II Structural Changes and Related Policy Issues in Financial Markets

International Monetary Fund
Published Date:
January 1992
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Main Features of the Emerging Financial System

Although the evolution of finance into a competitive international industry progressed gradually during the 1980s, the process gathered speed during 1991. Not only did the European Community’s Single Market in financial services—perhaps the most ambitious and comprehensive financial-sector reform undertaken in recent history—near completion, but the next stage in U.S. and Japanese banking reforms also got under way in earnest.1 As a result, by 1992, domestic financial markets, particularly wholesale markets, have become adaptive and international, with segmented financial structures increasingly giving way to broader-based, more integrated ones.2

A key feature of the new financial environment is the competition-driven disintermediation from banking systems—particularly from wholesale banking—into securitized money and capital markets. The more creditworthy corporate borrowers in major industrial countries are increasingly able to satisfy their liquidity, risk-management, and financing needs directly in liquid securities markets. Commercial paper and repurchase agreements are becoming the short-term financing instruments of choice; money-market mutual funds are siphoning deposit liabilities out of the banking system; and exchange-traded futures and options are growing rapidly. Financial claims, ownership rights, and contingent obligations are ever more taking the form of liquid securities. The credit-rating function is increasingly performed by specialized firms (e.g., Moody’s, Standard and Poor’s, IBCA) rather than by banks. In short, relationship banking is being replaced with transactions-driven securities finance. This securitization is farthest advanced in the United States, the United Kingdom, and France, but it is also picking up steam in Japan and in other industrial countries.

Securitization is forcing adjustments across the entire spectrum of activities and institutions in financial markets. The loss of traditional balance-sheet business has led to cost cutting and to consolidation in the wholesale banking sector and to an expansion in off-balance sheet activities, including backup lines of credit and forward interest rate and foreign exchange contracts. Banks are now acting as counterparties to more than $3 trillion in currency and interest rate swaps, the revenue from which has become the major source of fee income for banking institutions. At the same time, bank-led financial conglomerates are using their branch networks to charge into new financial service areas, such as insurance.

The declining importance of the banking sector in three major industrial countries is readily apparent from the aggregate portfolio data presented in Table 1. The proportion of corporate and household financial assets held in the form of bank deposits declined significantly in the 1980s in Japan and Germany—mimicking a trend that had occurred earlier (by the beginning of the 1980s) in the United States. At the same time, bank loans as a proportion of corporate liabilities declined steadily in these countries. Underlying these developments, which were apparent in many other countries as well, was the relatively rapid growth of mutual funds and commercial paper (Box 1).

Table 1.Germany, Japan, and the United States: Indicators of Relative Importance of Banks in Financial Activities of Corporations and Households(In percent)
Bank Deposits as a Proportion of Corporate Financial AssetsBank Deposits as a Proportion of Household Financial AssetsBank Loans as a Proportion of Corporate Liabilities
United States
Sources: IMF staff estimates; and national flow of funds data.

Box 1Growth in Mutual Funds and Commercial Paper

The advent of money market mutual funds in the United States in 1972 was a watershed for the mutual fund industry. Money market funds concentrate their investments in highly liquid, short-term money market instruments, such as treasury bills and commercial paper. Such funds were particularly attractive investments when deposit rates were bound by legal limits. Money market funds also served to introduce investors to other types of mutual funds. At the end of 1991, investments in U.S. mutual funds totaled $1,347 billion, over one third of which was invested in money market funds (Table A1).

The relatively rapid growth of mutual funds (securities investment trusts) in Japan over the past two decades was spurred by the large issuance of government bonds and by the introduction of medium-term government bond (Chukoku) funds. Like money market funds in the United States, Chukoku funds invested in liquid assets and initially paid yields somewhat above those on short-term time deposits. At the end of 1991, investments in Japanese mutual funds totaled $349 billion, about one fourth of which was invested in Chukoku funds.

The European Community (EC) in December 1985 issued a directive to coordinate laws, regulations, and administrative provisions relating to mutual funds (undertakings for collective investment in transferable securities (UCITS)); this directive was implemented by October 1989.1 The directive facilitates the cross-border marketing of mutual funds by permitting a fund registered in one EC country to offer its shares for sale in other EC countries without duplicative registration. The directive also establishes a common regulatory scheme for investment policies, public disclosure, structure, and control. The directive did not, however, address the issue of harmonization of tax treatment.2 As a result, many European funds operate from Luxembourg, which does not deduct withholding taxes from interest and dividend payments. An additional impediment to the cross-border marketing of funds in Europe is differences in distribution systems. In France and Germany, the retailing of mutual funds is dominated by banks, which sell their own investment products. In the United Kingdom, independent brokers and advisors distribute and manage funds, although in recent years, many of them have been affiliated with banks. In Italy, both banks and specialized agencies market funds.

While differing tax regimes and distribution methods have impeded the emergence of European mutual funds, such funds are well established within several European countries. France has the largest pool of mutual fund assets in Europe, totaling $396 billion at the end of 1991. Of this amount, three fourths is invested in debt (and most of that in money market instruments). German funds, with $175 billion under management at the end of 1991, are also heavily concentrated in debt instruments, while most British funds invest in equities. A total of $101 billion was invested in British schemes at the end of 1991, while Italian funds managed assets totaling $47 billion at the end of 1991.

In the 1980s, commercial paper, long established in the United States and Canada, gained widespread acceptance in a number of other domestic markets and in the Euromarket.3 Between the end of 1986 and the end of 1991, the amount of commercial paper outstanding in domestic and international markets more than doubled.4 The domestic U.S. market, with $528 billion outstanding at the end of 1991, is the largest commercial paper market by a substantial margin (Table A2). Japan has the second largest domestic commercial paper market with $87 billion outstanding at the end of 1991, even though the market has been in existence only since 1987. In Europe, the French, Spanish, and Swedish domestic markets—all established in the mid-1980s—have displayed the most rapid growth in recent years and by the end of 1991 had the largest amounts of paper outstanding among European countries.

The Euro-commercial paper market emerged in the mid-1980s as a further development of the market for Euro-notes issued through a note issuance facility; the latter is a medium-term arrangement under which a borrower can issue short-term paper backed by bank underwriting commitments. The Euro-commercial paper market has largely displaced that for other Euro-notes in recent years because of the greater flexibility of issuance procedures and a wider range of maturities.5 At the end of 1991, the outstanding amount of Euro-commercial paper totaled $80 billion, making this market the world’s third largest.

1Council Directive 85/611/EEC (Official Journal of the European Communities, December 30, 1985). Greece and Portugal were given until April 1992 to implement the directive.2Kopits (forthcoming) examines the coordination of financial taxes among EC countries.3Rowe (1986), and Stigum (1990) discuss the development of the U.S. commercial paper market.4The growth rates in commercial paper outstanding in individual countries tend to exceed by a wide margin growth rates in the nominal value of output, pointing to gains in market shares for this credit instrument.5Bank for International Settlements (1986) examines the evolution of the Euro-commercial paper market.

The above trends notwithstanding, pronounced differences still remain in financial structure across the major industrial countries. Specifically, while New York and London, and increasingly Paris and Tokyo, conform to the securitized, bank-disinter-mediated prototype outlined above, Frankfurt—and to a lesser extent, Amsterdam and Brussels—does not. In Germany, a few large, universal banks continue to dominate the financial system, and private securities markets have remained relatively illiquid, fragmented, and of secondary importance.3 German universal banks enjoy close institutional ties to the corporate sector (in terms of both equity stakes and their membership on corporate supervisory boards) and often play a major role in helping the corporate sector work out debt difficulties. They benefit from a large and relatively loyal domestic retail base and, at least so far, have not had to confront the effects of a large-scale direct approach of the corporate sector to credit markets. When firms need liquidity, they typically turn to their “house bank”; similarly, when they have excess liquidity, they deposit it there. Thus, in addition to longer-term credits, short-term wholesale payments also flow across the banks’ balance sheets. Their considerable placement power allows universal banks to exercise strict quality control over which potential domestic and foreign borrowers obtain access to the direct deutsche mark debt markets.

One issue thrown into relief by these differences in financial structure, with the United States and Germany at either end of the spectrum, is which structure is most likely to prevail over the medium term. While each carries its own strengths and weaknesses (see discussion below), the evidence indicates that the trend is toward a disintermedi-ated, liquid, securitized structure, although some role for traditional relationship banking will remain. Increased competition in a liberalized financial market generally means that domestic money and capital market activity will migrate to the most hospitable environment; and since some authorities, particularly in France and the United Kingdom, have supported the development of securitized markets, an alternative to bank intermediation is likely to be in reach. For this reason, say, five years from now, the continental European financial markets will probably look more like the New York and London markets than they do today.4 The significant recent and continuing transformation of the French financial market (especially the rapid development of the money market) is indicative of this evolution. The recent growth of the deutsche mark commercial paper market5 and of the Deutsche Terminbörse may be viewed as another indication of things to come.6 The continuing interest rate liberalization in Japan will likewise reinforce this trend.

Risks in the New Environment

The current evolution toward more liquid, securitized markets is part and parcel of the maturing of financial systems, and it has considerable potential for increasing the contribution that the financial sector can make to growth and efficiency. Nevertheless, the process of restructuring is not without risks or potential sources of instability. Structural change, involving the displacement of established institutions and practices, is difficult in any sector; it is in certain respects much more difficult in the financial sector, with its fiduciary responsibilities, its extensive public sector safety net, and its globally interrelated activities.7

Wholesale banks—particularly those in the United States, the United Kingdom, and Japan, whose traditional business of supplying liquidity and of lending through large syndications is shifting to securities markets—appear to be responding to competitive pressures in part by undertaking higher-risk and higher-return activities. The availability of deposit insurance and other safety net guarantees in these countries permits an increase in the riskiness of bank assets without a corresponding increase in the cost of bank liabilities.8

This strategy is reflected in considerable exposure to sectors and activities with high upfront fees, such as leveraged buyouts and other highly leveraged transactions, and a host of off-balance sheet contingent commitments. The potential risks in such activities, combined with significant concentration of loans to developing countries and, more recently, to commercial real estate, have placed considerable pressure on bank earnings (Box 2).

Box 2Trends in the Financial Performance of Banks

While the profitability of banks in industrial countries has exhibited no clear trend in the 1980s and early 1990s, at least according to accounting data (Table A3), this first impression masks significant structural changes within the industry. Narrower net interest margins of banks (net interest income as a percent of total assets) have emerged in several countries, particularly in Japan, France, and the United Kingdom (Table A4). Moreover, while net interest margins of commercial banks in the United States have tended to widen in recent years, particularly those of the large banks, these gains in income have been achieved at the expense of greater asset risk (see discussion of net loan-loss provisions below).

In order to shield net interest margins, banks in some countries have pursued riskier lending strategies to bolster their profitability. The recession, which resulted in a need for mounting loan-loss provisions, revealed the dangers in this approach. Provisioning has increased the most in banks in the United Kingdom and the United States, where it has exceeded the levels reached during the recession in the early 1980s (Table A5). Prior to 1990, these provisions were made largely against loans to heavily indebted developing countries, but the more recent set-asides are primarily against bad domestic debts, such as commercial mortgages and loans to highly leveraged corporations. Japanese banks have also stepped up their loan-loss provisions in recent years, although they remain at low levels.

In an additional effort to maintain their profitability, banks in industrial countries have shifted their revenues away from net interest income toward noninterest income, which has also served to economize on scarce bank capital. This type of income includes fees for the underwriting of security issues, providing backup facilities for commercial paper issues, arranging swap and forward foreign exchange and interest rate contracts, and advising corporate clients on mergers and acquisitions. While this shift was more pronounced for banks in Canada, France, Japan, the Netherlands, the United Kingdom, and the United States, it is evident for banks in other countries as well (Table A6).

Yet another response has been an effort to pare operating expenses, the main expense of banks (Table A7). Japanese and Canadian banks, in particular, have significantly reduced their operating expenses in recent years, which now approach the level achieved by the relatively efficient Swiss banks. Banks in Luxembourg also have relatively low operating costs—albeit vitiated by high loan-loss provisions. Despite the increased competition, operational efficiency of banks in other countries has remained broadly unchanged at relatively high levels.

In addition, the growth of off-balance sheet business has contributed much to the growing opaqueness of the financial system. While swaps and other hedging instruments often reduce the end-user’s exposure to risk, it has become increasingly difficult to assess fully the risk exposure of the entire consolidated balance sheet of financial institutions that are the counterparties to these instruments. For example, in order to compensate for the loss of more traditional business, wholesale banks have been aggressive in their pricing strategies in some newer activities (e.g., the swap market), often at the expense of other competitors (e.g., the organized future exchanges). As a result, U.S. banks, only one of which has a AAA rating, were counterparties to swaps with a notional value of $1 trillion at the end of 1991, up from $250 billion at the end of 1987.

At this point, it remains to be seen how the elimination of excess capacity from the wholesale banking system worldwide will be resolved; it is not too early, however, to assert that this restructuring problem is a source of vulnerability in the period ahead.

A second source of systemic risk is the ever-greater dependence of securities markets and financial institutions on the uninterrupted availability of liquidity. In highly securitized financial systems, such as those of the United States and the United Kingdom, there exists an intricate network of short-term obligations connecting diverse financial institutions. Broker/dealers rely on the liquid repurchase markets to finance their positions.9 Corporate borrowers rely on the commercial paper market to satisfy their short-term liquidity needs. Participants in the futures exchanges rely on wholesale banks for liquid funds to meet their margin requirements. Wholesale banks themselves rely on the interbank market and on the wholesale certificate-of-deposit (CD) market to meet their end-of-day settlement obligations to the payments system. Finally, all nonbank financial institutions, as well as the corporate sector, rely on wholesale banks to act as lender-of-next-to-last-resort through prearranged lines of credit. Here, the vulnerability arises because problems at an already weak, but not yet insolvent, institution can lead to a loss of access to money markets, which in turn can cast doubts on the solvency of the creditors of this institution. Without central bank support and assurances, such incidents could pile up into a liquidity gridlock in the financial system, with a serious impact on the real economy. For example, during the precipitous decline in equity values in October 1987, U.S. wholesale banks were reluctant to keep on financing dealers in securities markets. The solvency of dealers was in question because of losses on their inventories. It took the Federal Reserve’s reassurance to prevent a generalized liquidity crisis.

Ensuring that a highly developed financial system has enough liquidity to keep the wheels of its interdependent parts well greased when there is a shock to the system is one thing. Doing so without creating a “moral hazard” of excessive risk taking in the future is quite another. As is well known by monetary authorities, a central bank has to be careful in responding to liquidity strains, not to widen the safety net unduly, lest it encourage the very kinds of behavior that it seeks to restrain. Indeed, it is for this reason that some central bankers operating in more securitized markets argue in favor of maintaining “constructive ambiguity” about which types of institutions might qualify for liquidity support, while others stress the desirability of either inducing more secure, private market participants (senior partners) to lend the first line of assistance, or of requiring collateral (from the endangered institution) before undertaking such liquidity support.

Again, market structure counts. The risks associated with interruptions in liquidity are clearly lower in a less securitized, more bank intermediated, market. Here, short-term funding and liquidity management must occur through bank balance sheets, and banks also act as the major brokers and dealers for money. In such a system, there has generally been a small number of large bank players in the market for wholesale funds. Clearing of payments is effectively done internally to banking organizations or among a small group of tightly connected banks. Without securitized money markets, loans on the books of banks are difficult to value and cannot be accurately “marked to market.” Though banks are leveraged, their ability to obtain short-term funding is not impaired by sudden swings in the trading prices for securities. Few occasions will arise when large amounts of funds are demanded for unexpected settlements. The central bank, therefore, will not often be called upon to provide credit. By contrast, in a more liquid, highly securitized market, the central bank will step in when necessary to prevent a liquidity gridlock from occurring and to be closely involved in supervision and regulation of the financial institutions that it deals with on a recurrent basis. Indeed, the real economy in the industrial world has been quite resilient to the large financial shocks that have occurred in the past five years in large part because central banks have acted to ensure that these shocks did not result in generalized liquidity crises.10

Which structure of financial markets will yield the best combination of efficiency and stability remains an open question. The possibility of a trade-off between efficiency and stability is illustrated by the evolution of the financial structure in the major industrial countries. As financial systems have become more competitive, more securitized, and more liquid, they have become more efficient. At the same time, such financial systems may be more susceptible to liquidity strains and crises than are less liquid, more bank-intermediated financial structures.11

Policy Response to a Changing Financial Structure

The evolution of financial systems is perceived by authorities as a major policy challenge. Public policy should avoid distorting competition between nonbank suppliers of financial services and the banking system. However, while the special nature of banks in providing liquidity and payments services must be safeguarded, efforts by banks to offset declines in their traditional lines of business by engaging in higher-risk, higher-return activities (including off-balance sheet activities) and by leveraging their access to the safety net need to be carefully monitored and evaluated. The U.S. saving and loan crisis is a reminder that deregulation in an environment with weak market discipline can have very severe fiscal repercussions.

Indeed, it is widely recognized that without reforms in financial policy and close attention by central banks, the new financial system could resemble a new, high-speed train attempting to run on old, ill-maintained tracks. For the most part, authorities have opted for a strategy that allows banks to engage in a wider set of activities, requires banks to hold internationally agreed levels of capital against risk-weighted assets, and seeks to increase the effectiveness of supervision and regulation.

The plight of the wholesale banking sector is generally viewed with sympathetic concern. In the United States and Japan, the authorities are responding with reform packages that would remove some of the geographic and product restrictions now faced by banks. In the United States, these reform efforts are aimed, at least in part, at “leveling the playing field” and improving the competitiveness of home banks vis-à-vis foreign banks (particularly, large universal European banks). The Japanese banking reforms are motivated in part by a desire to introduce more countervailing power into the securities market, where the four largest securities firms have long held a dominant position. In Japan, banks would be allowed to undertake securities activities in a separately capitalized subsidiary. This subsidiary would be separated from the bank by a “firewall” to restrict the exchange of information and funds, thereby limiting conflicts of interest and protecting the banks’ financial integrity. The legislative process on bank reform moved steadily forward in Japan and the Diet passed the bill this June. In the United States, the authorities favor interstate branching and the concept of a financial-service holding company that would allow the holding company of a well-capitalized bank to engage in a broad range of financial services, including securities and insurance. The U.S. Congress passed in November 1991 a narrow reform bill that stopped far short of the administration’s proposals but nevertheless strengthened banking supervision, replenished the Bank Insurance Fund, and rolled back somewhat the too-big-to-fail doctrine. Two particularly welcome features of the bill are procedures aimed at closing troubled banks before they become deeply insolvent and guidelines to subject banks with relatively weak capital positions to more intensive supervision than those with higher capital.

The effectiveness and desirability of allowing banks to expand their activities remains a hotly contested issue. Bankers take the view that existing legal restrictions on their activities, together with the decline in some of their traditional lines of business (especially falling corporate demand for bank liquidity), have put them in an inviable long-term position.12 Critics, however, note that, unless there exist unexploited monopoly profits, entering a market “late” does not offer the newcomer favorable prospects; in this connection, the track record of wholesale banks, as well as of financial corporations as a whole, in trying to dislodge entrenched competitors in established markets has been less than impressive. It is reasonable to argue that the deregulation of functional restrictions will attract new capital to banks if there are complementarities between the securities business and the wholesale payments business.13 Bankers argue that the information generated in the course of providing bank credit and of underwriting and dealing in securities generates potential saving (i.e., “economies of scope”) in the real resources spent on information gathering. But such synergy in the gathering of information also must confront the question of possible conflicts of interest: a banker who knows more than the public securities market might be tempted to use such information for profit. In any event, it is important that any increased powers granted to banks be accompanied both by increased supervision and regulation and by appropriate capital requirements on those new activities, so as to reduce their ability to leverage the safety net by taking on excessive risk. In this regard, quicker acknowledgment by banks of asset losses (on both their traditional and their newer lines of business), more consistent implementation of accounting procedures that provide comprehensive coverage of a bank’s activities, and greater attention to the risks of large exposures would pay handsome dividends.

In Europe, the European Community’s Second Banking Directive and its (proposed) Investment Services Directive are giving a liberalizing impetus to the financial restructuring process by essentially authorizing a “single passport” (to be issued by the home country) for conducting banking and securities business throughout the European Community (EC). National authorities are making efforts to upgrade their financial infrastructures so that they can be competitive within the Single Financial Market in 1993. This generally means modernizing clearance and settlement systems for payments and securities transactions, establishing automated market mechanisms, and strengthening supervisory and regulatory structures; it also means dismantling or reducing any local taxes or regulations (e.g., turnover taxes) that put home institutions and exchanges at a competitive disadvantage relative to their Community competitors. In some cases, even long-standing institutions (e.g., the state pension system in France and the regional stock exchanges in Germany) are being re-examined with an eye to assessing how they affect financial competitiveness. The continental European countries, in particular, are keenly aware of the migration over the past decade of a significant share of trading activity to London, and are naturally interested in recapturing some of that business by offering, where possible, comparable transaction costs. More generally, there is recognition that, with the completion of the Single Market, the national financial systems with the most developed infrastructures will attract the lion’s share of EC financial transactions. In this regard, the efficiency of the dollar payments system has been regarded as a nontrivial contributory factor to the dominance of the U.S. dollar as a vehicle currency in foreign exchange markets; the country with the most efficient payments system in the EC would likewise enhance its chances of attracting the bulk of EC money market transactions after European economic and monetary union comes into effect.

The financial restructuring that is under way in Europe invites two immediate policy questions: (1) What will it imply for monetary policy? and (2) Is the intensified competition in financial services generally constructive?

On the issue of monetary control, there are some differences of view among national authorities.14 Some believe that the benefits associated with more liquid, securitized markets outweigh the cost of the possible increases in risk. Indeed, they are confident that such markets can be managed without hindering monetary control so long as the authorities are engaged in close surveillance of financial institutions, are prepared to step in firmly when there is a major liquidity disturbance, are constantly mindful of the moral hazards involved, and are committed to a medium-term noninflationary stance for monetary policy. In contrast, others are less convinced that more liquid, securitized money markets generate such significant social benefits—especially in relation to the potential dilution of monetary control brought on by the growth of close substitutes for bank deposit liabilities (such as mutual funds).15 More fundamentally, they argue that closely involving the central bank in regulation and supervision of financial markets inevitably distracts it from its primary responsibility of implementing monetary policy, with adverse consequences for inflation performance. As an example, supporters of this view cite the conduct of monetary policy in Germany. In their opinion, the fact that bank supervision in Germany is lodged in a separate agency, combined with the lesser need to monitor liquidity on a short-term basis, gives the Deutsche Bundesbank an advantage in implementing monetary policy.

Turning to the nature of financial competition among EC countries, we find that most of it so far is constructive. A strengthened clearance and settlement system is to be welcomed as a valuable preventative measure against systemic risk. The serious re-examination of national restrictions, taxes, and barriers to entry should also pay dividends in terms of improved resource allocation for Europe as a whole. Two caveats merit mention, however. The first is that each country has to assess realistically its comparative advantage in providing financial services in a single market, lest significant excess capacity be created. A good question, for example, is how many futures exchanges can coexist in Europe over the medium term; in a similar vein, it remains to be seen whether establishing a niche in the trading of stocks of smaller, national firms will be sufficient to guarantee the survival of some smaller, regional stock exchanges. The second is that competition should not be allowed to water down those features of the financial system that are necessary for safety and soundness.

The Community has implemented, inter alia, full liberalization of capital movements; also, a single license issued by the home authority allows banking institutions to engage in banking and securities transactions throughout the Community. Negotiations are under way that would permit nonbank investment intermediaries to operate on a Community-wide basis, once recognized by their home authority, and stock exchanges and derivative markets would be opened to cross-border membership of bank and nonbank financial firms.

Some of these developments have been chronicled in previous International Capital Markets Reports. See International Monetary Fund, International Capital Markets, 1985 to 1990.

Although there is a large government bond market, the German stock market is fragmented among eight regional exchanges, and approximately 30 percent of the turnover for German stocks takes place in London. The first commercial paper program was arranged in 1991. The first interest futures contract on a German Government obligation was not traded in Frankfurt until late 1990.

At the same time, to the extent that U.S. banks expand their range of activities, they may well in five years look more like continental European banks; see the discussion later in this section.

The growth of the deutsche mark commercial paper market has been facilitated by the abolition of transaction taxes.

The ability of the corporate sector to shift its financial activities into securitized foreign markets has induced universal banks to offer security-based financing domestically.

Not all aspects of restructuring are more difficult in the financial sector; for one thing, displaced physical and human capital can probably be redirected more easily from there (because they are less specific) than from some other sectors of the economy.

For a further examination of the link between increased competition and bank risk, see Keeley (1990), and Weisbrod, Lee, and Rojas-Suarez (1992). Despite the Basle Accord on risk-adjusted capital standards, banks can increase their portfolio risk owing to gaps in the standards (see Section III).

Trading strategies, such as stop-loss sales or portfolio insurance, likewise rely on market liquidity for their success.

Care needs to be taken here not to embrace the broader conclusion that securitization and disintermediation, by themselves, necessarily imply greater instability. This is because there are other characteristics of securitization and bank disintermediation (e.g., ease of marking assets to market, distance from the safety net, opportunities for diversifying risk, etc.) that may well enhance prospects for stability. Instead, the intention is to highlight one potential source of systemic risk (i.e., liquidity strains) that may well be higher in more securitized financial systems.

See Weisbrod, Lee, and Rojas-Suarez (1992). These pressures are more in evidence for wholesale banking than for retail banking.

An alternative justification for expanding the permissible activities of banks to include securities activities is gains from diversification. However, available evidence points to the limited nature of such gains. See Boyd and Graham (1988) and Kwast (1989).

To some extent, this debate mirrors that over the appropriate supervisory and regulatory responsibilities of the future European Central Bank.

The broader issue of the effect of financial liberalization on the efficacy and transmission mechanisms of monetary policy goes somewhat beyond the scope of this report. For an analysis, see Isard (1991).

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