2003-07-01 09:54:11
Why change banking system?
  Author: QIN FENGMING
 
 

A key element of the ongoing transformation of national and international finance over the past two decades is the blurring of distinctions between financial institutions and their activities and markets.

Global banks now provide a mix of financial products and services in a broad range of markets and countries.

Such changes have altered investors' and borrowers' perceptions of financial risks and rewards around the world.

Bank disintermediation and the further development and deepening of capital markets worldwide have allowed corporations to raise funds directly through bond and equity issues. As a result, the traditional source of bank profits - lending to small and large firms financed by low-cost deposits - has suffered due to competition from securities markets and institutional asset managers.

These competitive pressures on traditional bank franchise values have forced banks to seek more profitable sources of revenue, including new ways of intermediating funds.

Of course, these trends are less evident in countries where the capital market is not yet highly developed but, even in these countries, banks are aware that their traditional franchises are becoming more difficult to maintain.

The degree of disintermediation has not been shared equally by all banks and in all countries. Banks that are active in smaller markets have experienced less competitive pressure, and such pressures have been slower to take hold in countries that have historically relied more heavily on banks than on securities markets.

Traditional banking institutions have been transformed into new financial services firms taking on new lines of business and new risks, which include those faced by institutional securities firms, insurance companies, and asset managers.

At the same time, non-banking financial institutions now actively compete with banks for both the asset and liability sides of bank balance sheets. These activities increasingly blur the distinction between banks and other financial bodies.

The lowering and removal of regulatory barriers in many countries - both developed and developing - has meant that banks can enter areas of business that had previously been off limits. This has allowed them to diversify their sources of revenue by taking on related activities in different markets.

Take a look back at the 1980s and 1990s. Around 1980, there were two basic models for the relationship between commercial banking and securities activities.

One, which could be called the Glass-Steagall model, involved the legal separation of the two activities. Japan and the United States were good examples of countries using this model.

The second model could be referred to as the "universal bank" model. It allowed financial institutions to engage in both commercial banking and securities activities.

A related issue is the degree to which insurance was separate from banking and securities activities.

Every year, the world financial market becomes more integrated, competition in global banking becomes more intensive, and there are more financial innovations.

Commercial banks and investment banks have become involved in each other's traditional fields of expertise and the boundary between them is no longer very clear, since the financial environment has changed greatly. There is a global trend for the specialized banking system to be transformed into a universal banking system, especially since the Asian financial crisis in 1997, when South Korea and Japan were hit the hardest.

Historically, most countries chose a specialized banking system for specific reasons. For instance, banks in the United States were prohibited from conducting both commercial and investment banking operations by the 1933 Glass-Steagall Act, which was repealed in 1999.

The Glass-Steagall Act became law partly because of alleged banking abuses in the 1920s. These alleged abuses included loans to underwriting clients and easier loan terms offered to investment affiliates. In Japan, a similar law restricts Japanese banks from performing both functions.

A specialized banking system can help adjust and reform an unbalanced economy since specific institutions may deal with limited amounts of capital in different ways. This way of doing things also makes it convenient for the government to control financial institutions and their activities, as well as intervene in the market and the whole economy to achieve the government's goal quickly.

On the other hand, with a universal banking system, banks can run all kinds of business. They can continue with traditional commercial banking activities such as receiving deposits, issuing loans, bonds and investment bank stocks, and trade in some other securities, gold transactions and project financing. They even can get involved in insurance, mortgages, securities brokering, mutual funds, asset management, consulting and Internet-based financial services.

This set-up helps banks make a stable return under every kind of competitive circumstance. At the same time, they can adapt to changes in the market because of this diversification. There is more potential space to develop financial products, so banks can adjust their operations according to changes in demand for different products in the financial market.

Universal banks can also reduce the cost of services since they usually have lots of branches for different financial services, run businesses across each other and provide a whole package of financial services. When they deal with customers, they can depend on their internal system to design a package of financial products to meet customers' different.

Finally, universal banks have stable and excellent basic customer groups. They can understand their customers better thanks to the close relationship between the companies. The banks can support these companies when they come into difficulty. In this way, bank can also control risks.

Of course, these advantages can be seen only in good macroeconomic and financial circumstances. They then can ensure the stability of the whole financial and economic system.

In this scenario, the universal banking system demands a much higher standard of risk management and internal control as well as high-quality supervision by the central bank or monetary administration. Otherwise, it is easy to bring turmoil to a whole financial system and even the national economy as a whole. We call this the domino effect or herd instinct.

In practice, most countries have deregulated their financial institutions in order to promote their banking system's international competitiveness and a more efficient allocation of capital.

China's banking sector is seeking to change from its specialized banking position and explore universal banking.

This would mean new challenges both for financial institutions' internal governance and supervision of financial administration.

The writer is a professor at the economics school of Shandong University in Ji'nan.

(Business Weekly 07/01/2003 page1)

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