Notes from the Vault

Larry D. Wall
April 2015 

Will commercial banks remain central to the financial system? If banks are going to become substantially less important, should shadow banks be a central focus of macroprudential policy? The answers to these questions have important implications for the structure of prudential regulation of the financial system. More importantly, getting the wrong answers could have adverse implications for the probability of—and severity of—financial crises in the future.

These questions and more were addressed at the Atlanta Fed's recent Financial Markets Conference titled "Central Banking in the Shadows: Monetary Policy and Financial Stability Postcrisis," which is cosponsored by the Center for Financial Innovation and Stability.1 This Notes from the Vault reviews their discussion and draws some implications for who will be central to the financial system of the future. The conference also had two panels that considered the implications of financial market developments for the conduct of monetary policy. Atlanta Fed vice president and senior economist Paula Tkac will discuss this topic in a forthcoming macroblog post.

Will commercial banks remain central to the financial system?
The first panel agreed that banks have bounced back from the crisis and remain critical participants in the financial system. University of Chicago Professor and former Federal Reserve Governor Randall S. Kroszner (you can read his paper and view his presentation notes) observed that predictions of banks' demise go back to at least the early 1990s and continue to this day. But as a prelude to surveying the current state of affairs, he observes that "the obituary for some banks may be a bit premature." He finds that bank deposits and loans as a percentage of gross domestic product (GDP) are growing in the United States and that banks retain an even larger role in Europe and Japan than they do in the United States. Further, he observed that banks have been taking market share from the shadow banking system since the crisis.

Christopher Mazingo, a principal McKinsey & Company, agreed that U.S. banks are back with 2013 profits at their highest level since 2007 and close to their all-time peak. However, he observed that among the largest 500 banks globally, less than 20 percent of the banks accounted for all of the excess value creation, with three models that are particularly effective: banks as "back-to-basics" low-cost providers, banks with outstanding customer bases, and universal banks delivered in scale.

Although the panel thought banks were important, their role in the future was less clear. Kroszner argued that although banks remain "special," he further noted that "disruptive innovation and dyspeptic regulators will hold the keys to the future" of commercial banks. The most hopeful observations for the future of banks came from Paul A. McCulley, recently retired from PIMCO, who emphasized the role of small banks in providing loans that cannot be made via analysis of "big data." Specifically, small banks know their customers and can make loans based on character and local market conditions that cannot be known by other, nonlocal lenders. This perspective argues for a continuing role for small banks in the nation's economy but leaves open the question of how central the largest banks will be in the global financial system.

Much of the rest of the discussion focused on the blurring of lines within the financial system and the potential for disruptive technology. Panel moderator and Federal Reserve Bank of Cleveland President Loretta Mester observed at the start of the panel "if we ever did, we no longer have the luxury of drawing a bright line" between different financial institutions and markets, but we are instead in a new world where there are "fifty shades of gray." Kroszner observed that if banks are to succeed they may need to act more as "technology-data analytics firms in financial services" than as financial services firms using technology and big data. He also observed that although banks could embrace new technology, a question remains of whether they will. They may well not as new technologies have the potential for lowering profit margins on traditional products such as credit cards. Mazingo observed that many banks are finding it difficult to do big data well and that some had gotten it spectacularly wrong.

One final note on financial innovation from the panel: Kroszner described a scary possibility for the use of technology to overcome the barriers to judging individual character, suggesting that technology firms could use the tracking information obtained via ubiquitous mobile devices to obtain character information that they could use to evaluate loan applications.

Should shadow banks be a central focus of macroprudential policy?
Mark Flannery, chief economist at the Securities and Exchange Commission, began the panel on macroprudential regulation of shadow banks by noting that there are three types of shadow banks: nonbank financial firms that lend money, mutual funds, and securitization vehicles. He observed that these are structured very differently, and accordingly the appropriate type of regulation of any given shadow bank will depend upon its type.

Regardless of their type, shadow banks were able to remain in the shadows prior to the crisis with no regulatory mechanism available to the Federal Reserve for imposing tighter macroprudential regulation. After the crisis, Congress passed the Dodd-Frank Act, which gives the Financial Stability Oversight Council (FSOC) the authority to designate nonbank financial firms as being systemically important and mandates prudential regulation of these firms by the Federal Reserve. However, in the interim period (that is, during the crisis), many of the most obvious candidates for designation either went out of existence or voluntarily became subject to Federal Reserve supervision and regulation.2 Thus, a question arises as to which of the remaining nonbank financial firms should be designated as systemically important. To date, the FSOC has placed this designation on three insurance companies and GE Capital. However, debate rages about what additional firms, if any, should be so designated and, indeed, whether the existing designation of some firms should be reversed.

Not surprisingly, those firms and industries being discussed as being potentially systemically important argue that almost none of their activities are systemic and that the bank regulatory toolkit is at best largely irrelevant to any concerns that may arise. Two people from such industries participated on the panel: Barbara Novick, vice chairman of BlackRock Inc., and John Kim, vice chairman and chief investment officer of New York Life Insurance.

Novick observed that asset managers (a broad category that includes mutual funds) have a completely different business model from banks. Banks issue liabilities in their own name (deposits) and use those to fund risky assets. Asset managers hold assets in custody for their clients, using a legal structure in which the assets belong to the investors if the manager fails. She also observed that large-asset managers tend to have diversified decision makers rather than represent a monolithic force in markets. Novick conceded that although some asset managers engage in an activity that could be considered systemic, such as securities lending, many other parties also perform that activity. Thus, if supervisors consider securities lending to pose a systemic risk, any regulations should be placed on the activity and not the asset managers.

Kim also started by observing similarities but also noted important differences between his industry and commercial banks. Both life insurers and banks take credit risk on their own balance sheet. However, banks have historically funded longer-term loans and securities with shorter-term deposits, exposing them to liquidity risk. In contrast, insurers tend to match the maturities of their assets and liabilities, thus avoiding the risk of panic withdrawals. Kim observed that some insurers are involved in some types of shadow banking, such as securities lending. However, he agreed with Novick that the appropriate supervisory response is a focus on the important activities and not on individual firms. Indeed, Kim observed that bank-like requirements, such as mark-to-market accounting, could interact with capital regulation to induce insurers to act more procyclically and sell assets during periods of large price declines, which could further exacerbate the declines.

Simon Johnson, a professor at the Massachusetts Institute of Technology, had a different perspective on the problem. One of his observations was that a common cause of financial crisis was that some groups on the fringes of the regulated financial system would drive up asset prices using leverage from banks. When the asset-price crash comes, everyone comes down, with the most worrying part being the outcome on the core functions in that banking system. A second point he made was that the prospect of government bailout created a substantial incentive for firms to become too important to be allowed to fail. Johnson asked, "Who becomes implicitly too-big-to-fail... when the next crisis hits?" Thus, he argued that we cannot adopt a system that focuses exclusively on regulating systemically risky activities but need to continue to regulate firms that become systemically important.

Finally, Johnson had one of the better lines of the conference, describing a series of Goldman Sachs reports on the future of finance as "a fox's guide to designing henhouses."

Concluding thoughts
The panel on commercial banking made a strong case that the banking industry remains important in the United States. However, one of the medium- to longer-run threats to banks' importance is regulation that threatens to push financial activity into the shadows. The panel on whether shadow banks should be a focus of central banks clarified the challenge of identifying which nonbank financial firms have become systemically important. Arguably those nonbank firms that posed the biggest systemic threat prior to the crisis converted to bank holding company status during the crisis. Their conversion does not mean new too-important-to-fail shadow banking firms cannot arise—as Johnson points out, the crisis taught financial firms an important lesson about the benefits of becoming too important to fail.

Taking a two-track approach represents one way of addressing the question of how to manage systemic risks from commercial and shadow banks. One track would retain the current institution-based approach to deal with current and future systemic institutions, and the other track would provide enhanced mechanisms for dealing with risks arising in specific financial markets regardless of the participants' industry classification. Such an approach would relax the pressure to use FSOC designation and Federal Reserve regulation of specific firms to address market-based problems while retaining the capacity to more strictly supervise systemically important institutions.

Such a two-track approach, however, requires in-depth understanding of how the various parts of the financial system work, not only those currently subject to regulation but also those that might reasonably have an effect on financial stability. Martin Hellwig, director of the Max Planck Institute for Collective Goods and a professor at the University of Bonn, provided one such idea later at the conference when he discussed the need to create an independent "devil's advocate" to evaluate financial system developments and challenge the complacency that may arise in central banks and supervisory authorities. I discuss another, not mutually exclusive, idea for end-to-end market reviews in one of my recent Notes from the Vault.

Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments on the paper. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail


1 The agenda with links to videos of the policy panels, presentation slides, and papers is available at See also a recent Notes from the Vault titled Central Banking in the Shadows by my colleague Paula Tkac.

2 Bear Stearns was acquired by JP Morgan Chase in a transaction that required extraordinary assistance from the Federal Reserve. Merrill Lynch was acquired by Bank of America in an unassisted transaction shortly before Lehman Brothers failed. American Express, CIT Group, General Motors Acceptance Corporation, Goldman Sachs, and Morgan Stanley all sought to become bank holding companies (BHCs) during the crisis so they could obtain better access to liquidity. However, as a part of becoming BHCs they also became subject to the same Federal Reserve regulations and supervisory procedures as other BHCs.