We are witnessing—and, indeed, as legal representatives of central banks throughout the world, participating in—dramatic changes in the worldwide banking and financial-services industries. The changes now in progress are not limited to a single country and, in fact, represent major steps toward the development of a global financial-services market.

I. Introduction

We are witnessing—and, indeed, as legal representatives of central banks throughout the world, participating in—dramatic changes in the worldwide banking and financial-services industries. The changes now in progress are not limited to a single country and, in fact, represent major steps toward the development of a global financial-services market.

Internal pressures for deregulation in individual countries, the internationalization of securities and capital markets, and especially advances in computer and communication technology, as well as the growing dependence of countries on trade with each other, have combined to increase the pressure on individual countries to liberalize their banking systems. Different countries have reacted to these pressures in different ways, but a considerable number of countries, particularly in the major financial centers, have moved to permit banks to become more involved in new financial activities, including securities activities, and to expand their activities into new markets.

Today I would like to explore the different approaches that countries have taken to deal with these pressures for deregulation and to outline some of the challenges that deregulation creates for bank supervisors.

II. Forces Leading to Deregulation of the Financial-Services and Banking Industries

A number of economic factors in the 1970s and the 1980s, in particular the sharp rise in inflation and the increased volatility of interest rates and exchange rates, placed significant pressure on banking institutions to develop new financial instruments to deal effectively with these economic trends. In addition to these economic events, fundamental changes have occurred in the last two decades in communications and computer technology that have irreversibly changed the manner in which financial transactions are conducted worldwide.

These technological developments have dramatically lowered the cost of storing, transmitting, and evaluating information necessary to make credit and investment decisions. As a result, the key role of banks as financial intermediaries has been importantly altered. In the past, the high cost of gathering and using facts permitted banks and other financial intermediaries to profit from their cumulative store of knowledge about borrowers, and to make significantly better-in formed credit decisions than most other market participants. The technological innovations to which I have referred have permitted the direct acquisition of credit market instruments by private investors to substitute for the traditional intermediation role of banking institutions. This, in turn, has created pressures for banks to expand their role as financial intermediaries to incorporate the function of securities and commodities broker and dealer, investment advisor and underwriter, and insurance broker and underwriter.

These technological developments have also permitted the linking of securities and other markets across the world in a manner that permits trading of securities, commodities, and new derivative products virtually 24 hours a day, thereby allowing financial institutions and investors continuously to monitor and adjust their investments and to hedge in one market investments made in another. The amount traded on a daily basis is very large, with, for example, dollar interbank settlements over the Clearing House Interbank Payment System (CHIPS) network, which involves primarily international settlements, reaching more than $550 billion.

The same developments have also spurred the creation of innovative financial products. Much of this innovation has come through the exploitation of opportunities in the various areas in which banks and other types of financial-services companies compete. Banks have also developed credit and hedging tools that remove these new financial products from balance sheets, thereby avoiding capital requirements and lowering the costs of these products and services to bank customers. These innovations may also represent increased risk to financial institutions—risks that often are not cushioned by additional capital because of their off-balance-sheet status. I would now like to review, based on developments in a number of major financial markets, how these forces have affected the conduct of the banking business.

III. Survey of Deregulation Worldwide

Developments in the United States

The United States has, compared with the rest of the world, a rather peculiar and complex banking system. For historical reasons too involved to explain here, the United States has over 14,000 commercial banks, about 400 savings banks, 3,200 savings and loan associations, and about 15,000 credit unions—all federally insured, deposit-taking institutions. Together their assets total $4.2 trillion, of which about 67 percent is held by commercial banks.

The system has three different federal chartering authorities; in addition, each of the 50 states has the power to charter each of the various kinds of depositories. These institutions are regulated by five different federal supervisory agencies. Finally, each of the states has its own supervisoryagency, and in many cases a separate one for each type of depository institution.

Within this system, depository institutions are subject to a complex regulatory and supervisory regime that does the following:

(1) limits the scope of geographic expansion;

(2) for the most part, confines the powers that may be exercised to “traditional banking activities”;

(3) provides a framework of more or less rigorous examination and supervision; and

(4) until recently, placed a ceiling on the amount of interest that was payable on deposits of $100,000 or less.

Over the years there has been much talk about changing regulatory and supervisory arrangements to make the banking system both safer and more competitive, particularly with regard to nonbank suppliers of financial services. Despite this ferment, no one has come up with a satisfactory, broadly accepted reform plan. That is not to say that important changes have not been made. In fact, two of the changes have been fundamental—interest rate deregulation and interstate banking—while a third—the expansion of banks’ powers—is in an incipient stage. It is on these three changes that I will focus in my review of de regulatory developments in the United States.

In the United States, one of the most significant de regulatory steps taken in this decade has been the removal of restrictions imposed on the interest rates that banks and thrift institutions could offer on deposits. Since the 1930s, banks in the United States had been prohibited from paying interest on demand deposits, and could pay only an artificially limited interest rate on time deposits of less than $100,000. Thrift institutions were similarly limited in the amount of interest they could pay on deposits, although they were allowed a slightly more advantageous rate than banks. These interest rate controls were enacted as part of a Depression-era effort to increase the stability of the banking system by forestalling interest rate competition for deposits, and to protect the viability of thrift institutions and the flow of funds to the home-mortgage markets.

In the late 1960s and the 1970s, banks and thrift institutions experienced stiff competition from nonbank financial-services organizations for the funds of consumers and corporations alike. Money-market certificates, mutual funds, and other innovative instruments offered by nonbanks were not subject to interest rate controls, and succeeded in siphoning significant amounts of deposits from banks and thrifts. Experience during the inflationary period of the 1970s also indicated that interest rate controls did little to stabilize funding to the housing market and, in fact, impeded the ability of banks and thrifts to compete for funds for home-mortgage lending.

As interest rates rose to very high levels in the early 1980s, substantial disintermediation occurred; banks and thrifts incurred a substantial erosion in their deposit bases while money-market funds experienced spectacular growth. Spurred by these developments, Congress established the Depository Institutions Deregulation Committee (DIDC) in 1980 to prescribe rules for the orderly phaseout and ultimate elimination of limita tions on the interest that could be paid by banks and thrifts on deposits. In a major breakthrough for the banking industry, in 1982, in the Garn-Saint Germain Act, Congress mandated the establishment of an account that would be equivalent to an unregulated money-market fund without any limitation on the amount of interest that could be paid.

Subsequently, the DIDC oversaw the complete removal of interest rate caps on time deposits, effective in April 1986. Thus, today, banks and thrifts in the United States may compete with nonbanking institutions for deposits free of artificial restrictions on interest rates.

The second most important de regulatory development has been the growth of regional interstate banking and the establishment of so-called super-regional banks. This development was made possible by the landmark decision of the U.S. Supreme Court in the Northeast Bancorp case, in which the Court held that federal law allowed states to permit entry of banks from other states on a selective basis. This decision thus permitted states to join together in regional arrangements that sanctioned reciprocal acquisitions of banks within the region, but still excluded banks from outside the region, particularly banks from those states where the very large money-center banks were located.

The results have been remarkable. Today 26 states are participants in regional arrangements. At the same time, there has been a very large increase in the number of mergers and acquisitions approved by the Federal Reserve Board. In 1982, the Board approved no interstate consolidations, while in 1986 and 1987 the number it approved exceeded 300 in each year.

The Federal Reserve was initially quite concerned about the regional banking concept, because it was feared that the regional groupings would remain exclusive and would impair the establishment of nationwide banking, with a resultant balkanization of the U.S. banking system. This has not proved to be the case, as many states have adopted regional arrangements, but only as part of a transition to full interstate banking. At present, 15 states permit full or reciprocal interstate banking, and an additional 14 are scheduled to implement it within the next several years. Still, additional progress toward the goal of nationwide deposit taking would further strengthen the banking system in the United States by permitting maximum effective use of the new computer technology, thus achieving important cost savings, and by providing stable and diversified sources of deposit funding.

I would say, as an aside, that these steps seem somewhat tame compared with the ambitious plan for integration of the financial communities that is planned for the European Community by 1992. I find it at least a bit strange that the United States—a country that has had a common market for almost 200 years in almost all things other than banking—is just beginning to develop one for this essential service. This situation speaks a great deal about the political sensitivity and economic importance of banking, particularly in the United States. It also speaks to the significant scope of the ambitions of our colleagues in Europe.

In deposit rate deregulation and the expansion of interstate banking, much has already occurred, but the process of expansion of banks’ powers is very controversial and is just beginning. Some steps have been taken at the state level. Over the past decade, the individual state authorities that charter banks have expanded the powers of banks located in their jurisdictions to include real estate development and brokerage authority; broad insurance powers; and, in some states, leeway authority to invest up to a limited percentage of the bank’s assets in any activity. Some of these state initiatives raise important issues for the system as a whole and for the federal safety net in particular, since they often create destructive competitive pressures on other states (and on federal regulators as well) to expand banking powers in order to attract business, as well as to increase jobs and revenues, without regard for bank safety and soundness or for proper supervision.

At the present time the real action is at the federal level. A number of steps have been taken to liberalize the powers of banks, particularly in the securities area. For example, the Federal Reserve Board has permitted bank holding companies to engage in discount securities brokerage and, subject to the outcome of pending litigation, would allow these companies to engage in limited underwriting and dealing in certain securities.

However, the most important initiative now underway is a legislative proposal to repeal the restrictions contained in the Glass-Steagall Act that were imposed more than a half century ago, in 1933, on the conduct of securities activities by banks. Under a bill passed by the Senate, bank holding companies would be permitted to underwrite and deal in commercial paper, mutual funds, municipal securities, mortgage-backed or other asset-based securities, and corporate debt securities. Corporate equities could only be underwritten after a congressional vote scheduled to take place in 1991.

A critical element of this approach has been the use of the bank-holding-company framework, which allows an affiliation between banking and nonbanking companies (with the advantages of diversification and economies of operation) while also providing a vehicle that permits some degree of isolation of a bank from the risks associated with nonbanking activities. The core of this proposal is an attempt to insulate the bank from any losses that might be experienced by the securities affiliate and to reduce the potential for conflicts of interest that might result from the affiliation of a bank and a securities firm. The proposal also attempts to prevent the federal safety net—Federal Deposit Insurance Corporation (FDIC) deposit insurance and Federal Reserve discount-window assistance—from being extended to securities firms that are affiliated with banks.

Among the so-called firewalls that would be constructed between the bank and the securities firm are the following:

(1) restrictions on the purchase by banks of assets and securities underwritten by the securities affiliate;

(2) a prohibition on lending by the bank to the securities affiliate;

(3) limitations on director and officer interlocks between the bank and the securities affiliate;

(4) limitations on extensions of credit by the bank for the purpose of enhancing the value of the securities underwritten or distributed by the affiliate; and

(5) a prohibition on lending: (a) to the public for the purchase of securities underwritten or distributed by its affiliate or (b) to the issuer of securities underwritten or distributed by the affiliate, for the purpose of paying interest, dividends, or principal on those securities.

In addition, the proposal would require the bank and the securities affiliate to make certain disclosures to customers that were designed to assure that the customer was aware that the securities underwritten by the securities affiliate were not obligations of the bank, were not guaranteed in any way by the bank, or were not insured by any agency of the federal government.

The initiatives in the United States to repeal the Glass-Steagall Act would also permit foreign banks that operate in the United States to be affiliated with securities firms operating in U.S. securities markets. This is in keeping with the U.S. approach, encompassed in the International Banking Act of 1978, which provides for the national treatment of foreign and domestic banks in competition in the United States. The proposals also would not affect the manner in which U.S. banking organizations were permitted to engage in securities activities under the laws of various foreign countries.

It is now too early to say how this legislative initiative will work out. As I said, it is controversial because of competitive reasons and because there is genuine concern that securities activities would undermine the safety and soundness of U.S. banking institutions. If it is adopted, and I think it will be, the experiment based on the expansion of holding-company powers will be closely watched and, if successful, could well pave the way for broader expansion of bank-holding-company activities into other financial services. It also raises the broader question, about which there is even more controversy, of whether banking organizations should be permitted to engage in commercial activities. Debate about this subject is nowhere near resolution in this country.

Developments in the United Kingdom

In the United Kingdom, the technological and competitive pressures described earlier combined with other initiatives that were already underway in that jurisdiction to result in the “Big Bang”—so called because after the Bang a new financial universe would be created. The initiatives had begun with efforts to provide better protection for investors after a number of market scandals and to end the restrictive market practices of the London Stock Exchange. However, the need for reform became greater as U.K. financial firms, which were generally specialized, small in size, and had limited capital, faced ever-increasing competition from larger, better-capitalized foreign firms.

In order to allow local financial-services firms to compete with foreign institutions, formal and informal prohibitions were removed on affiliations among different types of institutions. For example, banks received approval to acquire money brokers and discount houses—affiliations not previously authorized. More importantly, the London Stock Exchange removed restrictions on corporate memberships on the Exchange, opening the way for domestic and foreign banks to become full participants in securities underwriting and dealing operations. The Stock Exchange also removed the barriers that prevented companies from acting as both broker and dealer. All of these were important deregulatory moves.

Of course, the term “deregulation” is something of a misnomer. Aslawyers, we should know better than anyone that attempts to change an existing system through imposition of a new structure are bound to result in new rules and regulations. The situation in the United Kingdom illustrates this. Although the Big Bang was a deregulatory step, there is also a regulatory side to what has been done.

This new regulatory structure attempts to limit government intrusion into the affairs of the various institutions by establishing a system of self-regulatory organizations (SROs). Every entity carrying on an investment business is required to join an SRO.

SROs grant authorization to, and monitor the activities of, entities engaged in the various types of investment business, including securities activities, dealing in futures and options, investment advisory and management activities, and life insurance. An SRO establishes capital-adequacy standards and investor-protection requirements for those entities it regu-lates. The legislation, however, does not leave investor protection entirely to the SROs. Consequently, the SRO will be overseen by the Securities Investment Board (SIB), which is a private company whose board of directors is appointed by the U.K. Government and the Bank of England. The SIB establishes the standards for investor protection; the rules of individual SROs must be at least as stringent as those of the SIB in order to be considered acceptable. Moreover, the SIB’s rules are subject to review and oversight by the government.

Developments in Canada

In 1987, Canada followed the United Kingdom with its own version of the Big Bang. Prior to this time, Canada had one of the most segmented financial markets in the world. The “four pillars” of its economy—banks, trust companies, insurance companies, and investment companies—were restricted as to the products and services they could offer and could not become affiliated through common ownership. One result of this segmentation was that, as had happened in the United Kingdom, securities firms were small and relatively undercapitalized and therefore unprepared to compete successfully internationally. In addition, Canada’s own capital market was losing out in the increased competition with other financial centers. Canadian banks were also concerned because they were losing customer business to securities firms, with whom by law they could not compete. Consequently, the Canadian Government felt compelled to reform the financial system.

Changes in Canadian federal law, also spurred by deregulation of the provincial securities exchanges, allowed banks to acquire securities companies; gave new lending authority to trust companies; and permitted all regulated financial institutions to offer investment advice and portfolio-management services. In adopting this approach, the Government stated that it was taken in recognition of

… market trends toward greater competition among all types of financial institutions. It removes regulatory restrictions that no longer serve public policy goals and that, in fact, risk denying full benefits of competition, efficiency and innovation to Canadian users of financial services.

At the same time, important barriers were erected to prevent linkages between commercial firms and financial institutions; these were intended to promote competition and enhance solvency by ensuring that banks, trust companies, and insurance firms were widely held. To this end, future substantial affiliations will be prevented between commercial and financial entities. Financial institutions without commercial ownership will be allowed greater scope for their activities.

In both the United Kingdom and Canada—as in the United States—deregulation efforts have also made apparent the conflicts that can arise when one organization acts in a number of different roles. As a result, these two jurisdictions have also established, to a greater and lesser degree, customer protections designed to ensure that users of financial services are not badly served by the providers of these services.

Developments in Japan

In Japan, several new instruments and markets have been established as a result of pressure to open the domestic money market. In 1985, a banker’s-acceptance market was established; and in 1986, short-term treasury bills were introduced. Deposit interest rate deregulation continues, with lowering of the minimum denominations for money market certificates and raising of the maximum maturities of such certificates. Large time deposits are now eligible for free-market interest rates.

Japan also established a commercial-paper market in November 1987, although both the minimum maturity (one month) and the minimum denomination ($750,000) are contributing to make the market less attractive and therefore less successful than it could be. In addition, the Ministry of Finance plans to establish a financial futures and options market this year in which securities companies and banks (foreign and domestic) will be able to compete on an equal basis, with two exceptions: Only securities firms may trade in stock-index options, while options on foreign exchange may only be traded by banks.

Developments in the Federal Republic of Germany, France, and Italy

In the Federal Republic of Germany, capital markets have been liberalized somewhat. In 1985, the Deutsche Bundesbank permitted the introduction of a number of non traditional debt instruments and practices. These include deutsche mark floating-rate notes, multiple-currency issues, zero-coupon bonds, and swap-linked issues. In 1986, certificates of deposit denominated in deutsche mark were permitted to be offered. Creation of a new market segment on the stock exchange made it easier for small and medium-sized issuers to come to the market by reducing fees and the required size of issues, as well as by requiring less information from these issuers than is required of a regularly listed issuer.

France is moving toward re privatization of the banks that were nationalized in 1982, and it has adopted legislation that creates a uniform framework for all credit institutions. French banks have also been permitted to join the financial-futures exchange and to issue new instruments, the most important of which is a negotiable certificate of deposit. Other institutions have also been permitted to offer new instruments in order to enable them to compete with financial institutions operating internationally.

In Italy, recent legislation allows the Bank of Italy to authorize new forms of banking service s without derogating from the clear separation in Italian law of banking and industrial activities. The Bank of Italy has authorized banks to invest in specialized companies to carry out merchant banking activities.

Other Markets

Even in major markets that are not moving toward radical realignments in the structures of their financial-services industries, there has been a loosening of restrictions on the powers exercised by banking institutions. Futures and options contracts are now standard financial instruments. Within just six years, the market in interest rate-swap contracts has grown from nothing to a multi-billion-dollar industry.

Opening of Markets to International Competition

All of the market and technological factors I have described today have also promoted the opening of domestic markets to foreign participation. This stems from a common recognition of the benefits of open capital markets and from pressures brought to bear by market participants on jurisdictions that are not open. The following are a few examples.

As noted above, a significant step in London’s Big Bang was allowing foreign ownership of member firms on the London Stock Exchange. In Canada, foreign companies are now permitted to take 50 percent interests in Canadian investment firms, with the ability to go to 100 percent ownership in the next few years. In the Federal Republic of Germany, local subsidiaries of foreign financial institutions are now permitted to act as lead managers of foreign deutsche mark bond issues (i.e., deutsche mark bonds issued in the Federal Republic of Germany by nonresidents).

In Japan, although much work remains to be done, significant progress has been made in the last few years. Foreign banks are now allowed to participate more extensively in Japan’s domestic financial markets by dealing in government bonds. Beginning in April 1987, the Japanese Government increased the foreign share of the underwriting syndicate for government bonds and modified the rules to reduce the length of time—from ten years to five—that foreign banks must have operated in Japan before they may enter the bond syndicates.

Foreign banks are also now permitted to have joint-venture securities operations in Japan, and nine foreign banks have been authorized to acquire trust banks. Foreign membership on the Tokyo Stock Exchange has been authorized, and about 22 foreign-based firms are now members. Moreover, an advisory body to the Ministry of Finance has carried out a study and has strongly recommended the repeal of Article 65 of Japan’s Securities Exchange Law, which is the Japanese equivalent of the United States’ Glass-Steagall Act. As result of this study, a number of study groups have been formed to evaluate the probable effects of removal of barriers between different types of banks but no study groups have been formed to consider seriously the repeal of Article 65 of Japan’s Securities Exchange Law.

The United States and Canada are moving toward implementation of their Free Trade Agreement, which eliminates many of the existing trade barriers between the two countries. The agreement also governs cross-border financial services, establishing national treatment for financial-services institutions in each country.

To sum up: At this point, major financial markets are changing, and changing rapidly, with new participants employing new instruments in the context of a highly competitive global market involving round-the-clock trading. In response to these changes, the legal framework for the conduct of financial business is changing, too. These developments will bring problems—of competitive innovation, of troubled institutions, and of uncoordinated regulation in an integrated world—as well as benefits.

IV. Problems for the Future

I would like to discuss three problems that I see looming on the horizon that seem particularly appropriate for review and evaluation by a group of central bank lawyers. The first concerns a trend toward insistence on reciprocity, particularly as changes take place at different tempos in different markets. The second problem concerns the conflicts that could arise from the different approaches being pursued in the United States and other countries with respect to the financial responsibility of a bank for the nonbanking activities of affiliated companies. The third problem concerns the implications of expanding deregulation of powers for the informal, but real, safety net that central banks around the world have erected to support the international financial system.

Pressure for Reciprocity

One result of the changes that have been taking place is a demand by those countries that have opened their markets to foreign competition for reciprocity from those countries that have not yet responded to the new global market environment. As the forces of internationalization and interdependence increase, countries that take advantage of other nations’ open markets but do not provide similar opportunities for their trading partners in their own markets are increasingly vulnerable to retaliation in some form. Certainly those countries with relatively open markets are increasingly frustrated by the barriers to entry in other jurisdictions.

Let me give some examples. I have mentioned the U.S.-Canada Free Trade Agreement as a trade-promoting measure designed to eliminate barriers, including barriers to providing financial services across an international boundary. This agreement, however, has been characterized by some as a preventive measure, designed to ensure that U.S. markets would remain open to Canadian companies in the event the United States established retaliatory trade barriers.

The United States, which has a long history of providing open markets and national treatment to foreign-owned firms operating here, has under consideration legislation that would establish a principle of reciprocity for the entry of banking organizations into the U.S. market. This replaces the earlier approach of national treatment. Although this legislation is opposed by the administration and the Federal Reserve, it has a chance of becoming law as part of the pending trade legislation.

Finally, other jurisdictions have felt a need to establish reciprocity provisions. The United Kingdom, in its Financial Services Act, provides that a foreign firm may operate in London only if the firm’s home country permits U.K. firms to operate on the same basis as they operate in the United Kingdom. The European Community, as it moves to complete its internal market by 1992, has also adopted the requirement of reciprocity.

I fear that requiring reciprocity is a dangerous course to follow. Eventually someone will be impelled to go beyond the bluff that is inherent in reciprocity measures and into actual retaliation, naturally enough setting off another round of the same by others. An integrated world economy should not be subject to such risks. The course that should instead be followed is greater international coordination of the deregulation process.

The Bank-Holding-Company Separation Issue

Underlying the statutory and regulatory expansion of bank powers that we have seen in various countries is a fundamental difference in philosophy that is a product of our different approaches to bank regulation and our different historical experiences. As I have emphasized, in the United States, we are attempting to use the bank-holding-company framework as the means of expanding the scope of banking organizations’ powers. The objectives of this framework are fourfold:

(1) to isolate the banks from risks associated with these new activities;

(2) to prevent the bank from using its financial resources to support its nonbank affiliates;

(3) to ensure that the bank holding company serves as a source of financial strength to its banks—and that, if necessary, the holding company will dispose of its non banking assets as a means of supporting its banks; and

(4) to use the federal safety net so that it protects only banks and does not extend to nonbank affiliates of the banks.

Part of the reason for this approach is derived from the vigorous debate that has taken place in this country about whether it is appropriate to maintain the present rules of the Bank Holding Company Act, which provide for the separation of banking and commerce.

While no legislative action to change these rules is likely in the near future, this debate has taken on an intensity in this country that has some of the characteristics of the religious wars of the sixteenth century. For those that wish to eliminate the banking-commerce distinction, it is essential to be able to argue that the resources of a bank that is part of an industrial, commercial, and financial conglomerate will not be available to support the other parts of the enterprise. Similarly, it is essential for them to argue that the federal safety net will not be indirectly available to support the enterprise as a whole through the affiliated bank. I would add that the debate has a somewhat different significance in this country than it might elsewhere, because its major focus is on the interest of commercial firms in buying banks, rather than vice versa; in most other countries, to the extent such common ownership exists, it is in the form of banks owning other types of firms.

The objectives that I have described will not be easy to accomplish. Firm laws and new attitudes of markets, managers, and regulators will be required to maintain the necessary degree of corporate se parateness. Yet I have the feeling that in major financial markets outside the United States, the markets, the managers—and especially the regulators—take an integrated view of a banking enterprise. They appear to believe that a banking enterprise has the responsibility to come to the aid of any of its troubled parts and, in fact, that the bank should draw upon its resources to protect an affiliated commercial firm that is in trouble.

Common ownership of banks and commercial enterprises is fraught with the danger of conflict, particularly regulatory conflict. A bank in such a situation could receive contradictory commands from the relevant regulatory authorities. Since the expansion of banks’ powers is only beginning, these problems are still potential rather than real. But—I will make the point I made before—in an integrated world economy, it is essential that this difference of philosophy be resolved in a cooperative international framework before irreconcilable conflicts appear.

The Worldwide Safety Net

The problem of differing philosophies on the issue of holding-company separation is exacerbated by the third problem on my list—the existence of a de facto international safety net. It appears to me that as a practical matter, the central banks and monetary authorities in the United States and elsewhere have, without formal agreement, and even without specific legal authority, been acting to prevent financial shocks to the world economy as the result of the failure of depository institutions.

My case that this practice exists is based on the record of official action:

  • the establishment in 1982 of an extraordinary administration for Banco Ambrosiano and its acquisition by a consortium of Italian banks under the auspices of the Italian monetary authorities;

  • the rescue of Continental Illinois Bank in 1984 with the assistance of the Federal Reserve and the FDIC;

  • the sponsorship in 1984 of a rescue package by the Bank of England—using in part its own resources—for Johnson Matthey Bankers;

  • the Deutsche Bundesbank’s arranged rescue in 1985, of Schroeder, Muenchmeyer Hengst and Company, an institution with less than $1 billion in assets; and

  • in 1987, the bailout of the Hong Kong futures exchange with a HK$2.0 billion credit facility arranged by the Hong Kong Government with the participation of member banks of the exchange.

I confess I am not sure why this safety net exists. As I said, it is not required by law. This is clearly so in the United States, and I understand this is the case in other countries as well. To the extent I can make sense of it, I trace the financial-rescue policy to a deep-seated desire to avoid financial instability, perhaps arising from the experience of the period after World War I, when such a high price in lives and treasure was paid for the financial and political instability that then prevailed.

Yet I do not believe our current relative financial stability, which has been more or less sustained for about forty years, has not been achieved without cost. In my judgment, one result of the protected atmosphere we have maintained has been an impairment of prudential standards, with a consequent deterioration in the quality of lending and financial judgments (as well as in credit quality) on a worldwide basis. This situation can only become more serious if the safety net is expanded to cover a widening group of enterprises, as banking organizations undertake a broader spectrum of financial—and possibly nonfinancial—activities in response to the opportunities provided by burgeoning technology. I am not sure I know the solution to this problem—perhaps it can be found in the holding-company-separation concept. I feel certain, however, that an indiscriminate extension of the safety net will undermine, rather than enhance, the safety and soundness of our banking institutions and the stability of the international financial system for which we have a shared responsibility.



The subject of this panel is deregulation. However, I do not like the word “deregulation.” I prefer the word “reregulation,” because that is, indeed, what is going on. The Organization for Economic Cooperation and Development (OECD) published a series of monographs on the issue of the internationalization of banking. In them, the business of financial liberalization, as it has generally been implemented in the OECD countries, arises out of a series of policy decisions: first, liberalized capital movements; second, liberalized deposit ceilings or regulations on interest rates; third, a series of liberalizations granting banks the authority to do cross-border business; and fourth, an interpretation permitting broader banking business.

You have seen liberalization, in the sense that banks around the world, especially in OECD member countries, have been granted expanded powers and have been permitted to engage in more activities than in the past. So, you have liberalization on the liability side of banks’ balance sheets, as well as a much freer flow of capital across borders. You have liberalization in terms of the granting of banking licenses, expanded authority for banks to open branches overseas, and more scope for banks from one country to penetrate the markets of other countries.

All this liberalization has led, however, to a whole list of uncertainties. The pace of change accompanying this liberalization has stressed the financial system; has stressed central banking authorities seeking to maintain the transparency of the financial system; and has stressed the management and systems of each bank, because these continually have had to be adjusted in light of the wide range of innovations in finance that have been fostered by liberalization.

Given these trends, the response by a number of central banks really has been to reregulate, not deregulate. The response to liberalization is re-regulation. We have seen this throughout Europe, in the United Kingdom, and in Canada, and we are still struggling with the issue in this country and in Japan. Having permitted the free flow of capital and the internationalization of banking and financial innovation, the central authorities are left with the problems of safety and soundness.

The central authorities have an enormous problem in maintaining the transparency of financial markets because the changes in them have not fit within the traditional reporting systems of many central banks. Central banks, therefore, are not receiving current and accurate information about what is going on in their financial markets. Bank supervisors are having difficulties, since they do not have information that is current and accurate. They are therefore having difficulty understanding the new flows of finance, the new financial instruments, and the risks involved in using those instruments.

Thus we are seeing a second, reregulation phase. For instance, in the case of France or the United Kingdom or the Federal Republic of Germany, legislation essentially has been used to create new regulatory and supervisory frameworks for the business of finance. Generally, these new frameworks are much broader than the ones they replaced, because they may encompass not only the old issues of bank control but also securities activities and clearinghouse activities. They deal with the issues of what is going on in the financial-services industry, which goes far beyond banks. If we look at the new French Banking Commission vis-à-vis the old French Banking Commission, it will be evident that there is authority to supervise a broad range of activities that traditionally were not within its responsibility. The composition of the French Banking Commission includes representatives from the Bank of France, the Treasury, four representatives appointed by order of the Minister of Economy and Finance from the Council of State, an Appeals Court judge, and two members selected on the basis of their expertise in banking and financial matters—in other words, from parties that have a major interest. Moreover, the Commission has much broader powers than it did under the old system of bank control in France.

If we look at what has happened in the United Kingdom over the last ten years, we will see that while London has, in many ways, become a much more liberal financial center, the Bank of England has received an enormous amount of statutory authority that it never had before. As many of you know, up until maybe even five years ago, the Bank of England’s statutory authority for the oversight of finance in the City of London hardly existed; the basic authority came through its authority over the discount window. Generally if a financial firm wished to be licensed in London, it would be licensed under the Companies Act, not by the Bank of England. But in recent years, because of the need to reregulate the financial system in the United Kingdom, and especially in the City of London, Parliament passed statutes that gave the Bank of England specific authority to enter into a wide range of formal oversight activities in the City. In addition, Parliament established a series of “self-regulatory organizations,” which are designed to assist the Bank of England in overseeing some non-banking activities such as the securities business. Nevertheless, the scheme of oversight and regulation in the City has been reregulated as liberalization has proceeded.

If we look at Canada, we will see that the Canadians have moved from having an Inspector General of Banks to having a Superintendent of Financial Institutions. And within this new superintendency, there is broad responsibility for oversight of a spectrum of financial activities. Clearly, the entire structure of regulation and supervision in Canada has been redesigned. To a certain extent, this has also happened in the Federal Republic of Germany and some other countries. So I do not see deregulation as a worldwide phenomenon, but I do see reregulation as a worldwide phenomenon.

In the United States, we continue to struggle with the issue of what to do about the securities business, and I am sure at some point in this conference you have heard about the Glass-Steagall Act and the congressional debate about whether to give banks new authority to enter into the securities business. Incredibly, that ongoing debate includes discussion of neither who currently supervises these activities nor who would supervise or oversee these activities if banks were allowed to engage in them. Outside of that legislative debate, there is debate in Washington about the need to reregulate the U.S. financial system. The present system of regulation is anachronistic and does not in any way meet the needs of the marketplace. Consequently, what is probably needed is a whole new supervisory and regulatory scheme for the business of finance.

For instance, in the United States, there are nine federal agencies that have some involvement in the supervision or regulation of financial activities. In addition, there are 50 state bank commissioners, 50 state insurance commissioners, and a small army of about 10,000 bank examiners, who are hired by either the federal government or state governments. If one considers all of their activities, it is clear that we have a very messy system of oversight and regulation that is ill-suited to the realities of today’s marketplace. At some point during the next few years, the United States will have to reregulate its national financial system.

All of my discussion so far has been about the business carried on by national financial systems. Obviously, however, this whole period of liberalization has created a very interdependent worldwide financial system. As we see daily, events in one country affect other countries, and events in one financial institution can affect financial institutions all around the world. So there is also a need to think about creating a global scheme of oversight, of supervision. And, indeed, what is happening multilaterally is reregulation of finance around the world.

The leader in this effort to reregulate is the Basle Committee on Banking Supervision. For about five years, the Committee has devoted most of its time to establishing, or weaving, a network of communication and cooperation among banking authorities around the world.

In recent years, however, the Committee has begun to be assertive in establishing some compatible and consistent rules of supervision for banks that operate internationally. For instance, it has issued principles for foreign exchange dealing, for the assessment of country risk in international lending, and for other systems of internal controls in an effort to establish at least a more compatible common understanding of what should be in place.

Over the last two years, the Committee has been working on risk-based capital—a subject that, I think, takes everyone down the road to serious reregulation of the banking business, since such a scheme would establish a new form of bank control. The scheme of risk-based capital essentially says that banking authorities, in judging the adequacy of a bank’s capital, should weigh its stock of capital against the risks that the bank has assumed both off and on its balance sheet. The scheme calls for a common definition of what constitutes capital and a common weighting of various risks involved in the bank’s activities to that stock of capital. And, finally, the scheme calls for any bank that operates internationally and has its headquarters in a member country of the Group of Ten to have a capital ratio of 8 percent capital by 1992.

Now what this scheme actually is doing is, first of all, imposing a new tax on the business of banking, because if you mandate that so much capital must be held, then you are mandating that banks incur the cost of obtaining and maintaining sufficient capital to insure against the risks involved in its various activities. If one regulates the cost of capital, then in many ways one regulates the pricing of banks’ activities, because whatever activity a bank engages in, it has to weigh the potential earnings from that activity against the cost of capital—a very interesting aspect of the scheme. The scheme also sets out definitions of what a bank can or cannot consider as capital. For instance, present proposals state that common equity is considered to be real capital in all the Group of Ten countries: this is called Tier I capital or core capital. The scheme then goes on to state that banks may also have supplementary, or Tier II, capital: this may include preferred stock, convertible debentures, a certain amount of loan-loss reserve, etc. Clearly, the implementation of such a scheme is not part of a program of deregulation but rather is an attempt to reregulate the global business of banking in a common and compatible way. It is hoped that such a scheme will foster common standards and compatible behavior of banking institutions that operate across borders, with banks’ behavior driven by pricing and by the cost of capital.

I would also like to address the whole issue of technology and telecommunications. The movement toward liberalization and financial interdependence is being driven by developments in these areas. Technology and telecommunications have obliterated all of our traditional conceptions of what banks can do geographically, in terms of volume, as well as in terms of calculations or pricing or clearing transactions, and have accelerated the pace of change, which, in turn, has put pressure on banking institutions and encouraged their regulators to change their techniques of supervision and oversight.

But the liberalization that is going on in the Group of Ten countries, the financial innovation in their financial markets, and the modernization of their banking regulations and supervision is entirely contrary to what is going on in the developing countries. In the developing countries, one sees neither modernization of finance nor any liberalization. Instead, one still sees a very heavy public sector orientation toward the ownership of firms, government involvement in markets, etc. I do not see how developing countries can really improve their situations if the financial course that they are on is opposite to the course that developed countries are on. There must be a fundamental conflict in public policy and an undermining of orderliness in the financial markets if these two groups of countries remain on opposite courses.

Ideally, the same modernization that is going on in the Group of Ten countries will also occur in many developing countries; but until it does, I think it is unlikely that the developed countries will transfer large amounts of financial resources to the developing countries because their economic and financial policies are incompatible. I see the financial institutions in the Group of Ten as much more devoted to financing mergers, underwriting securities, and making investments within the Group of Ten markets than to undertaking any new financial initiatives in the developing world, because the latter’s system is getting less and less compatible with the system prevailing in the Group of Ten. Finally, in terms of reregulation or deregulation, probably one of the biggest loose ends in the international financial system today is created by the almost complete lack of any dialogue concerning how to deal with the international securities business. In other words, while the Basle Committee is doing what I think is an excellent job of trying to establish a multilateral framework for the international banking business, the interdependent international securities market is not receiving any multilateral attention or oversight. This creates an enormous danger to the system, and consequently someone needs to think about the reregulation of this market.


Prepared with the assistance of Kathleen O’Day and Scott Alvarez, Senior Counsels, Federal Reserve Board.