Working Paper: NBER ID: w4993
Authors: Franklin R. Edwards; Frederic S. Mishkin
Abstract: This paper outlines the fundamental economic forces that have led to the decline in traditional banking, that is the process of making loans and funding them by issuing short-dated deposits. The declining competitiveness of traditional banking may threaten financial stability by increasing bank failures and by increasing the incentives for banks to take on more risk, either by making more risky loans or by engaging in 'nontraditional' financial activities that promise higher returns but greater risk. This paper argues that most nontraditional activities, such as banks acting as derivatives dealers, expose banks to risks and moral hazard problems that are similar to those associated with banks' traditional activities, and that these activities can be regulated as effectively as can traditional activities. One regulatory approach to maintain financial stability and strengthen the banking system is to adopt a system of structured bank capital requirements with early corrective action by regulators. An important element in this approach is that market- value accounting principles would be applied to banks and there would be increased public disclosure by banks of the risks associated with their trading activities. With this regulatory structure in place, banks could be permitted greater freedom to expand into nontraditional activities.
Keywords: traditional banking; financial stability; regulatory policy; nontraditional activities; bank capital requirements
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| declining competitiveness of traditional banking (F65) | increased bank failures (F65) |
| declining competitiveness of traditional banking (F65) | heightened risk-taking behavior among banks (G21) |
| increased bank failures (F65) | threat to financial stability (F65) |
| declining competitiveness of traditional banking (F65) | riskier nontraditional activities (G24) |
| riskier nontraditional activities (G24) | moral hazard problems (D82) |
| regulatory measures (G18) | mitigate risks (G22) |