full speech at http://www.federalreserve.gov/BoardDocs/Speeches/2000/20000918.htm ...The subsequent evidence appears persuasive that the combination of a lender of last resort (the Federal Reserve) and federal deposit insurance have contributed significantly to financial stability and have accordingly achieved wide support within the Congress. As has often been the case in our long financial history, such significant government intervention has not been without cost. The federal safety net for banks, which clearly diminishes both the incentive for, and the effectiveness of, private market regulation, creates perverse incentives for some banks to take excessive risk. Indeed, the safety net has required that we substitute more government supervision and regulation for the market discipline that played such an important role through much of our banking history. Although the safety net necessitates greater government oversight, in recent years rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation. Indeed, these developments reinforce the truth of a key lesson from our banking history--that private counterparty supervision remains the first line of regulatory defense. This is certainly the case for the rapidly expanding bank options and swaps markets and other off-balance-sheet transactions. The speed of transactions and the growing complexities of these instruments have required federal and state examiners to focus supervision more on risk-management procedures than on actual portfolios. Indeed, I would characterize recent examination innovations and proposals as attempting both to harness and to simulate market forces in the supervision of banks. The impact of technology on financial services and therefore, of necessity, the way it will affect supervision and regulation as we move into the twenty-first century is the critical issue that frames the supervisory agenda now before us. The acceleration in the growth of technology that has so greatly affected our economy in general has also profoundly expanded the scope and utility of financial products over, say, the past fifteen years. The substantial increase in our calculation capabilities has resulted in a variety of products and ways to unbundle risk. What is particularly impressive is that there is no sign that this process of acceleration in financial innovation is approaching an end. We continue to move at an exceptionally rapid pace, fueled by both computing and telecommunications capabilities. How should the Federal Reserve, as the functional regulator of state-chartered member banks and, more importantly, as an umbrella supervisor of both bank holding companies and the financial holding companies forming under the Financial Modernization Act, react to this ongoing wave of innovation? The ability to answer that question rests on an understanding of how information technology has changed the nature of your business. The explosion in the quantity and quality of information is reducing uncertainty, and that is particularly important because the banker's stock in trade, the basis of an institution's franchise value, is information. The knowledge of the potential viability of their customers is all that prevents bankers from the equivalent of lending on the outcome of a roulette wheel's spin. To the extent that the newer technologies have opened up vast new areas of information, the banker's knowledge of the borrower's capacity to repay a loan is significantly enhanced. Risk premiums, internal risk classifications and modeling, and credit scoring are becoming ever more finely tuned. But the same advances in information innovation and communication are available to all of a banker's competitors as well. Thus, although increased information lowers the risk of lending, competition inhibits those advantages from translating into longer-run enhanced profit margins. Moreover, the quickened pace of market adjustments resulting from the newer technologies has significantly shortened the interval over which a debt can move from investment grade to default. This delimits the capacity of a bank to adjust its exposure to a failing borrower before the bank is confronted with default. Uncertainty is the creator of risk premiums, the creator of higher funding costs throughout the financial system and indeed throughout the economy generally. The increasing availability of accurate and relevant real-time information, by reducing uncertainty, is over time reducing the cost of capital. That is important to financial holding companies and financial institutions generally in their roles of both lender and borrower. It is important in their role as borrower because their funding costs are critically tied to the perceived level of uncertainty about their condition. It is important in their role as lender because a dramatic decline in uncertainty as a consequence of a large increase in real-time information availability engenders a reduction in proprietary information. One of the major reasons that financial intermediation worked well in years past, in addition to the values of diversification, was that financial institutions possessed information others did not have. This asymmetry of information was capitalized in fairly significant rates of return. But this advantage is rapidly dissipating, as any bank lender will testify. We are going to real-time systems, not only with transactions but with knowledge as well. The continued success of banking organizations, as at the time of the ABA's founding, is dependent upon their ability to reinvent themselves by providing new and different services and creating new and different ways to lend and to manage assets. Financial institutions can endeavor to preserve the old way of doing business by keeping information, especially adverse information, away from the funders of their liabilities. But that, I submit, would be unwise. Inevitably and increasingly it will become more difficult to do. And, when it becomes clear that the information coming out of an institution is somehow questionable, that institution will pay an uncertainty premium, perhaps a costly one. It is well worthwhile remembering that stock prices almost invariably go up when companies write off investment mistakes. The reason is the removal of uncertainty and the elimination of a shadow on the companies' credibility. What does all this mean for supervision and regulation in the twenty-first century? If the supervisory system is to effectively enhance the capacity of the country's financial systems to function, it must adjust to the changing structure of that system. There is no frozen fix on supervision and regulation. We are always changing and moving forward, endeavoring to adjust in a manner that facilitates innovation. We are in a dynamic system that requires not just us but also our colleagues in the Group of Ten to adjust. Today's products and rapidly changing structures of finance mean that supervisors are backing off from detail-oriented supervision, which no longer can be implemented effectively. We are moving toward a system in which we judge how well your internal risk models are functioning and whether the risk thus measured is being appropriately managed and offset with capital. And we are moving toward a system in which public disclosure and market discipline are going to play increasing roles, especially at our large institutions, as a necessity to avoid expansion of invasive and burdensome supervision and regulation. We have a long way to go, but this is where competitive pressures and the underlying economic forces are pushing both you and the supervisory system. The Financial Modernization Act is only a flag on the way to future changes. It is a piece of legislation that will bring major changes for the good, I trust, in all respects. During the transition, the Federal Reserve and other supervisors must work through the issues of how to blend functional regulation and umbrella supervision. Creating that blend will not be easy. And it must be done substantially right the first time because, with the financial system changing so rapidly, we do not have the luxury of reversing course and going in a wholly different direction.
