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BANK REGULATION
Will Regulators Catch Up with the Market?
BY
R
ANDALL
S. K
ROSZNER
Executive Summary
Legislation on financial services modernization hastaken on special urgency since the banking industry is tran-sforming itself through mergers stretching across finan-cial services and across countries. Phil Gramm (R-Tex.),the new chairman of the Senate Banking Committee, has madebank reg-ulatory reform his "number-one priority." A reviewof his-torical and contemporary evidence shows how marketforces can address concerns about consumer protection andthe soun-dness of the financial system. The financial ser-vices mod-ernization legislation thus should• repeal the 1933 Glass-Steagall Act and reform the1956 Bank Holding Company Act,• allow banks to structure their new activities throughoperating subsidiaries or affiliates,• reduce the "moral hazard" of federal deposit insur-ance by mimicking private bond covenants, and• not raise any new regulatory barriers.
No. 45 March 12, 1999
Cato Institute•1000 Massachusetts Avenue, N.W.•Washington, D.C. 20001•(202) 842-0200
 
BANK REGULATION
Will RegulatorsCatch Up with the Market?
by Randall S. Kroszner
Introduction
The regulation of financial institutions has importantconsequences for the efficiency and performance of the fi-nancial system and the economy as a whole. Banks play a keyrole in encouraging and gathering the savings that finance acountry's economic growth. By monitoring the use of thesavings they lend to enterprises, banks are an integral partof the corporate governance system that ultimately affectsthe productivity of resources throughout the economy.Although competition is the traditional means ofachieving efficiency in any sector of the economy, bankingis one of the most heavily regulated industries in the Unit-ed States. Most rationales for bank regulation fall intotwo broad categories: (1) consumer protection, which con-cerns potential conflicts of interest when a bank has multi-ple roles, and (2) safety and soundness, which concerns thepossibility of bank panics and financial instability. It isimperative that the regulatory system that has governedbanking with little change since the 1930s be modernized.Each Congress for the past dozen years has made a major at-tempt to revise our Depression-era banking regulations,whose overhaul is long overdue. Each attempt at fundamentalreform has failed. Most recently, the House of Representa-tives of the 105th Congress voted for the first time in fa-vor of a bill (H.R. 10) that would end those Depression-eraregulations, but the Senate never voted on the measure. Asthe proposed merger between Citibank and the Travelers Groupclearly illustrates, the markets simply cannot wait anylonger for legislative reform and are taking deregulationinto their own hands.While reform of financial services regulation is ex-tremely complex, the general direction of reform is clear.The Glass-Steagall Act of 1933 and the Bank Holding CompanyAct of 1956 should be altered fundamentally to permit com- ____________________________________________________________
Randall S. Kroszner is an associate professor of economicsin the Graduate School of Business at the University of Chi-cago.
 
Page 2mercial banks to engage in a wide variety of financial serv-ices and to permit other financial services firms to engagein commercial banking. The artificial walls separatingthose activities should be eliminated. Those changes arenecessary to provide greater convenience for the consumer aswell as to keep financial institutions in the United Statesglobally competitive. As Table 1 shows, banks in the UnitedStates have faced increasing competition from other finan-cial institutions over time, and their market share has beendeclining. That share went from 62.9 percent of total as-sets of financial institutions in 1900 to 55.9 percent in1948 and to 25.4 percent in 1993.Permitting commercial banking and investment bankingunder one roof, however, does raise important questionsabout potential conflicts of interest and about the stabili-ty and soundness of the financial system. Competitive mar-ket forces and incentives can address those issues if theinstitutions are sufficiently capitalized. To survive inthe marketplace, a commercial bank must be able to develop areputation for fair and honest dealing with its customers;otherwise, customers will turn elsewhere. Pre-Glass-Stea-gall evidence shows how banks successfully resolved the con-flict-of-interest issue and provides insights into how mar-ket forces would shape the involvement of commercial banksin other financial activities. Banks appear to have volun-tarily developed effective "firewall" structures that pro-vide lessons for the current debate about the appropriatestructure of activities in a financial services firm.The recent mergers of such banking organizations asBank of America-NationsBank and Banc One-First Chicago arepart of a broader trend toward consolidation and rational-ization of the structure of the U.S. banking system. Duringthe past quarter century, states have been eliminating arti-ficial barriers to the geographic expansion of banks. Thatregulatory reform culminated at the national level with theRiegle-Neal Interstate Banking and Branching Efficiency Actthat went into effect in June 1997 and will now allow themarkets to create truly nationwide banks. Those mergers arehelping to create efficient and convenient interstate bank-ing networks that would have arisen 30 years ago if theUnited States had not severely restricted bank branching.Geographic and product-line diversification can providegreater stability to the financial system and enhance itsefficiency and convenience for consumers. Contrary to theconcerns of many consumer and community advocates, it is thetraditional U.S. system, fragmented both along product linesand geographically, that is fundamentally anti-consumer.The transformation of the banking industry--illustrated by
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