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July 23, 2012

A Principle for Forward-Looking Monitoring of Financial Intermediation: Follow the Banks!

Nicola Cetorelli

In the previous posts in this series on the evolution of banks and financial intermediaries, my colleagues and I considered the extent to which banks still play a central role in financial intermediation, given the rise of the shadow banking system. There’s no arguing that financial intermediation has grown in complexity. And there’s also little doubt that the balance sheet of banks is not as representative of financial intermediation activity, and the associated risks, as it once was. Yet as we’ve argued, regulated bank entities have remained very much involved in virtually every aspect of modern financial intermediation, either directly or indirectly providing support to other entities that themselves operate more in the regulatory shadow. I suggest in this post that the insights from the series can be relevant to the design of modern regulation as well.

    The framework governing the monitoring and regulation of financial intermediation is currently under significant revision on the international stage. This effort is likely to lead to the prudential oversight of shadow banking entities and activities that during the crisis proved to pose systemic risk. This path seems sensible, and the associated expansion of regulatory boundaries is probably needed. However, an even bigger challenge going forward is how to address what we don’t know and don’t see just yet. In other words, how do we design a regulatory framework geared toward identifying and monitoring future innovations that may create systemic risk? This is especially important considering that—if recent history has taught us anything—much of these yet-to-come changes will likely arise exactly in response to the next batch of regulatory “fixes.”

    Perhaps playing regulatory catch-up is unavoidable, but there may be ways for the regulator to at least reduce this positional disadvantage. For example, I argue that the demonstrated ability of banks to adapt to the evolving system of intermediation actually suggests a principle for more forward-looking, dynamic monitoring and regulation: Follow the banks! If there’s a new product or activity related to financial intermediation that we’re likely to see in the future, there’s a very good chance that a regulated bank entity will be part of it. The articles in the Economic Policy Review volume we’ve been blogging on document banks’ pervasive role along the credit intermediation chain. Yet there’s another way to illustrate banks’ presence in pretty much every facet of intermediation: by focusing on entity types. Bank holding companies in 2011 controlled about 38 percent of the assets of the largest (top twenty) insurance companies, roughly 41 percent of total money market mutual fund assets, and approximately 93 percent of the assets of the largest (top thirty) brokers and dealers. Moreover, very little securities lending and related cash collateral reinvestments take place without the services provided by the main custodian banks. These are activities that have been much in the news during and after the crisis as part of the shadow banking world, and yet we observe that regulated banks have a considerable footprint in all of them.

    By the way, this isn’t a Ptolemaic view of financial intermediation, with banks at the center of the universe. Quite the contrary, this proposed principle recognizes that banks are one component of a more complex system and that monitoring of intermediation should be less bank-centered. At the same time, however, as part of its regular monitoring effort, the bank supervisor is naturally bound to learn about new products, markets, and entity types that might constitute new sources of systemic risk. Hence, I contend that the banking world offers a unique observation point to detect developments across the whole system, and this positional advantage should be exploited to design more effective forward-looking monitoring and regulation.

    Why is this important? Under the current supervisory framework, if we see a bank engaging in a new activity, we may take action to preserve the health of the bank and to contain the related systemic consequences. However, this supervisory action may not necessarily lead to regulation of the underlying activity itself, nor restrict or monitor the participation in such activity by other entities outside the scope of bank supervision. Therefore, the bank supervisor gathers information along the way, but this knowledge is likely to remain underutilized for broader oversight of financial intermediation activity. Recognizing the existence of this information externality should make the bank supervisor an agent that’s instrumental to achieving more forward-looking monitoring of intermediation at large.

    Building on the existing structure of bank supervision seems the natural starting point to design effective intermediation monitoring for the future. For one, bank supervisory agencies already exist, and their operation and expertise could be deployed to internalize this information externality. We should consider ways to implement this broader mandate even before or in addition to the creation of any new regulatory bodies that’s likely to result from current reform efforts across the globe. Besides, regulatory agencies have a natural tendency toward sclerotization: today’s tasks and priorities tend to dominate future priorities. Thus, whatever new agency we end up putting in place today will likely persist well past the relevance of the entities or markets that it’s supposed to oversee. Instead, my proposed principle is intrinsically dynamic. The mandate would require continuously updating the frontier of innovation rather than focusing on any specific activity or entity type. A full regulatory catch-up may be beyond reach, but I think this could represent an improvement in the position of the regulator on the starting block.



Disclaimer
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.




Cetorelli_nicola
Nicola Cetorelli is a research officer in the Research and Statistics Group of the Federal Reserve Bank of New York.
Posted by Blog Author at 07:02:00 AM in Financial Institutions
Comments

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Regulatory agencies must supervise and enforce regulation. To do BOTH effectively, they must study recent, current and emerging market forces. They can reasonably anticipate the directions in which the private sector will most likely react in the near term. History tells us that they must revise regulatory interpretations and supervisory practices, and in some situations they must do so swiftly. Enforcement is different; it is an ex post role – it happens after the barn door had been left too far open.
The regulatory agencies may also be able to anticipate the directions in which the private sector may adapt to medium-term market forces. To some extent, the regulatory agencies may even be able to anticipate how the private sector may evolve over longer time periods. I am certain of this, because an anticipatory approach was utilized when the FRB developed Rx21 in the mid-1990s. That seminal effort correctly anticipated several adaptations by the private sector. It set the way forward for risk-based supervision, and when necessary enforcement.
The fundamental assumption should be this: market forces have been dynamic and will continue to be so. To the extent that fundamental assumption of dynamism holds over time, the regulatory approach must be anticipatory; planning is essential for near-term, medium-term and long term changes in supervisory and regulatory changes. It is about Change Management. In recent years, the regulatory approach has seemed increasingly reactive. The question on the table is why.
It may in part be because the speed with which the private sector evolves has become much faster than anyone had expected. That is to say, the private sector not only reacts and adapts, but nowadays actually evolves faster. Because regulatory change is so significant, the private sector now actively anticipates regulatory changes, and begins its change management processes sooner and evolves to the new regulatory and enforcement paradigm more swiftly.
No matter what new agency is designed and implemented, the capacity to anticipate the drivers of change will remain the fundamental challenge for those filling the public policy seats at the roundtable.
JH Wistman

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