Implications for Financial Stability and Regulatory Policy

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The article “The decline of traditional banking: implications for financial stability and regulatory policy” by Franklin R. Edwards and Frederic S. Mishkin presents a very detailed and well researched exploration of the current movement of banks away from traditional banking. The authors describe their objectives as including an examination of the reasons behind the decline of traditional banking, and an identification of the effects that these would have on the stability and regulation of banks. The article meets these goals well, as it begins by demonstrating the complexity of the current banking situation and how/why balance sheets reflect information that go far beyond mere lending.

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The non-traditional methods of banking as well as the financial institutions that have evolved and crowded the banking market are also explored in detail. Finally, the authors expound on the ways that banks might improve their status in the financial market and maintain stable regulatory policies within such a highly competitive and unstable environment. Therefore, while in some areas the explanations were a bit awkward, overall the authors manage to unite the causes, effects, and possible remedies of the current problems being faced by banks, and this is done in a manner that demonstrates a deep understanding of the situation.

The introductory pages of the article do give a very detailed picture of why the authors found it necessary to explore the decline of traditional banking. Traditional banking, they explain, dealt mainly with the issuing of long term loans financed by short-term deposits (Edwards & Miskhin, 27).

They provide evidence in the form of graphs and statistics, showing both the size of the decline in earnings from such traditional (financial) borrowing, as well as the share of non-financial borrowing granted banks and their competitors.

The fact that both commercial and thrift banks’ non-financial borrowing declined by an average of 7% over a thirty-five year period demonstrates that significant decline has indeed taken place in their share of that market. The authors also give concrete evidence concerning the decline in these institutions’ returns on such holdings as assets and equity. Finally the authors demonstrate the trend in banks’ share in the market concerned with non-interest income. This increasing trend represents precisely the move away from tradition they have identified. The placement of these facts and charts was effective as a method of vindicating the authors’ decision to explore reasons for the decline in traditional banking.

Edwards and Mishkin go on to explore such areas as the decline in banks’ advantage as far as liabilities are concerned. This is demonstrated in terms of declining cost advantages, which as shown to have become a reality when other institutions found a way to capitalize on the banks’ financial privileges. They explained the fact that ceilings and other restrictions (at one time favorable to the banks) had been placed upon their ability to offer interest on certain types of deposits (such as checkable deposits).

These regulations restricted their ability to be competitive at a crucial time in the market and therefore opened the doors for other lending institutions (exempt from such restrictions) to attract customers by offering higher interest. This serves as a cogent explanation of why banks have declined in this traditional area. Yet, the authors represent the complexity of the market by exploring a few other reasons why such decline has taken place.

The existence of the new paper market (securities) has also been cited as a reason that adds to the complexity of the problem that banks now face (Edwards & Miskhin, 31). The previously mentioned decline in banks’ lending to commercial entities is now explained by the fact that these businesses have been given the option of borrowing directly from the public through the issuance of securities.

The authors also cite the rise of mutual funds and junk bonds on the money market as having an indirect effect on the market position of banks. They write, “The growth of assets in money market mutual funds to more than $500 billion created a ready market for commercial paper because money market mutual funds must hold liquid, high-quality, short-term assets” (31). This serves the explanatory purposes of the authors by demonstrating the sheer size and number of the alternatives to banks that exist on the financial market.

The authors, Edwards and Mishkin, also explore some of the reasons why such alternative institutions have become such a threat to banks. Besides their ability to offer attractive alternatives to customers, these financial institutions have also demonstrated an ability to secure their assets. They explain these institutions’ methods of originating loans and then creating more loans from these. They write: “Advances in information and data processing technology have enabled non-bank competitors to originate loans, transform these into marketable securities, and sell them to obtain more funding with which to make more loans” (Edwards & Miskhin, 32). The rise of financially capable technology has made easy these maneuvers by such non-bank facilities, and this has led to the current position of decline in banks’ traditional activities.

The authors of the article also demonstrate the route that banks have had to take in order to combat the effects of being forced to share their market. They use graphs and data effectively to demonstrate the sharp climb in what had traditionally been considered risky types of loans. These graphs depict a rise in bank issuance of real estate loans, and further details the authors provide demonstrate that banks have had to stoop to lending to “less credit-worthy borrowers” in order to increase their financial viability in these tough times (Edwards & Mishkin, 27& 33).

They also depict the methods chosen by banks to increase their activities that take place off the balance sheet. Banks have expanded into the market for financial derivatives, in which they serve as “off-exchange or over the counter (OTC) derivatives dealers” (34). In order to increase the authority of the article, the writers then provide in several charts concrete evidence of the different kinds of derivative deals in which actual banks have recently participated or mediated. Further evidence concerning the proportion of income banks have derived from these off-balance transactions serve to depict the extent to which they have effaced or replaced traditional banking.

Edwards and Mishkin’s exploration of the nature of the risk faced by these banks in involving themselves in OTC activities demonstrates the extent to which these institutions have been forced by a declining traditional market to engage in alternate financial activities. Since their derivative activities have mainly been in the area of swapping interest rates, the risk involved in this can be seen to be high—though tempered by the fact that they “do not involve payment of principal amounts” (Edwards & Miskhin, 38). Furthermore, the authors’ detailed explanation of swaps and the risks they carry aid the overall understanding of the type of risks banks have been forced to take in order to retain their profits. This leads to a better understanding of the extent to which traditional banking has been transformed.

Finally, the authors Edwards and Mishkin go on to outline the regulations that have been put in place and the implications that they are likely to have for bank policies. The need for regulation is expressed in the evidence they produce from the GAO (U.S. Government Accounting Office). It explains that the discounts and insurance provided by Federal Reserve Bank accords to banks a level of security that might induce them to take higher risks that they would (or should) otherwise have taken.

Regulations have therefore been made that allow only banks with good management and high capital to engage in some of the riskier types of non-traditional banking activities. Such activities include securities underwriting and trading, and dealing in the derivatives market. The inclusion of these explanations in the article demonstrates the thoroughness of the authors in identifying other reasons (beyond mere competition) why some banks have been or may be forced out of the financial business.

The details of policy implications for banks given by the authors are shown to include regulations that strengthen banks’ ability to compete. These measures have also been shown to include the seeking of methods that prevent the fall of capital below certain levels (Edwards & Mishkin, 40). In presenting the pros and cons of these ideas, the authors demonstrate and impart a thorough understanding of the intricacies of banking and further communicate the complexities of the business. The writers, through their efforts, also demonstrate the gravity of the situation that banks now face in their need to write policy giving them the ability to expand beyond their traditional financial market.

Despite the overall clarity and detail of the ideas presented in support of the authors’ claims, a level of awkwardness does enter into a few paragraphs of this article. The awkwardness within this article mainly exists in the introductory pages, where Edwards and Mishkin enumerate (rather than explore) the reasons for and the extent of the decline in traditional banking. The confusing nature of the financial situation being faced by banks is translated to the work, as the writers continually meet their given reasons with qualifications to the effect that demonstrate the inadequacy of each explanation.

They, for example, identify their measure of banks’ profitability over a period of time as “crude” and explain that other measures do not “adjust for the expenses associated with generating noninterest income” (Edwards & Miskhin, 29-30). One gets the feeling that the writers might have taken the trouble to do the extra calculations in order to provide a more comprehensive view of the situation. However, they do provide much more detailed explorations in the ensuing paragraphs.

This article by Edwards and Mushkin presents a very interesting and informative view of the current situation facing banks in today’s financial market. The traditional role usually occupied by banks as lenders has been undermined by the influx of non-traditional lending institutions. These institutions have taken the opportunity to provide lower-interest loans and higher-interest deposits to customers, thereby forcing banks to flee to riskier methods of gaining revenue. Policies that regulate banks’ behavior have become necessary as a result of this trend toward riskier business, and this has sparked ideas concerning policy making and the risks and benefits they would impart to all stakeholders.

Work Cited

Edwards, Franklin R and Frederic S. Mishkin. “The decline of traditional banking: implications for financial stability and regulatory policy.” FRBNY Economic Policy Review. July (1995): 27-45.