THE DILEMMAS OF THE REGULATOR
A number of factors helped stabilize the banking environment in the 1970s. Strong and constraining regulations weighed heavily on banks. Commercial banking was separated from investment banking in the US. Commercial banks collected resources and lent. The commercial banking industry was fragmented, being allowed to operate state wide but not across states. Limited competition facilitated a fair and stable profitability. The rules limited the scope of the operations of the various credit institutions and limited their risks as well. In Europe, no such rules were enforced, and large banks operating nationwide in capital markets and acting as commercial banks were far more common.
The waves of deregulation and re-regulation were more drastic in the US than in Europe. Continental Europe kept relatively conservative rules enforced while the US favored deregulation to resolve specific issues raised by rules that segmented the market. Increased deregulation allowed entry of new players unprepared by their past experiences, resulting in increasing risks for the system. Re-regulation in the 1980s aimed at setting up a regulatory framework reconciling risk control and fair competition.
Regulation and Competition
Too many regulations refrain competition. Those who are constrained by regulations are at a disadvantage compared to other players. Regulations limited the scope of operations of commercial banks, interfering directly with free competition. Examples of inconsistencies between competition and regulations were numerous. A well-known example was the unfair competition between commercial banks, subject to the old regulation Q in the US imposing a ceiling to the interest paid on deposits, and investment bankers offering money market funds earning market interest rates, creating a shift of depositors from bank deposits to money market funds. The motivation of regulation Q was to cap the cost of funds for banks. But it could not prevent other players than commercial banks from offering products more attractive to depositors.
The unfair competition resulting from non-economic rules combined with competition among players motivated the deregulation and the barriers to competition were progressively lifted. The 1970s and the 1980s were the periods of the first drastic waves of changes in the industry. The disappearance of old rules created a vacancy.
Deregulation drastically widened the range of products and services offered by banks. In the US, the Glass-Steagall Act enforced a separation between commercial banking and the capital markets. Similar segmentation existed in Japan. Such cleavages were progressively lifted. For those countries where "universal banking" existed, the transition was less drastic, but segmentation was a heritage of the past rather than being imposed by rules, and was also progressively dismantled.
Most credit institutions diversified their operations out of their original businesses. The pace of creation of new products remained constantly high, especially for those acting in the financial markets, such as derivatives. The research for new market opportunities and products stimulated the growth of other fields than intermediation by banks. The banks entered new business fields and faced new risks. The market share of classical bank lending decreased with the development of capital markets. The competition for market share rose abruptly.
Risks increased because of new competition, of product innovations, of shift from financial intermediation by banks to capital markets, and because of the disappearances of old barriers. New competition generates new risks during the transition period. The deregulation of the 1980s allowed players to freely enter in new markets, including those players that were less ready to do so.
A well-known episode of deregulation, combined with high interest rates, was the failure of the former Savings and Loans institutions which lasted for a decade. Originally, the trigger of these failures was mismatch risk between fixed rate loans and short-term funding at prevailing rates, which materialized when the US monetary policy raised interest rates to unprecedented levels for fighting inflation. Authorities allowed more freedom to surviving institutions, allowed banks to take over some of them while authorizing local banks to extend their activities in other states, for example when taking over ailing institutions.
Preemptive Risk Control versus Risk Insurance
Risk control should be preemptive, while insurance is passive, or "after the fact." Deposit insurance mechanisms exist in most countries, for ensuring the safety of depositors. But risk insurance generates moral hazard and creates a bias towards risk-taking behavior. Theoretically if depositors had their money at risk with the banks, they would closely monitor the bank behavior, just as any lender does. In practice, if depositors' money is perceived at risk, any sign of increased risks triggers withdrawals of funds that maximize the difficulties, leading to failures. And such old-time "bank runs" were again observed in 2008. This adverse effect is a good reason to insure depositors against bank failure, but it is not sufficient.
Insurance complements the preemptive policies that create disincentives for taking too much risk and avoid failure. For the regulator, the goal became to minimize the risk of failures instead of managing them once they occurred.
The theoretical solution is that financial firms impose enough incentives to control their risks within acceptable bounds. The regulators started redefining new rules along those lines. The BIS (Bank of International Settlements), in Basel, designed new regulations and national regulators relayed them for implementation within the national environments.