RBA Annual Conference – 1991 Regulatory Competition and the “Generic” Financial-Services Firm Ed Kane[1]

Myths are made-up stories about how the world works that simultaneously guide and mislead an entire culture. In recent months, financial deregulation (conceived as a deliberate unfettering of market forces) has begun to be transformed from a mythological hero into a mythological scapegoat. In its glory days financial deregulation was given too much credit; today it is receiving too much blame.

Technological change, not regulatory change, has been the primary force in what we may call the worldwide delocalisation and despecialisation of individual financial markets and institutions (Kane (1984) and Steinherr (1990)). Far from leading a cavalry charge to eradicate inherited geographic and product-line barriers to competition, most government deregulators initially sought to defend their regulatees' share of financial markets. They ratified shrinkage in the institutions they regulate only when and to the extent that this change was forced upon them by armies of well-adapted financial competitors that they could not control.

Current efforts to scapegoat deregulation correspondingly re-elevate financial regulation to heroic status. The myth of financial regulation treats the government as a nation's problem-solver of last resort. This myth overstates in two ways what regulation can accomplish. First, it pretends that regulators can command and tightly control market forces in the face of rapid environmental change. Second, it portrays top politicians and regulators as completely unconflicted servants of the public good.

This paper seeks to communicate a non-mythological view of the process of regulatory adjustment. It shows that elected politicians and top regulatory officials have in most countries been more willing to deregulate entry by foreign entities and diversified domestic firms than to deregulate exits by their traditional domestic clients. This is because they have a short-ran reputational interest in retarding the exit of economically insolvent and inefficient firms that fall within their purview. The conflict this creates with taxpayer interests is particularly acute when, as in the United States, authorities have the ability to conceal for long periods the true cost of sustaining the operations of failing firms.

Although the theory of conflicted regulation has general applicability, the specific features of the model offered here emphasise defects in accountability inherent in political and bureaucratic arrangements in the United States. Even if few other countries face such strong conflicts, the relative size of the US financial sector makes its efforts to impede efficient market-structure adjustments felt around the world.

1. Why Do Financial-Services Firms Change?

Mainstream economic theory is largely static. It seeks to explain patterns of repeated behaviour rather than evolutionary patterns of change.

The static theory of financial intermediation is well-developed (see e.g. Sinkey (1989) and Stiglitz (1991)). Theorists portray financial institutions such as banks as “middle-men” who collect inflows of “savings” from one set of customers and allocate the funds they amass to another set of customers who plan to “invest” them in productive ways. Financial intermediation consists of soliciting funds from customers that have funds available for rent, and prudently leasing their funds out again to other customers at a higher return. The prudential part of the business has two parts: diversifying the risks inherent in the investment process and monitoring the activities of funds users to minimise opportunities for default.

An institution's returns and funding costs must be defined carefully. Interest is compensation paid for the use of funds. This compensation can be either explicit or implicit. Explicit interest accrues in funds and is calculated straightforwardly on a cash-over-cash basis. Implicit interest accrues in the form of non-cash services such as transactions execution, lending commitments, record-keeping activity, and financial advice.

Every financial-services firm (FSF) seeks to earn a return on assets large enough to create a positive net interest spread over its total funding costs. Net interest spread is the profit margin that exists between explicit and implicit interest paid to funds suppliers.

In this theory, banks are cast as the pre-eminent species of FSF. Other species of FSF (such as securities brokers and insurance firms) differ from banks in the particular legal empowerments associated with their corporate charters. Each type of charter can be regarded as a government “license” that authorises its recipient to offer a specific range of the products listed in Table 1 to a specific range of customers.

Table 1 Classes of Finance-Related Services
  1. Transactions
    1. Funds transfers
    2. Payments processing
    3. Clearing
    4. Loan servicing
    5. Securities purchases and sales
    6. Foreign exchange purchases and sales
  2. Investment and Liquidity Vehicles
    1. Deposits
      1. Immediately transferable
      2. Term maturities
    2. Direct issues of fixed income instruments
      1. Short-term maturities
      2. Longer-term maturities
    3. Equities
    4. Commingled funds
    5. Futures and options
    6. Swaps
  3. Fund Raising
    1. Borrowing
    2. Equity issuance
    3. Facilitating
      1. Origination
      2. Underwriting
      3. Distribution
  4. Insurance
    1. Life
    2. Casualty
    3. Fidelity
    4. Credit protection or enhancement
    5. Market valuation
      1. Interest rate
      2. Foreign exchange
  5. Fiduciary
    1. Investment management
    2. Trust
    3. Agency
    4. Safekeeping
    5. Advice
Source: Aspinwall (1991)

This paper seeks to explain how over time technological and environmental change permit an FSF to overcome formal restrictions on diversification to expand the effective reach of its formal license. This expansion is accomplished by installing generic technologies, product lines, and organisational forms that substitute for the narrower arrangements that each species' original corporate charter specifically envisions. This substitution process connects previously segmented financial markets and makes them more competitive.

The long-run effect of the interpenetration of previously distinct financial markets is to change the global equilibrium market structure for financial activity. To make room for the optimal expansion of generic financial-services firms requires a shrinking or eliminating of incumbent competitor species.

The short-run process of adjusting to the new global equilibrium is a stressful one (Aguilar (1990)). The short-run effect of market entry by technologically better-adapted competitors is to narrow margins temporarily in each market they invade until the structure of competitors has moved to the new long-run equilibrium. Additional competitors and narrower profit margins increase the time and energy that FSF managers have to devote to staying on top of their jobs. Painful pressure is exerted at both ends of FSF profit margins. At the lower end, fund-raising becomes tougher, as firms with their backs to the wall force unsustainably high explicit and implicit interest rates to be paid to savers. At the upper end of the profit margin, competition from failing firms pushes asset returns temporarily to unsustainably low levels.

Focusing on recent US experience, Table 2 shows that narrowed profit margins translate into below-market returns on FSF equity. These below-market returns tend to promote exit and to re-allocate private capital from traditional institutional species toward more profitable generic types of financial enterprise.

Table 2 Recent US Commercial Bank Performance
(per cent)
  Return on Assets Return on Equity Non-Current Loans* Relative to Assets Equity Capital Ratio Banks Losing Money
1990 0.50 7.84 2.92 6.47 12.6
1989 0.49 8.13 2.28 6.21 11.6
1988 0.84 13.61 2.14 6.28 13.9
1987 0.12 2.00 2.46 6.04 17.7
1986 0.63 9.94 1.95 6.19 19.8
Banks with Assets Over $10 billion
1990 0.40 7.83 3.82 5.26 24.5
1989 0.10 2.20 3.12 4.86 25.0
1988 0.97 20.58 2.96 5.10 2.6
1987 −0.65 −14.74(e) 3.47 4.41 n.a.
1986 0.57 11.09(e) 2.30 5.14 n.a.
* Loans past due 90 days or more plus loans in non-accrual status
(e) Estimate
Source: Aspinwall (1991), constructed from FDIC data

(a) The Concepts of Net Regulatory Benefits and Structural Arbitrage

Every regulator offers its clients a combination of benefits and costs. Regulatory activities that foster customer confidence and convenience reduce a regulatee's operating and funding costs, while user fees and restraints on regulatee behaviour act to increase an FSF's costs. The net effect on client costs that a given regulator offers to its prospective or actual clients constitute the “net regulatory benefit (burden)” or opportunity cost inherent in its regulatory contract.

In principle, changes in the terms of a regulatory contract may alter both a firm's regulatory environment and the net regulatory benefits it faces. Kane (1984) conceives of these contractual net benefits as offering or asked prices quoted by competing regulators. He describes as “structural arbitrage” any adaptions that an FSF makes to lessen its net regulatory burden. The pace of structural arbitrage depends in part on the costs of switching regulators. Throughout what is known as the era of deregulation, technological change was reducing the level of these exit and entry costs and bringing regulators in different jurisdictions into sharper competition with one another.

The pace of structural arbitrage also responds to differences in the adaptive capacity of different players. Particularly important are differences in response speed between private and government enterprises and between traditional species of financial firms, non-traditional entrants into various species' traditional markets, and species-oriented regulators that are typically charged with overseeing these markets.

Regulatory lags play a critical part in the shifting patterns of global market shares. Managers of pro-actively expanding generic enterprises are typically faster on their feet than regulators and traditional competitors.

Contemporary FSFs are adapting to two technologically-driven trends. On the one hand, scope economies (cost reductions from producing a range of intermediational, transactional, and informational products) are undermining pre-existing patterns of institutional specialisation in the finance-related services listed in Table 1. Across the world, vanguard firms of disparate species are growing alike in the generic funding and credit activities they perform.

At the same time, innovations in telecommunications and information technology are pushing distance-related transactions costs and market-entry costs toward zero. As these costs decline, so do the short-run margins that can be earned in raising money and lending it out again in traditional ways and so does the force of longstanding geographic and institutional barriers to entry.

2. Financial Deregulation as a Two-Stage Process

This conference seeks to analyse the effects that financial deregulation has had on the structure of banking markets in Australia and elsewhere. To appreciate how interactive these two processes are, it is important to define both concepts. By deregulation, an economist means relaxing one or more regulatory restrictions without increasing any others. By a market's structure, an economist means four elements of supply-side activity:

  1. the number of competing firms;
  2. the distribution of market share across these firms;
  3. the range of related products that incumbent competitors offer; and
  4. the risk-adjusted profit margins these incumbent competitors earn.

Contemporary theories of industrial organisation seek to explain each market's structure as evolving through time to permit efficient firms to discipline or displace relatively less-efficient competitors. The force of these theories is particularly easy to grasp when we focus on hypothetical markets that meet a set of ideal conditions that Baumol, Panzar, and Willig (1986) call “perfect contestability”.

A market is perfectly contestable when entry and exit costs are each zero and incumbent firms exit quickly whenever they find themselves faced with negative profits. In perfectly contestable markets, low-cost firms readily displace high-cost firms and incumbent competitors are prevented from setting monopoly prices by the threat of hit-and-run entry by other equally-efficient firms.

This paper deploys this perspective on market-structure change to discern two stages of financial deregulation in Australia and elsewhere. The first stage takes the form of de facto deregulation by market forces. The second stage consists of subsequent de jure ratification and regularisation of market developments by the financial regulatory establishment.

During the 1970s and 1980s, technological change made banking and other financial markets increasingly contestable. This brought clients regulated by regulators from other countries and from other domestic jurisdictions into increasing competition with one another. The second stage of deregulation followed when this mutual invasion of traditional markets put pressure on various regulators to re-examine the burdensomeness of their rules.

(a) First Stage: De Facto Market Deregulation

For several decades and particularly in corporate banking markets around the world, technological change has steadily lowered entry costs for foreign and non-traditional competitors. Initially, foreign and non-traditional financial firms booked their market-share gains in innovative ways. They did banking business by making creative use, as Ian Harper's conference paper indicates, of substitute products, substitute organisational forms, and substitute offshore locations. In most countries, a new entrant's ability to use generic substitute opportunities was facilitated by longstanding and burdensome restrictions on how traditional deposit institutions could compete domestically.

(b) Second Stage: De Jure Ratification and Regularisation of Market-Driven Deregulation

The second stage occurred when regulators officially acquiesced in this innovative entry by foreign and non-traditional firms and relaxed many of the restraints under which their traditional clients had previously operated. As banks' aggregate market share shrank, they pressed politically for their traditional domestic regulators to relax or jettison their most burdensome regulations. At the same time, foreign and non-traditional entrants into a country's banking markets pressed authorities to offer them charters that could regularise and reduce the costs of their de facto incursion into that country's banking markets. In Australia and elsewhere, authorities' positive response to these political pressures during the 1980s has come to be called financial deregulation.

Around the world, governmental and market deregulation has been greater for wholesale than retail banking markets. Moreover, the word deregulation is in any case a misnomer for the complete pattern of second-stage or “regularising” regulatory adjustments that followed. The problem is that in many countries a deregulation of entry costs was combined with lags in imposing adequate prudential supervision that amounted to a far from “deregulatory” accentuation of regulatory barriers to exit for insolvent domestic deposit-institution competitors. Using the contestable-markets paradigm of market-structure change makes it clear that banking regulation has in most countries – and especially in the United States – occurred only on the entry side and that regulatory efforts to resist the exit of at least some classes of traditional domestic competitors are acting to curtail some of the increased contestability in specific banking markets that entry relaxation would otherwise produce. Banking regulators have lowered regulatory entry costs almost to zero, but (again, especially in the United States) they appear to have raised incumbent exit costs soon thereafter.

It is important to see that incumbents' ability and willingness to run negative profits are a form of exit costs that serve to limit a new entrant's ability to penetrate a market. By resisting the exit of unprofitable clients, regulators can prevent efficient competitors from being able to earn a margin of profits that is sufficiently high to sustain entry. As foreign and non-traditional competitors have begun to recognise the existence of regulator-financed exit costs in many countries, they have slowed their rate of entry into new banking markets and have even reversed some past entry.

3. Environmental Forces Requiring Adaptation

This paper portrays two kinds of adaptation as driving financial innovation: pro-active market adaptation to environmental change and reactive regulatory adaptation to market developments. To sharpen the distinction between these processes, it is convenient to assume that managers of private and public enterprises differ in the objective functions they pursue. We assume that takeover pressures in the market for their firms' stock lead private managers to maximise something like the value of the discounted future profits of the enterprise they control. While we recognise that government officials also value their bureau's long-run profitability, they face far more sporadic forms of takeover pressure than private managers do. In many government enterprises, strong takeover discipline is exerted only in crises and around election times. Moreover, the extent of even this pressure varies with the standing of the incumbent political party and of the particular party members to which a given manager directly reports.

We interpret this less-intense takeover pressure as an imperfection in the markets for government-owned banks and for state and local governmental regulatory services. We model this imperfection as creating a link between the market share of a government bank or regulatory agency's market share and manipulatable reports of the enterprise's accounting profits on the one hand and the current reputations of top managers and incumbent politicians on the other.

In most political systems, the probability of remaining in office rises and falls with the reputations of incumbent officials. Defects in accountability create opportunities for politicians and government managers to enhance their short-run popular standing at the expense of the unobserved market value of the banks and regulatory enterprises they control. Faced with a technologically-driven invasion of generic competitors, the most straightforward such strategy is to subsidise the market positions of troubled government enterprises and failing regulatees. This slows the exit of inefficient firms, but is hard to sustain unless the long-run costs the strategy implies can be hidden for a long while from the taxpaying public.

In our model, the lack of a stock market for government regulatory enterprises encourages bureaucrats to operate with a decisionmaking horizon keyed to the next election and to pursue personal and sectoral ends that conflict with the simpler goal of maximising enterprise value. We assume that short horizons and poorly-controlled conflicts of interest tempt government officials in most countries to pursue strategies that redistribute resources from taxpayers toward themselves, their enterprises, and their regulatory clients.

FSF and regulator adaptations respond to changes in the constraints under which their firms operate. When the constraints facing an institution change, managers must adapt their behaviour to make the best of the new circumstances. Three types of constraint apply: regulatory, technological, and market. Regulation delimits what opportunities are legal. Technology delimits what opportunities are feasible. The market environment delimits what opportunities are profitable. Technology bounds what a firm could do if the laws and market pressures did not interpose restrictions. We may view the impact of effective regulatory and market constraints as things that a firm's regulators or competitors make it do.

Shifts in any of a firm's threefold constraints lead managers of a well-run firm to reconfigure its business strategies and tactics. During the past two decades, FSF and regulator adaptation responded predominantly to restraint shifts caused by three environmental forces:

  1. technological change;
  2. volatility of inflation, interest rates, and foreign-exchange values; and
  3. changes in regulatory limits on the exercise of adaptive efficiency by members of different institutional species chartered in different nations.

(a) Avoidance and Reregulation

Market adaptation to lessen the opportunity costs of regulation may be described as avoidance activity. When regulators react to the avoidance they observe, the changes they make may be described as reregulation. In this conception, deregulation is a special case of reregulation. It occurs when at least one restraint is relaxed without any other restraint being simultaneously tightened.

This paper emphasises similarities and differences in the operations of government regulatory enterprises and private business firms. Most regulatory changes respond to prior changes in private or regulatory behaviour that affect a given regulator's market share. In re-aligning its control network, regulators act either to bring innovative substitute products, locations, and organisational forms within their regulatory net or to lessen the handicaps that a pre-existing pattern of regulation was imposing on its traditional regulatees.

In our model, every act of regulatory adaptation maximises an objective function that embodies a trade-off between the long-run value of the regulatory enterprise and various bureaucratic, sectoral, and personal interests. Among other things, these adaptations respond to competition from regulators in foreign and sub-national jurisdictions. If these various governmental competitors were immediately accountable for the long-run costs that their behaviour imposes on their taxpaying publics, this competition could be relied upon to support rather than to oppose exits needed to effect an equilibrium adjustment in long-run market structure of financial services competition.

Unfortunately, governmental accounting systems do not force authorities to reveal the long-run consequences of the exit-retarding decisions they make. Regulators are rewarded not only for extending their dominion to new localities, institutions, and instruments; they are also rewarded in the short run for preventing inefficient regulatory clients from shrinking or closing down and for keeping their efficient regulatees from switching to a more efficient regulator.

Without tough sunset laws, it is almost prohibitively costly to force the complete exit of a government regulatory agency, particularly one that is part of a national government. It is able to take economically-inefficient actions to arrest declines either in its share of financial regulatory services or in its accounting profit. It can defend the size of its budget and its political prestige at substantial long-run taxpayer expense. The unpleasant consequences of potential losses in regulatory domain tempt a besieged regulatory manager:

  1. to use accounting tricks to overstate the agency's income and net worth; and
  2. to lighten imprudently some of the burdens (such as capital requirements) that an efficient system of regulation would impose on failing regulatory clients and their customers.

In the increasingly global and generic financial-services industry of today, regulatory conflict is only occasionally driven by aggressive acts of bureaucratic expansion. Exceptional cases primarily concern the efforts of a few countries to attract financial business to their shores by transforming themselves into tax or regulatory havens. Regulatory conflict develops most often as a delayed response to prior structural arbitrage undertaken by domestic or foreign private FSFs. Pro-actively expanding private institutions may be described as revising their organisational structures and extending their product lines and geographic reach to serve new markets and to select a set of regulatory micro-climates that maximise the net regulatory benefits they enjoy.

(b) Resisting the Law of One Net Benefit

Structural arbitrage disrupts the inherited regulatory equilibrium. What we may conceive as a “law of one net benefit” forces even non-assertive regulators to struggle to defend or redraw the borders of their domains. Structural arbitrage by FSFs causes problems for society because of defective incentives for elected politicians to monitor and minimise the long-run opportunity cost for government agencies of producing regulatory services. A good portion of the reductions in net regulatory burdens that multi-national and multi-purpose financial firms create by structural arbitrage shifts real costs onto general taxpayers in hidden fashion. The most important of these hidden costs are subsidies that flow from the improper pricing of explicit and implicit government financial guarantees. These guarantees dramatically lower the risks that individual firms face in extending their product lines and geographic markets. Supporting these guarantees imposes implicit and largely conjectural liabilities on governmental finances. The unaccounted expense and unrecognised liabilities that governmental guarantors incur pass through to unwary taxpayers and well-capitalised “survivor” financial institutions that as a matter of practical politics bear ultimate responsibility for making good on unfunded governmental commitments.

Democratic governments around the world respond to political pressure to protect domestic institutions from the incursion of foreign competitors and to bail out important domestic enterprises (including government-owned entities) when they become insolvent. The predictability of this qualitative response implies the existence of implicit taxpayer guarantees even in societies that operate with no formal deposit insurance or other form of statutory safety net for financial firms. The desirability of limiting these guarantees and imposing user fees on institutions that conjecturally command them provides a clear rationale for governments to construct and enforce explicit deposit-insurance contracts. However, to minimise taxpayer costs, managers of every deposit-insurance enterprise must be made accountable for measuring, pricing, and managing all claims upon taxpayer resources and must be required to recapitalise explicit and implied insurance funds promptly whenever their reserves become inadequate.

Because of regulatory lags, underpriced opportunities for shifting risk onto governmental guarantors are especially great for innovative activities. Market participants that put their own wealth on the line inevitably receive better information on the risk implications of developing financial opportunities than governmental regulators do. Lags inherent in governmental information, monitoring, and regulatory-response systems are lengthened by self-interested management of information concerning the changing market value of government guarantees. Such information needs to be published in transparent and timely fashion for the press and taxpayers to monitor. The bottom line is that what is not adequately measured will not be adequately managed.

Mispricing governmental guarantees creates strong incentives for financial institutions to search out new forms of risk taking and for foreign financial firms and non-financial domestic institutions to devise inventive methods of folding government-guaranteed financial subsidiaries or affiliates into their organisational form. Increases in a firm's market capitalisation that result from government guarantees derive from increasing the risk that the firm may fail. By expanding the risk that individual FSFs will fail, defective regulatory incentives have been undermining the stability of the world's financial system.

Misregulation, not technological change, has made structural arbitrage destabilising. Around the world, misregulated structural arbitrage is increasing insolvencies among deposit institutions and complicating the task of measuring and controlling the money stock.

4. More on Regulatory Competition

Market forces lead regulated parties to reduce the net burdens (or increase the net benefits) that regulation brings. Similarly, decisions made by regulators seek to lessen net penalties that would be imposed on them by market forces in political, bureaucratic, and career-management environments (Kane (1984) and (1991b)). This market-oriented perspective portrays the shape and ultimate effects of regulation as an economic rather than politically determined phenomenon.

Financial regulation comprises purposeful efforts to monitor, to discipline, and to co-ordinate the behaviour of individual firms in the financial-services industry. Regulation is a class of service valued not for itself, but for the benefits it confers on those who produce and use the products of the regulated industry. Financial regulation is supplied competitively to members of each FSF species by government bodies and private self-regulatory organisations. Because government suppliers of regulatory services play a large role in the market for regulatory services, the demand for regulation links financial markets with political and bureaucratic markets.

Regulatory services develop and enforce rules of competition to attain industry and societal goals. The efficiency goals that individual regulators pursue may be described broadly as building and maintaining customer confidence in the integrity of the species they serve and efficiently enhancing the convenience that customers experience in using their species' part of the financial system. Systemwide efficiency and stability always compete to some extent with politically-expressed demands to protect narrower sectoral or individual interests.

What we have called the myth of financial regulation assumes away two problems. The first is the need for patterns of regulation to adapt realistically to technological changes in opportunities for avoidance. The second is that conflicts exist between the public good and the narrow political, bureaucratic, and economic self-interest of official decisionmakers. If we want to understand differences in patterns of regulatory response around the world, we must not presume that in different circumstances, polities, and cultures policymakers are equally tireless, selfless, and fully informed.

(a) Imperfect Contestability of Regulatory Markets

Financial regulators compete with each other in a worldwide industry. Decisions are made by at least partly self-interested agents who respond to economic incentives. They deploy productive resources to pursue broadly-identifiable goals and are subject to recognisable political, bureaucratic, market, and technological constraints. The market for financial regulatory services has an evolving global market structure. This structure may be analysed by the same contestable-markets model (Baumol, Panzar, and Willig (1986)) that economists use to explain the market structure of any product.

However, the market for regulatory services has a serious imperfection in managerial accountability. Suppliers compete not just in the quality and resource efficiency of the confidence-building and co-ordinating services they provide their regulatees. Government regulators also compete as to where they ultimately lay the burden for financing their costs of production. This potential for burden shifting can support an unhealthy competition in regulatory laxity. Whenever (as in government deposit-insurance schemes around the world) the cost burden can be laid surreptitiously on general taxpayers rather than on the specific beneficiaries of these services, transactions in regulatory markets subject net regulatory burdens to an incomplete benefit-cost efficiency test. Opportunities for decoupling regulatory burdens and benefits makes it possible for a regulatory entity, without losing its market share, simultaneously to lower the benefits of the confidence and convenience services it offers and to raise their cost of production.

The market for regulation comprises a body of persons that carry on extensive and, at least partly voluntary, transactions in the specific activity of promulgating and accepting regulatory restrictions. Regulation is supplied competitively and accepted voluntarily, in that entry and exit opportunities exist for clients to switch all or part of their regulatory business to another supplier. Geographic overlaps in the global market for financial regulatory services have expanded as entry and exit costs for foreign FSFs have declined around the world. On-going downward trends in these costs have made regulatory competition increasingly world-wide.

Although regulation is shaped and reshaped by market discipline, competition in regulatory markets is inherently imperfect. Any individual regulatory entity has market power if it can lower the net benefits its operations offer without losing all of its market share. While it is important that society strive to minimise the degree of this market power, the deeper problem is that the market discipline to which labour, capital, and political markets subject regulators (including elected politicians) is less than complete.

Regulators' market power has two sources. First, the number of potential new entrants that can economically supply regulatory services is limited in the short run. Second, the costs of entering and exiting a particular regulatory market are typically high. Would-be entrants need specific skills, financial strength, and prior reputational capital that take time to accumulate. New entrants must be able to promise credibly that they can carry out the necessary tasks and that they are prepared to do so for years on end.

Behavioural psychologists teach that it takes a system of rewards and punishments to modify individual behaviour. This means that any entrant to the regulatory market needs a capacity for raising and distributing funds and a capacity for exercising disciplinary power. Along with the financial strength imparted by the right to shift costs to taxpayers, the right to use the force of law to punish violators gives government entities inherent advantages in regulatory markets. Hence, in pursuing market share, differences in entry and exit costs confer definite competitive advantages on government and long-established private regulators. The market structure in regulatory services is distorted by two kinds of market power that the law freely gives to governments and that pre-existing contractual arrangements give to established private and public regulators. One is that the law temporarily confers special monopoly powers to make and enforce rules on elected politicians and appointed bureau heads. This power becomes all the stronger, the more confidently either that politicians may count on re-election or that top bureaucrats may count on holding onto their offices. The second is that incumbent regulatory firms such as stock exchanges and central banks that achieve dominance in a particular financial-services sphere have substantial cost and enforcement advantages over new entrants.

For regulators, market discipline acts through political and bureaucratic accountability and not just through voluntary economic trades. Hence, a nation's constitutional structure and bureaucratic empowerments set limits on the extent to which imperfections in regulatory competition can be improved. In parliamentary democracies, long-lived political parties tend to control the careers of incumbent officials more effectively than they do in the United States. This increased scope for party discipline creates additional penalties for short-sighted political dealmaking by individual party members. In parliamentary systems, this may help to keep conflicts of interest between top officials and the general taxpayers below the level observed in the United States.

In any representative democracy, taxpayers may be conceived as stockholders in each and every government enterprise. It is in their interest to establish a political and economic environment in which efficient regulatory enterprises routinely receive opportunities to expand and inefficient ones routinely come under pressure to contract. It is unfortunate that government enterprises are not subject to continual takeover discipline in the market for corporate control. To substitute for this discipline requires subjecting government regulatory entities to reliable accounting and auditing standards and to statutory requirements for explicitly replenishing their capital accounts in timely fashion whenever events push the value of their assets below the level needed to cover the actuarial value of their contingent liabilities.

Taxpayers around the world must come to appreciate the wisdom of demanding that managers of government enterprises (including regulatory agencies) be at least as accountable to them for cumulative changes in the market value of each enterprise as the managers of the firms these officials compete with or regulate are to their own corporate stockholders. At a minimum, this means making authorities analyse in reproducible fashion the distributional and longer-run market consequences of domestic and international regulatory arrangements and expose this analysis to the light of outside criticism.

To the extent that any country's regulatory officials are imperfectly accountable for their performance, incentive conflict makes it dangerous for either their taxpayers or regulators in other countries to trust them to negotiate anti-competitive agreements and statutes designed to re-assign regulatory turf. For the world as a whole, the efficiency problem is to prevent such re-assignments from protecting undercapitalised and technologically-maladapted institutions and regulatory systems from the gales of healthy market discipline.

(b) The Impact of Official Deregulation in Australia

To understand the post-deregulation profit margins and patterns of product-market entry and exit observed in Australian banking markets, it is important to note the difference in entry and exit costs that new entrants face in the retail and wholesale sectors.

In the retail sector entry barriers are much higher than they are in the wholesale sector. For incumbent banks, the most important competitive advantages are:

  • a base of loyal customers willing to supply deposits and loans on advantageous terms. Customer loyalty develops both from simple inertia and from past satisfaction with bank service;
  • special knowledge about the creditworthiness of its customers that incumbent competitors have acquired over the years;
  • networks of office locations and servicing capacity adapted to existing customers' needs for servicing;
  • an experienced management team with proven strategies for cultivating existing and emerging product markets;
  • substantial amounts of hidden (or “intangible”) capital value that these barriers and exit-resisting regulators create.

Many conference papers ask why, during what our perspective labels as the initial stages of the official deregulation process, were so many poor-quality loans made? The lesser contestability of retail banking markets means that official deregulation could offer new entrants relatively little prospect for profitable retail entry. Instead, entry focused on wholesale and corporate banking markets. Unfortunately, even in these markets, informational advantages and management experience possessed by the incumbent Big-Four banks made it hard for new entrants to win profitable intermediation business away: only relatively less-promising borrowers were up for grabs on even terms. Ex post, we can see that the best opportunities for new entrants lay in fee-for-service business associated with developing and marketing innovative asset-management, transactional, and informational product packages for customers.

In some cases, the knowledge that transitional losses would have to be incurred in intermediation by a new entrant reduced the accountability for the losses that managers of entering enterprises might be expected to incur in trying to win intermediation business. Weaknesses in accountability were particularly dangerous for inexperienced managers who had not yet laboured through the workout half of the corporate lending cycle. Managerial accountability was in any case particularly weak at two classes of aggressive firms: state banks and foreign banking and merchant-bank subsidiaries operating in Australia. For these two competitor classes in recent years, exits and emergency recapitalisations have been relatively frequent.

(i) The Special Case of State Banks

State banks in Australia raise two problems. First, they are regionally undiversified. Second, it would raise conflicts of interest to expect them to be regulated by officials of the same governments that hold formal title to these banks. The politics of government ownership make it hard for a state's taxpayer-owners to enjoy the privilege of limited liability for bank losses that accrues to the stockholders of a private corporation. Economic theory suggests that taxpayers' unlimited liability would distort managers' risk-taking incentives and that state-owned enterprises are invariably less efficient than private competitors.

These presumptions are confirmed to some degree by the fact that over the last few years domestic banking problems have been disproportionally concentrated in the state regulatory sector. State-owned banks in Tasmania, South Australia, and Victoria have required some form of rescue, while related weakness in state-level regulation and supervision is suggested by the 1990 failure of the Farrow building society group in Victoria.

The accountability problem at state-owned banks is two-fold. The first problem comes from the absence of a private market for a state-owned corporation's stock. This removes a potentially important signalling mechanism that taxpayer-owners could use to help monitor in timely fashion the quality of management performance. It also removes an avenue for managerial discipline that ordinarily operates through the threat of corporate takeovers mounted by third parties responding to opportunities to earn profits by better managing the bank.

The second problem is that state politicians' and regulators' responsibility for monitoring managerial performance is inadvertently lessened by anti-corruption safeguards erected against political interference with the bank's credit-allocation decisions.

(ii) Evidence of Delays in Recognising and Resolving “Problem Situations” at the State Level

A substantial portion of the losses incurred by the Farrow Group has been openly transferred to Victorian taxpayers via an increased petrol tax. This is an astonishing exercise in government accountability that contrasts with the incomplete accounting adopted for taxpayer losses in state-owned banks.

Relative to what would have occurred if all parties were fully informed, the exit or recapitalisation of troubled state-owned and state-supervised firms was delayed. Whether knowingly or unknowingly, state regulatory authorities allowed these firms to operate in an undercapitalised condition for a while before formally acknowledging and resolving their problems.

Delays in recapitalisation are costly for taxpayers because managers of undercapitalised deposit institutions have an incentive – because of limited corporate liability – to engage in go-for-broke risk-taking. It pays them to seek to “grow out of their problems” by bidding up deposit interest rates above sustainable levels to induce an increased flow of loanable funds and to place the funds raised into highly-speculative projects, even into projects whose net present value is negative.

In the short run, the bulk of the true costs that supervisory recognition lags and exit-resistance policies can impose on taxpayers is routinely covered up by weaknesses in banking and governmental accounting systems. Current accounting systems provide inadequate measurements of the bottom-line performance of deposit institutions and of the performance of current politicians and top regulatory officials as well. Weaknesses in accountability for losses encourage an institution that has suffered potentially ruinous losses (such as Pyramid) to stay in the market and expand its risk-taking. They also encourage regulators to overprotect the market share of traditional domestic regulatees because in the short run this policy protects their public standing as effective regulators. Keeping insolvent banks and near-banks in business has two bad effects. First, it blocks the efficient banking market structure from emerging. Second, by subsidising patterns of high-risk lending, it distorts the macro-economic flow of real investment.

(iii) Performance of Federal Regulators in Australia

In the 1980s, defects in the accountability of regulatory authorities in Australia proved much less costly than in the United States. On the federal level, the conditions that led US policymakers so determinedly to resist exits by insolvent and inefficient deposit institutions did not develop in Australia. To the extent that they did develop on the state level, less-effective state regulators ended up losing market share to federal authorities.

Nevertheless, the pattern of banking market-structure developments that other conference papers, Ackland and Harper (1990), and Hogan (1991) report for the 1980s in Australia, leave room for worry about the future. The mission and responsibility assigned to banking and other financial regulators need to be more clearly defined and more closely monitored. Exit resistance and ambiguous regulatory boundaries between state and federal entities are potential problems.

Damage done by undercapitalised firms in Australia has focused on corporate banking markets and been made worse by market-entry losses sustained by foreign banks whose interim performance came to be measured internally by the volume of business they booked rather than by its long-run profitability. Institutions with this incentive structure were attracted to a promotional strategy of rolling the dice in booking risky loans and accepting unsustainably low risk-adjusted profit margins.

In this and other ways, market entry by foreign and non-traditional types of financial firms in Australia helped to drive risk-adjusted profit margins down. Several state-owned traditional firms got into trouble, but, to the extent that these undercapitalised firms were kept from having to close or recapitalise promptly by a combination of regulatory blindness and forbearance, they and other failing firms had an incentive to bid up the industry's funding rates and to bid down the industry's returns on risky projects as a way to “grow back to profitability”. This pressure produced profit margins that seem too low to sustain more than a fraction of the net entry made by efficient foreign and non-traditional firms. Viewed globally, exit resistance favours some withdrawal from (or non-entry into) foreign and non-traditional markets by efficient, technologically-adept firms and larger market shares for local and traditional firms (and for host-country and traditional regulators) than would develop in the absence of the subsidy.

(iv) What Can Be Done to Attenuate Future Waves of Speculative Lending?

A fundamental problem in corporate lending has been a lack of timely accountability for loan losses, particularly losses incurred in Australian merchant-bank subsidiaries. This problem could be lessened by requiring improved disclosure: market-value accounting (or reporting) for capital at Australian banks, subsidiaries, and affiliates. By this I mean a self-reporting early-warning system for banks that is made effective by ex-post civil or criminal penalties for wilful misreporting. The difficulty with historical-cost accounting is that it puts too heavy a burden for timely analysis on under-informed outside observers. This burden serves to lessen pressure on authorities to take prompt action to resolve emerging insolvencies. It does this by routinely concealing adverse developments, at the same time that it leaves managers freedom to undertake transactions that serve asymmetrically to reveal the occurrence of favourable events.

Even without a market-based information system, Australia's federal banking regulators have so far avoided the worst consequences of supervisory recognition and action lags. They have managed to force recapitalisation of troubled institutions before any bank's unbooked losses could spill over to the accounts of depositors. With depositors left whole, it has not been necessary to test whether and how extensively, as market participants reasonably presume, federal taxpayers implicitly guarantee Australian bank depositors against loss.

At the same time, federal authorities have chosen not to intervene into banks' specific loan decisions. Economic theory labels such intervention dangerous because it is unlikely that government authorities can measure and value differences in the quality of individual credit demands as well as bank loan officers can. Around the world, few central bankers believe they can outperform the judgment of the market in allocating credit.

Avoiding the twin disasters of taxpayer losses and government credit allocation is a proud achievement that compares favourably with the record of state and US regulators. To hold market share, US regulators let their traditional clients sustain enormous losses. They did this by encouraging insolvent and inefficient banks and thrifts to conceal their cumulative weakness from customers, investors, and taxpayers. Victorian officials were slow to recognise developing losses in the Pyramid debacle.

The US deposit-insurance mess is undermining profit margins in banking and the value of real estate around the world. The effects of these trends on foreign real estate markets and deposit institutions can impose relatively sudden and massive losses on currently sound institutions in any country and on their regulators. We have seen in the Farrow case and in losses experienced by the US deposit-insurance funds that, when the amounts of hidden losses overwhelm the explicit resources budgeted for resolving insolvencies, regulatory incentives sour.

It should be understood that allowing US banking subsidiaries in Australia to convert to branch status would broaden the ways in which the still-growing US mess could spill over into Australian markets during the next boom. Even without such conversions, the willingness of troubled US banks to accept unsustainably low margins on risky loans could foster sizeable deposit-institution insolvencies. Without an information system based on market-value accounting, Australian regulators would find it harder to stop the losses in time to protect Australian taxpayers.

In tough times, the benefits of stopping industry losses promptly comes into conflict with the advantages of shifting trouble to someone else's watch. Taxpayer losses can occur even in a country that has no explicit deposit-insurance arrangements. Lending to insolvent institutions through a central bank's discount window or merging an institution's unbooked losses in an unaccounted form into a government-owned institution are two ways in which taxpayers' wealth can be raided in hidden fashion and without formally establishing a system for explicitly guaranteeing deposits.

5. Financial Globalisation as International Competition Among Regulators

International competition for regulatory jurisdiction is inherent in the multinational organisation of the world economy. At the margin, FSFs are regulatorily footloose. To the extent that it improves an FSF's regulatory climate, developing offshore loan and deposit products, opening an international branch office, or acquiring or forming an international banking or non-banking subsidiary is an act of structural arbitrage. Restrictions on the entry and expansion of foreign financial firms and on domestic institutions' capital exports are common features of individual countries' regulatory architecture. Because they limit foreign regulators' access to the home country's markets and institutions, restrictions on foreign entry and expansion protect not just domestic FSFs but domestic financial regulators as well.

In virtually all countries during recent years, competition from foreign regulators for domestic financial opportunities has become more intense. Macro-economic events have made restrictions on international financial competition more burdensome to regulated firms while technological change has made them easier to circumvent. For both reasons, traditional restrictions have progressively lost force. This loss of force is what some observers mean by financial deregulation.

In competing for clients, governmental regulators have two complementary advantages over private suppliers of regulatory services. Their governmental status confers reputational capital that makes it hard to force their exit when they operate inefficiently. It permits them both to bear the financial strains of subsidising critical elements in their service package for years on end and to manage self-interestedly the short-run flow of information concerning the effectiveness and cost-efficiency of their performance. Concealing regulatory subsidies from taxpayers makes their long-run effects destabilising in that information-control policies make it hard for taxpayers to fill the disciplinary role that stockholders and creditors play in a private firm.

Ideally, globalisation should help efficient (i.e. low-cost) financial-services firms and regulators to grow at the expense of inefficient ones. To establish whether this happened in the global wave of deregulation that is now beginning to recede, we need information about the efficiency of regulatory enterprises that no-one has yet bothered to compile.

(a) The US Case

In a representative democracy, political processes define and also distort operational perceptions of what constitutes the common good. It is striking that, in US regulators' longstanding demand for the international “harmonisation” of financial regulatory structures, they have yet to include a call for adequate performance information for individual-country regulators.

In the United States, top financial regulators prefer to produce disinformation rather than to release market-value performance statistics that would expose them to timely and informed criticism. These officials have fostered an accounting framework that conceals rather than emphasises differences in their relative performance.

In the United States, government reporting systems downplay the overwhelming parallels that exist between operating a regulatory agency and operating an ordinary business. These parallels tell us that the performance of a government agency deserves to be judged by quantitative measures of the discounted value of the net regulatory benefits it can be expected to produce for society. This net benefit constitutes the difference between a measure of the average quality of a regulator's co-ordinating and confidence-building services and a measure of the average cost of producing services of this quality.

What matters is not whether regulators in different countries use the same control framework, but whether they can each economically justify the net differences that their individual systems entail. The appropriate efficiency criterion should focus on the discounted value of the net benefits of each system, analogous to the discounted-cash-flow criterion stock analysts use to evaluate the success of a private firm.

Of course, a less-perfect, first-cut performance criterion does exist. A statistic that has the virtue of being easily estimated is the trend of changes in different countries' and different agencies' regulatory market shares. It is ironic that, on this looser efficiency criterion, the successful firms and regulators turn out to be the ones attacked by those who push the hardest for a global regulatory stiffening. For example, Bank for International Settlements Chief Lamfalussy (1989) and New York Federal Reserve Bank President Corrigan (1987) intimated that bank regulators in countries that were expanding their markets' shares were dangerously undermining world financial stability.

Observed market-share shifts are the source of political pressure for “harmonising” and tightening-up regulatory structures across countries. Proposals to eliminate differences in regulatory structures across countries are evidence that someone is unhappy with the current arrangements. But it is disturbing that the pressure for regulatory adjustment is coming, not from unhappy taxpayers or customers in the countries and sectors that are expanding, but from competing suppliers, from competing regulators, and from politicians whose fortunes are directly or indirectly associated with these shrinking entities. In effect, a system of poorly-performing institutions and regulators is seeking to use the force of international or domestic cartel agreements to gain back financial-market share for which the firms in other countries or industry sectors have previously outcompeted them.

(b) Harmonisation versus Regulatory Convergence

The alleged desirability of regulatory harmonisation is the watchword of international regulatory agreements such as the Basle accord on risk-based capital and of international regulatory associations such as the Bank for International Settlements and the International Organisation of Securities Commissions. However, by harmonisation such parties mean a convergence across countries and across types of FSF to a single set of rules for financial competition and a universal mechanism for their enforcement.

To see that convergence is an inappropriate goal, it is useful to contemplate the meaning that harmonisation takes in esthetics. In art, harmony refers to the effect of combining two or more disparate elements into a pleasing aggregate that nevertheless preserves the individual identity of the component elements. The sound of a barber-shop quartet illustrates the idea and clarifies the value of not trying to force everyone either to sing precisely the same tune or to adopt the same voice quality.

Globalisation acts to reduce differences in the net regulatory benefit or burden particular regulators may offer to a client FSF. As noted earlier, a client's net regulatory benefit may be defined as the net value of regulatory services received, after deducting explicit and implicit charges that inhere in its regulator's scheme of regulation. The key point to see is that – ignoring the transitional costs of switching regulators – net, not gross, burdens are what market forces equalise across countries and sectors. Gross benefits and burdens can and should differ as much as a country's informed regulatees and taxpayers would be willing to tolerate.

In the past, inefficient elements in the country-specific character of inherited patterns of financial regulation were protected by distance-related, culture-related, currency-related and language-related costs that serve as barriers to entry for foreign financial firms. In dramatically reducing the significance of these barriers in recent years, technological change is imposing painful adjustment or transition costs on previously self-satisfied operators of regulatory enterprises. These adjustments will produce more efficient regulation and do this faster, the more accountable are regulatory enterprises in the countries that are losing market share.

Globalisation of real and financial markets may be defined as a process in which increasing international competition imposes market discipline on government regulators. Technology-driven and irreversible downward trends in the costs of switching regulators and co-ordinating a multinational enterprise imply shrinking spheres of autonomy for economic policymakers in different countries. These trends constrict the freedom of politicians, government regulatory bureaus, and self-regulatory organisations to impose or maintain burdensome differences in the rules of financial competition.

However, the US deposit-insurance mess demonstrates that healthy market-structure adjustments can be curtailed when the cost of producing inefficient regulatory benefits can be laid off in hidden fashion on general taxpayers (Kane (1989)). In the United States, officials see themselves as only temporarily occupying a regulatory or political hotseat. A short term in office makes it rational (albeit less than perfectly ethical) to suppress evidence of emerging regulatory weaknesses and hidden subsidies and to defer the application of unpopular remedies in the hope that the officeholder can make a reputationally-clean getaway either to another job or at least to another term in office.


Reese Professor of Banking and Monetary Economics, The Ohio State University, Columbus, Ohio.

This paper draws on and extends Kane (1991b). The author wishes to thank Richard C. Aspinwall, Robert Eisenbeis, Charles P. Kindleberger, George Kaufman, Joseph Sinkey, Jr., James Thomson and participants in a seminar at the Swiss National Bank for comments that have improved the analysis. [1]


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