… is a topic on which I have long been planning to write the definitive essay.
Today is not that day.
In the interim, I offer a link to a post by Marc Rubinstein that makes a few points I found worth noting and expanding upon.
Firstly, he starts with the observation that there are very few neat solutions to policy choices – mostly there are just trade-offs. He cites as a case a point the efforts by financial regulators to introduce increased competition over the past forty years as a means to make the financial system cheaper and more efficient. Regulators initially thought that they could rely on market discipline to manage the tension between increased freedom to compete and the risk that this competition would undermine credit standards but this assumption was found wanting and we ended up with the GFC.
When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem.The Policy Triangle, Marc Rubinstein -https://netinterest.substack.com/
We have learned that regulators may try to encourage competition where possible but, when push comes to shove, financial stability remains the prime directive. As a consequence, the incumbent players have to manage the costs of compliance but they also benefit from a privileged position that has been very hard to attack. Multiple new entrants to the Australian banking system learned this lesson the hard way during the 1980s and 1990s.
For a long time the trade-off played out on that simple one dimensional axis of “efficiency and competition” versus “financial stability” but the entry of technology companies into areas of financial services creates additional layers of complexity and new trade-offs to manage. Rubinstein borrows the “Policy Triangle” concept developed by Hyun Song Shin to discuss these issues.
- Firstly, he notes that financial regulators don’t have jurisdiction over technology companies so that complicates the ways in which they engage with these new sources of competition and their impact on the areas of the financial system that regulators do have responsibility for.
- Secondly, he discusses the ways in which the innovative use of data by these new players introduces a whole new range of variables into the regulatory equation.
New entrants have been able to make inroads into certain areas of finance, the payments function in particular. Some regulators have supported these areas of innovation but Rubinstein notes that regulators start to clamp down once new entrants start becoming large enough to matter. The response of Chinese authorities to Ant Financial is one example as is the response of financial regulators globally to Facebook’s attempt to create a digital currency. The lessons seems to be that increased regulation and supervisions is in store for any new entrant that achieves any material level of scale.
The innovative use of data offers the promise of enhanced competition and improved ways of managing credit risk but this potentially comes at the cost of privacy. Data can also be harnessed by policy makers to gain new real-time insights into what is going on in the economy that can be used to guide financial stability policy settings.
Rubinstein has only scratched the surface of this topic but his post and the links he offers to other contributions to the discussion are I think worth reading. As stated at the outset, I hope to one day codify some thoughts on these topics but that is a work in progress. That post will consider issues like the “prisoner’s dilemma” that are I think an important part of the competition/stability trade-off. It is also important to consider the ways in which banks have come to play a unique role in the economy via the creation of money.
Tony – From the Outside
p.s. There are a few posts I have done on related topics that may be of interest