. Deposit insurance and bank regulation: A partial equilibrium exposition. Journal of Business 51, 413±438. Keeley, M., 1990. Deposit insurance, risk and market power in banking. American Economic Review 80 (5), 1183±1200. Merton, R.C., 1977. An analytical derivation of the cost of deposit insurance and loan guarantees: An application of modern option pricing theory. Journal of Business and Finance 1, 3±11. Saunders, A., Walter, I., 1994. Universal Banking in the US. Oxford University Press, New York. US Treasury, 1991. Modernizing The Financial System: Recommendations for Safer, More Competitive Banks. Department of the Treasury, Washington, DC.
Expansion of commercial banking powers . . . or, universal banking is the cart, not the horse John H. Boyd
*
Carlson School of Management, University of Minnesota, 271-19th Avenue, Minneapolis, MN 55455, USA
Abstract This short essay deals with universal banking in an environment in which a government safety net (for example deposit insurance) results in a moral hazard problem for banks. It argues that universal banking signi®cantly exacerbates the problem. Speci®cally, universal banking extends the distortion of incentives caused by moral hazard to other sectors of the economy. Ó 1999 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21 Keywords: Universal banking; Commercial banking; Bank regulation
1. Introduction The title of my essay is a paraphrase of the title of an earlier paper by my colleague, and dear friend, Jack Kareken. His much cited paper (Kareken, 1983) is rather famous because it essentially predicted the savings and loan crisis. Unfortunately, it was not so widely read in the early eighties. Whereas I am not predicting any impending crisis, I am making the same logical point as *
Corresponding author. Corresponding address: Kappell chair in Business and Government, Finance Department, Carlson School, Room 3-110, 321 19th Avenue South, Minneapolis, MN 55455, USA; e-mail: [email protected]. 0378-4266/99/$ ± see front matter Ó 1999 Elsevier Science B.V. All rights reserved. PII: S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 1 0 1 - 0
656
J.H. Boyd / Journal of Banking & Finance 23 (1999) 655±662
Kareken regarding the importance of sequence. In this essay, universal banking is the ``cart'', and reform of the bank safety net (deposit insurance, the Discount Window, etc.) is the ``horse''. My punch line is this: if a universal banking system is implemented in the US without, ®rst, eliminating moral hazard due to the safety net, the consequences could be most undesirable. Since, in my view, the safety net issue is the deepest and thorniest issue in the prudential regulation of banks, I am not optimistic about a quick ®x. 1 Let me anticipate for a moment. An argument I expect to hear is that we have already ``solved'' the moral hazard problem in banking due to recent regulatory innovations such as the BIS capital standards and other provisions of FDICIA, etc. Critics of this essay will also surely note that the US banking industry is remarkably healthy and well capitalized at present, as is the FDIC. In response to such anticipated arguments, I would ®rst observe that the US is not the only country in the world. Many other nations ± including several which also employ the BIS capital standards ± have experienced severe banking problems in the last ®ve years or so. The list of nations with banking crises runs from much of South America and Mexico to some of Europe and most of Asia. It includes nations with isolated banking problems such as England and France, and others such as Japan with crises involving, essentially, the entire system. Do we really think our banking system is so unique that it is immune to such forces? In so far as the recent US banking experience is concerned, we have bene®ted from a superb macroeconomic environment in recent years. To be sure, US banks have done well recently ± but, they have done well during one of the longest and strongest economic recoveries in post-war history. Recall that in just the last macroeconomic downturn (roughly 1989±1991) US banks did so miserably that the Congress felt it necessary to authorize bailout funding for the FDIC. Although a bailout proved unnecessary, I submit it is too soon and too risky to declare victory. The new regulatory regime has not been put to the test in anything except a benign environment. Next, I turn to a brief description of universal banking. 2. Universal banking A universal banking system is one in which banks are permitted to make equity investments in ®rms rather than, or in addition to, extending them loans. In practice, the best example of such a system is in present-day Germany where banks hold large blocks of equities, vote their shares and serve as directors of
1 Many of the arguments contained in this essay are put more formally in Boyd et al. (forthcoming). My coauthors are responsible for none of the errors, if any, in this essay.
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corporations. Through the policy of ``Auftragsstimmrecht'' they can also vote the shares of other parties (Gorton and Schmid, 1996). Fundamentally, under universal banking, banks can own and control other ®rms, including commercial and industrial enterprises. 2 This topic is of more than theoretical interest. Variants of such a system have been, and continue to be, proposed for the US: by the US Treasury (1991), the so-called Shadow Financial Regulatory Committee (American Banker, 1997) and some members of Congress. Indeed, universal banking legislation is under active debate in Washington today. Now, at face value, such proposals might appear innocuous; ``Just let banks buy some stocks, in addition to their loan portfolio holdings''. But things are not always what they seem, and these proposals could have profound eects on our ®nancial markets. For example, universal banking is not at all ``friendly'' to markets; indeed, these two arrangements, markets and universal banks, are to a considerable extent substitutes. In Germany, the universal banking system does not exist alongside large and active stock and corporate bond markets as we have in the US. There, securities markets are narrow, trading volumes are low, and it is quite uncommon for individuals to hold stocks and corporate bonds for their own accounts. (Gorton and Schmid, 1996). This sort of ``crowding out eect'' is not the main point of my essay ± but it is worth thinking about. 3 Next let us talk about moral hazard in banking. 3. Government-induced moral hazard in banking: What is it? The problem of government induced moral hazard in banking (GIMHIB) has been recognized by theorists at least since the seminal works of Merton (1977) and Kareken and Wallace (1978). Industry practitioners and regulators were slower to recognize the problem (or at least to admit its practical signi®cance) ± that is, until the savings and loan crisis in the US. At that time, GIMHIB was publicly and ¯agrantly displayed in extremis, and no one could deny its importance. For a time, bankrupt (or ``Zombie'') S&Ls were permitted to continue operating by the FSLIC even though they were economically broke. Having nothing to lose and much to gain, many of the Zombies took huge portfolio risks and/or were looted by their managers. The resulting losses were large and caused an angry Congress to disband the S&L regulators, and
2
Another feature of universal banking systems is that banks are permitted to engage in the full range of intermediation services including brokerage and investment banking. Although important, that dimension of universal banking is not the focus of this essay. 3 Also worth thinking about is the concentration of ownership which might occur under universal banking.
658
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to pass legislation (most notably the FDICIA legislation of 1991) which is quite explicit in its recognition of GIMHIB. 4 I next turn to a simple but illustrative example of what GIMHIB is and how it works. 3.1. An example of GIMHIB Many scholarly studies have been written about GIMHIB, and I cannot begin to do justice to that large literature here. However, a simple example will help to set out the principles involved, and to illustrate why GIMHIB so badly distorts market-based incentives. I note that the points I am about to demonstrate by example have been rigorously proved elsewhere. Here, I employ the theoristÕs ploy of reducing a problem to its purest form, so that nothing but the essential features remain. In particular, GIMHIB induces an incentive to gamble ± so I discuss this phenomenon in a gambling framework. The most important point is to show that under GIMHIB, bankers will quite rationally seek out gambling opportunities, even when they are naturally averse to risk-taking. The example: An entrepreneur is endowed with $4 million in personal wealth. She opens a new bank, putting $2 million in equity and raising $18 million in insured deposits, which are the only bank liabilities. Bank assets will be ``invested'' using the roulette wheel. Speci®cally, the full $20 million will be placed on the color black, which pays two-for-one for a win. The entrepreneur is, by assumption, averse to risk-taking with her own wealth. To hedge her bank bet, she places her other (personal) $2 million on red. For now, I ignore the zero on the roulette wheel; this comes up only 1/36 of the time and ignoring the zero does not aect my calculations very much. (Conceptually, if not quantitatively, this is however an important assumption. But I will get to that in a moment.) With this simpli®cation, the only possible outcomes are red and black. Now, if red comes up the bank is broke, but the owner wins. She takes away $4 million and has just broken even, personally, since her initial endowment was $4 million. Alternatively, if black comes up, the owner loses on her own account. But the bank, which she also owns, wins $20 million, net. She can pay o the depositorsÕ $18 million (plus interest, which I ignore) and walk with $22 million. Before the fact, her expected net rate of return on this ``investment'' is (($22 ) $4) / $4) ´ (1/2) 225%. 5 And, of course, from the entrepreneurÕs perspective there was never a risk of loss. I submit, a 225% expected rate of return on a one day investment, with no risk
4 For example, the provisions which make it more dicult to invoke the ``too big to fail'' policy are explicitly an attempt to contain GIMHIB. So is the policy of ``prompt closure''. 5 In words, a $4 million investment results in a ®fty±®fty chance of winning an $18 million net pro®t, or breaking even.
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of loss, is pretty tempting. That is the main point of the example, because GIMHIB creates this situation. 6 The example can be pushed a bit further, to illustrate three additional features of GIMHIB. For brevity, I will not present the calculations but the reader can easily do that for himself. First point: If I did allow for the zero on the roulette wheel, both red and black would lose 1/36th of the time. 7 With this change, roulette would become a negative net present value ``investment''. However, the expected return to the entrepreneur would only be slightly reduced and it would still be possible to create a perfect hedge. 8 Thus playing roulette would still remain a very attractive proposition. WhatÕs the point? GIMHIB induces banks to willingly invest in negative NPV projects, if they are suciently risky. Obviously, from an economic eciency perspective, this is a particularly undesirable eect since negative NPV investments are socially wasteful. Second point: The second point is that the entrepreneur has an unlimited appetite for ®nancial leverage. In the original example, if the bank doubled its asset/equity ratio, from 10:1 to 20:1, the expected rate of return to the entrepreneur would rise dramatically, from 225% to 475%. More generally, the expected rate of return to the entrepreneur is increasing in leverage, without limit. Third point: The converse of the second point is also of some interest. In the original example (e.g. no zero on the roulette wheel) suppose that there were a 50% capital requirement so that the bank could only raise $2 in deposits to match its $2 in equity. Then, the expected rate of return to the entrepreneur would fall to 25%; but that is still a positive expected return on a risk-free bet. Indeed, in the example, capital regulation, no matter how severe, can never render gambling unpro®table. Or, to put the point another way, capital regulation by itself cannot overcoming the moral hazard problem. 9
6 Readers may think that this example is ``unrealistic'' and that my extreme assumptions drive the results. I of course disagree. In contemporary ®nancial markets, bankers have access to an unlimited array of risky investments. (Just consider the recent Barings incident.) The roulette example does provide for access to a costless, perfect hedge which admittedly may be a bit farfetched. However, in principle the bank owner could just as well eliminate risk of loss by diversi®cation; that is, by chartering a large number of independent banks. 7 Assuming there is only one zero on the roulette wheel, as in many European casinos. 8 This requires betting a small amount on the zero(s). 9 This statement is only true if the gamble has a non-negative expected return. If the expected return is negative, there will always exist a capital ratio which renders gambling unpro®table. It also requires that asset values be bounded from below at zero (Karaken et al., 1978).
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3.2. Summary What is going on in this example, obviously, is that gambling is enormously pro®table for the bank (on average) only because it is enormously unpro®table for the FDIC. When the gamble pays o, the gain goes to the bank; when it fails most of the loss goes to the deposit insurer. The clear implication is that whenever such incentives are created by GIMHIB, they must be somehow controlled. Otherwise, there will be an expected value wealth transfer of unknown magnitude from the government to the banks. (The S&L crisis was an excellent example of such forces being allowed to play out in real life.) As we shall see next, the distortions caused by GIMHIB are especially troubling in the context of universal banking. 4. Now, what about universal banking? I again employ the theoristÕs trick of reducing the problem to its fundamentals. The simplest universal bank possible is one whose only asset is a controlling equity investment in a single non-®nancial corporation; its only liability, insured deposits. Now, for exactly the same reasons as above, the bank has the incentive to choose a risky investment ± but now it will be, by construction, an investment in the non-®nancial sector. Too, the universal bank will ®nd it perfectly rational to invest in a negative NPV project, if risky enough. And ®nally, it will employ as much ®nancial leverage as permitted. It should be clear that the distortion of incentives caused by GIMHIB transmits directly to the non-®nancial ®rm because it is owned by a bank. And as sole owner the bank has control rights, meaning it can implement its distorted objectives. There are a host of complications which obviously need to be taken into account here. Examples include: allowing for other owners of the ®rm besides the universal bank; allowing the universal bank to hold a diversi®ed asset portfolio; and permitting it to make loans as well as equity investments. Such complications are beyond the scope of this essay but in any case do not alter the basic logic: GIMHIB induces banks to make risky investments and to ®nance them in a risky manner. This distortion of incentives extends to non-®nancial ®rms, and potentially to all sectors of the economy, when non-®nancial ®rms can be owned by universal banks. 10 I next turn to the question of how, and at what cost, GIMHIB can be kept in check.
10
It should also be noted that a universal banking system expands the potential liabilities of the FDIC to include losses occurring in the non-®nancial sector. This is a common argument (Saunders and Walter, 1994), and not the main point of this essay.
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5. Controlling or eliminating GIMHIB There is a large literature on controlling GIMHIB. However, there are realistically just two general classes of policies for this purpose. As we shall see, either class of policy can control moral hazard due to GIMHIB if applied with sucient vigor. Unfortunately, both classes of policies are very costly in terms of economic eciency. The ®rst tactic is to regulate, audit and supervise banks so as to limit their ability to take risk. In eect, GIMHIB is left in place, but is contained by direct governmental intervention. That approach, of course, is exactly what is done now with commercial banks, and in principle the policy could be extended to the operations of universal banks. To me at least, this raises several questions. First, ``Does one really want that degree of governmental intervention in the non-®nancial sectors of the US economy?'' Recall that we presently regulate and examine virtually every aspect of commercial banking operations: asset allocation, liability allocation, capital structure, control rights, entry and even exit. A second and related question is, ``Are the banking authorities prepared to regulate, supervise and examine the activities of non-®nancial ®rms at the same level of eectiveness that they now do commercial banks?'' Based on my years in the Federal Reserve System, the answer to this question is clearly ``No''. This probably explains why the US bank regulators are not in general among the advocates of universal banking. The second widely-discussed way to control GIMHIB is, essentially, to bribe the banks into behaving. The idea is that if banking franchises are made suf®ciently valuable, their owners become unwilling to gamble because they have too much at stake (Benveniste et al., 1991). The logic of this proposition is undoubtedly correct, and Keeley (1990) has presented persuasive empirical evidence of an inverse relationship between bank charter values and banksÕ risk-taking. The conclusion of KeeleyÕs important study is that, as the banking industry became increasingly competitive over the last several decades, increased risk-taking was an important side-eect. We cannot now return to the 1950Õs when banking was simple, not very competitive, and almost failure-free. But we surely could increase charter values of commercial or universal banks to the point where the forces of GIMHIB were oset. This could be done (for example) by implementing a policy of restricted entry and binding deposit and loan rate regulation. If pursued with sucient vigor, such a policy would undoubtedly ``work''. To me, however, (and I suspect to most free market advocates), this solution is no more appealing than the ®rst one. Finally, let me brie¯y mention the ultimate ``wunder waen'' in dealing with GIMHIB, which is simply to eliminate it by eliminating the banking safety net. Obviously this would require getting rid of deposit insurance which is politically unthinkable in the US. But even if that could be done, eliminating deposit
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insurance would not eliminate GIMHIB. The policy of ``too big to fail'' would also have to be dealt with. This would require that the government credibly commit to allow banks to fail, even the largest banks, and then actually allow that to happen. Ex-ante policy statements are not sucient if the market views them as incredible. And as recent events around the world have forcefully demonstrated, it is extremely dicult for policy-makers to allow such market forces to play out. In this respect, there is no reason to believe the US is different from other nations. In sum, I submit that controlling GIMHIB in an economically ecient manner is a daunting task for policy-makers. Getting rid of GIMHIB is, most likely, even harder. But, until one or the other is accomplished, universal banking remains the cart. And to put it before the horse of GIMHIB reform would be a risky business.
References American Banker, 1997. Criticism of Financial Reform Overblow, Shadow Panel Says, May 6. Benveniste, L., Boyd, J.H., Greenbaum, S., 1991. Bank capital regulation. Osaka Economic Papers. Boyd, J.H., Chang, C., Smith, B., Moral hazard under commercial and universal banking. Journal of Money, Credit and Banking, forthcoming. Gorton, G., Schmid, F.A., 1996. Universal Banking and the Performance of German Firms. Working Paper, University of Pennsylvania, Philadelphia, PA. Kareken, J., 1983. Deposit insurance reform or deregulation is the cart, not the horse. Minneapolis Federal Reserve Bank Quarterly Review 7, 1±9. Kareken, J., Wallace, N., 1978. Deposit insurance and bank regulation: A partial equilibrium exposition. Journal of Business 51, 413±438. Keeley, M., 1990. Deposit insurance, risk and market power in banking. American Economic Review 80 (5), 1183±1200. Merton, R.C., 1977. An analytical derivation of the cost of deposit insurance and loan guarantees: An application of modern option pricing theory. Journal of Business and Finance 1, 3±11. Saunders, A., Walter, I., 1994. Universal Banking in the US. Oxford University Press, New York. US Treasury, 1991. Modernizing The Financial System: Recommendations for Safer, More Competitive Banks. Department of the Treasury, Washington, DC.