Interaction of Financial and Regulatory Innovation

Abstract

What I find surprising about the phenomenon of is economists' insistence on thinking about regulatory adjustments that affect financial firms as exogenous disturbances to a general economic equilibrium. Far from being a politically self-contained disturbance to financial markets, deregulation is an endogenous response by regulators to changes in the economic constraints that financial markets impose upon them. My perspective on financial and regulatory innovation may be grasped by visualizing the front window of a large financialservices firm. In this window are four signs. Three of the signs constitute electronic displays. The messages on these three signs as well as the equipment used to display them are continually updated by the firm's employees. The three signs display respectively the following information: 1) The product lines the firm offers: different types of deposit or investment accounts, credit arrangements, and other customer services; 2) The prices the firm currently attaches to each type of product; 3) The name, office locations, and organizational form of the institution itself. What about the fourth sign? This one is painted permanently on the window in gold letters. It says that the debts of this institution are guaranteed in full by either its home or host government because the firm is too large for affected politicians to allow it to fail. This image hints at two points. First, the permanence of the information conveyed by the fourth sign and the slowness with which politicians and bureaucrats adjust their monitoring of institutions' risk-taking activity to changing opportunities for taking risk help to explain the impermanence or volatility of the information displayed on the other three. Underpriced and insensitively monitored government guarantees cushion the penalties from failure that ordinarily constrain innovative behavior. Second, government guarantees and supporting regulatory activity are only part of the story. The other major forces are volatility in financial firms' macroeconomic and microeconomic environments, particularly the rapid technological change symbolized by the electronic signs whose form and content the firm's managers directly control. Financial theory holds that financial firms exist to reconcile in an economical fashion the funding needs of entities that want to spend more than their income with the desire for credit-enchanced savings vehicles on the part of entities that want to accrue a surplus. Conventional theory portrays society's savings propensities, the productivity of real capital, fiscal and monetary policy, and the technology of information processing and financial transacting as determining both the prices at which a financial-services firm could afford to offer untaxed and unsubsidized financial products and the essential economic functions it seeks to perform. My research (1984; 1987) takes these elements of the problem as given. It stresses that, overlaying the pattern of financial opportunities, regulatory competition helps to shape the formal organization of the firm. By organization, I mean the details of a financial intermediary's corporate structure, the locations and processes it uses to produce and distribute financial services, and the names and contractual details of the financial instruments that constitute its product line. My analysis stresses further that regulatory burdens and subsidies and regulatee adaptation to them simultaneously determine each other. *Ohio State University, Columbus, OH 43210.

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