IDEAS home Printed from https://ideas.repec.org/p/pra/mprapa/47614.html
   My bibliography  Save this paper

Restructuring the Banking System to Improve Safety and Soundness

Author

Listed:
  • Morris, Charles
  • Hoenig, Thomas

Abstract

• This paper provides a specific proposal to limit the financial activities that are covered and thus subsidized by the government safety net in order to protect the financial system and the economy. The U.S. safety net, which consists of central bank loans to solvent but liquidity strained banks and federal deposit insurance, was developed in the early 1900s to protect commercial banks. • The safety net originally was limited to commercial banks because they are critical to an economy’s overall health and growth. Their core activities of making loans funded by short-term deposits provide essential payment, liquidity, and credit intermediation services. But banks also are inherently unstable because depositors will “run” if they believe their bank is in financial trouble. • While the safety net solves the instability problem, it also creates incentives to take excessive risk because it subsidizes banks. With safety net protection, depositors and other protected creditors are willing to lend to banks at lower interest rates, given the amount of risk. This cheaper funding and reduced market discipline creates incentives for banks to make riskier investments and increase leverage. The subsidy and associated incentive to take greater risks have grown substantially over the past 30 years because the activities the safety net supports has expanded beyond the core banking activities considered necessary to protect. • The recommendation in this paper is to limit the safety net – and thus its subsidy – to what the safety net should protect by restricting banking organization activities by business line. Under the proposal, banking organizations would continue to provide the core services of commercial banks – making loans and taking deposits to provide payment and settlement, liquidity, and credit intermediation services. Other allowable services would be securities underwriting, merger and acquisition advice, trust, and wealth and asset management. Banking companies would not be allowed to conduct broker-dealer activities, make markets in derivatives or securities, trade securities or derivatives for either their own account or customers, or sponsor hedge or private equity funds. • The difference between what banks would and would not be allowed to do is based on the principle that beyond their core services, they should not conduct activities that create such complexity that their management, the market, and regulators are unable to adequately assess, monitor, and control bank risk taking. Current activities conducted by banks that would be prohibited for them, such as trading and market making, are important to the economy. But they should not be subsidized by the safety net because it causes their overproduction, and therefore imposes unnecessary risks and costs on the financial system and economy. In fact, by removing the safety-net’s protection for activities such as securities and derivatives market-making, the market for these services should become more competitive and less dominated by the largest investment banks, which currently are all affiliated with commercial banks. • The benefits of prohibiting banks from conducting high-risk activities outside of their core business, however, would be limited if those activities continue to threaten stability by migrating to the “shadow” banking system. Shadow banks are financial companies not subject to prudential supervision and regulation that use short-term or near-demandable debt to fund longer-term assets. In other words, shadow banks essentially perform the same critical, core functions as traditional banks, but without an explicit safety net or prudential regulation. As a result, the shadow banking system is susceptible to disruptions that threaten financial and economic stability and lead to additional implicit government guarantees and the associated incentive to take excessive risks. • To mitigate the incentive for shadow banks and other financial companies to take excessive risk and the associated potential systemic effects, this paper makes two additional recommendations. First, money market mutual funds and other investment funds that are allowed to maintain a fixed net asset value (NAV) of $1 should be required to have floating net asset values. Second, bankruptcy law for repurchase agreement collateral should be rolled back to the pre-2005 rules, which would eliminate mortgage-related assets from being exempt from the automatic stay in bankruptcy when a borrower defaults on its repurchase obligation. • The problem with fixed NAVs and current bankruptcy law is they provide special treatment – that is, they essentially subsidize – short-term funding. As with the safety net for banks, the subsidy leads to the overproduction of risky shadow banking activities. By reining in this subsidy, these two recommendations should greatly curtail shadow banking activities by exposing shadow bank creditors to the true costs of their investments.

Suggested Citation

  • Morris, Charles & Hoenig, Thomas, 2011. "Restructuring the Banking System to Improve Safety and Soundness," MPRA Paper 47614, University Library of Munich, Germany, revised Dec 2012.
  • Handle: RePEc:pra:mprapa:47614
    as

    Download full text from publisher

    File URL: https://mpra.ub.uni-muenchen.de/47614/1/MPRA_paper_47614.pdf
    File Function: original version
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Acharya, Viral V. & Schnabl, Philipp & Suarez, Gustavo, 2013. "Securitization without risk transfer," Journal of Financial Economics, Elsevier, vol. 107(3), pages 515-536.
    2. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, vol. 92(4), pages 874-888, September.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Arnoud W. A. Boot & Lev Ratnovski, 2016. "Banking and Trading," Review of Finance, European Finance Association, vol. 20(6), pages 2219-2246.
    2. Leonardo Gambacorta & Adrian van Rixtel, 2013. "Structural bank regulation initiatives: approaches and implications," BANCARIA, Bancaria Editrice, vol. 6, pages 14-27, June.
    3. Hughes, Joseph P. & Mester, Loretta J., 2013. "Measuring the Performance of Banks: Theory, Practice, Evidence, and Some Policy Implications," Working Papers 13-28, University of Pennsylvania, Wharton School, Weiss Center.
    4. Mr. Sunil Sharma & Mr. Itai Agur, 2013. "Rules, Discretion, and Macro-Prudential Policy," IMF Working Papers 2013/065, International Monetary Fund.
    5. Marco Migueis, 2017. "Forward-looking and Incentive-compatible Operational Risk Capital Framework," Finance and Economics Discussion Series 2017-087, Board of Governors of the Federal Reserve System (U.S.).
    6. Song, Fenghua & Thakor, Anjan V., 2019. "Bank culture," Journal of Financial Intermediation, Elsevier, vol. 39(C), pages 59-79.
    7. R. Christopher Whalen, 2013. "Why Fixing the 'Shadow Banking' Sector is Essential for the U.S. Housing Market," NFI Policy Briefs 2013-PB-01, Indiana State University, Scott College of Business, Networks Financial Institute.
    8. Thomas Hoenig, 2013. "The Case for Simple Rules and Limiting the Safety Net," Cato Journal, Cato Journal, Cato Institute, vol. 33(3), pages 485-489, Fall.
    9. Charles S. Morris, 2011. "What should banks be allowed to do?," Economic Review, Federal Reserve Bank of Kansas City, vol. 96(Q IV), pages 55-80.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Abbassi, Puriya & Iyer, Rajkamal & Peydró, José-Luis & Soto, Paul, 2020. "Stressed Banks? Evidence from the Largest-Ever Supervisory Review," EconStor Preprints 217048, ZBW - Leibniz Information Centre for Economics.
    2. Woon Sau Leung & Nicholas Taylor, 2013. "Testing for contagion: the impact of US structured markets on international financial markets," Chapters, in: Adrian R. Bell & Chris Brooks & Marcel Prokopczuk (ed.), Handbook of Research Methods and Applications in Empirical Finance, chapter 11, pages 256-284, Edward Elgar Publishing.
    3. Kozubovska, Mariolia, 2017. "The effect of US bank holding companies’ exposure to asset-backed commercial paper conduits on the information opacity and systemic risk," Research in International Business and Finance, Elsevier, vol. 39(PA), pages 530-545.
    4. Viral V. Acharya & Stephen G. Ryan, 2016. "Banks’ Financial Reporting and Financial System Stability," Journal of Accounting Research, Wiley Blackwell, vol. 54(2), pages 277-340, May.
    5. Leung, W.S. & Taylor, N. & Evans, K.P., 2015. "The determinants of bank risks: Evidence from the recent financial crisis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 34(C), pages 277-293.
    6. Ralph De Haas & Neeltje Van Horen, 2013. "Running for the Exit? International Bank Lending During a Financial Crisis," Review of Financial Studies, Society for Financial Studies, vol. 26(1), pages 244-285.
    7. Emilios Avgouleas, 2015. "Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective," Economics Working Paper Archive wp_849, Levy Economics Institute.
    8. Gaoqing Zhang, 2021. "Competition and Opacity in the Financial System," Management Science, INFORMS, vol. 67(3), pages 1895-1913, March.
    9. Claudia Buch & Catherine Koch & Michael Koetter, 2016. "Crises and rescues: liquidity transmission through international banks," BIS Working Papers 576, Bank for International Settlements.
    10. Gambacorta, Leonardo & Oliviero, Tommaso & Shin, Hyun Song, 2020. "Low price-to-book ratios and bank dividend payout policies," CEPR Discussion Papers 15615, C.E.P.R. Discussion Papers.
    11. Dion Bongaerts & K. J. Martijn Cremers & William N. Goetzmann, 2012. "Tiebreaker: Certification and Multiple Credit Ratings," Journal of Finance, American Finance Association, vol. 67(1), pages 113-152, February.
    12. Acharya, Viral V. & Skeie, David, 2011. "A model of liquidity hoarding and term premia in inter-bank markets," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 436-447.
    13. Nicole Boyson & Jean Helwege & Jan Jindra, 2014. "Crises, Liquidity Shocks, and Fire Sales at Commercial Banks," Financial Management, Financial Management Association International, vol. 43(4), pages 857-884, December.
    14. Roland Meeks & Benjamin Nelson & Piergiorgio Alessandri, 2017. "Shadow Banks and Macroeconomic Instability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 49(7), pages 1483-1516, October.
    15. Alberto Franco Pozzolo, 2009. "Bank Cross-Border Mergers and Acquisitions: Causes, Consequences, and Recent Trends," Springer Books, in: Alberto Zazzaro & Michele Fratianni & Pietro Alessandrini (ed.), The Changing Geography of Banking and Finance, edition 1, chapter 0, pages 155-183, Springer.
    16. Gorton, Gary & Huang, Lixin, 2006. "Bank panics and the endogeneity of central banking," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1613-1629, October.
    17. Paul Pelzl & María Teresa Valderrama, 2019. "Capital regulations and the management of credit commitments during crisis times," DNB Working Papers 661, Netherlands Central Bank, Research Department.
    18. Anatoli Segura & Alonso Villacorta, 2020. "Demand for safety, risky loans: A model of securitization," Temi di discussione (Economic working papers) 1260, Bank of Italy, Economic Research and International Relations Area.
    19. Morten Balling, 2011. "Asymmetries in Financial Information, Risk and Know-how: The Roles of Disclosure Rules, Financial Safety Nets and Market Discipline," Chapters, in: Christopher J. Green & Eric J. Pentecost & Tom Weyman-Jones (ed.), The Financial Crisis and the Regulation of Finance, chapter 13, Edward Elgar Publishing.
    20. Ricci, Ornella, 2015. "The impact of monetary policy announcements on the stock price of large European banks during the financial crisis," Journal of Banking & Finance, Elsevier, vol. 52(C), pages 245-255.

    More about this item

    Keywords

    Safety Net; Too Big To Fail; Restructuring Banking Regulation; Glass-Steagall; Shadow Banking;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G2 - Financial Economics - - Financial Institutions and Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L5 - Industrial Organization - - Regulation and Industrial Policy

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pra:mprapa:47614. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: . General contact details of provider: https://edirc.repec.org/data/vfmunde.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Joachim Winter (email available below). General contact details of provider: https://edirc.repec.org/data/vfmunde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.