Activity-based regulation would mean a more competitive financial system

Jakub Jirsak/jirsak – stock.adobe.com

In the corporate world, banks occupy a unique niche. They are hybrid entities — unlike most corporations with a singular focus, banks offer products that are both liabilities and assets (or deposits and loans) as products. A bank’s balance sheet reflects this core function. A bank’s assets are primarily the various types of loans they extend, financing everything from cars and homes to businesses and entrepreneurial ventures. On the flip side, their liabilities represent the funds entrusted by their depositors, categorized as either longer-term investments or readily accessible checking accounts.

This unique ability, to both take deposits and make loans, however, is no longer sufficient to guarantee banks a dominant position in the financial system. Competition is rising across their entire spectrum of offerings. Nonbank lenders have emerged, offering everything from quick payday advances to complex structured corporate loans. The return of interest rates has empowered broker-dealers to introduce attractive, interest-bearing money market accounts, competing directly with traditional bank savings products. Perhaps the most disruptive force comes from the rise of fintech companies. These agile players are particularly adept at capturing a new generation of customers with innovative payment solutions,

Banks are perhaps the most heavily regulated institutions in the United States. These regulations, while sometimes viewed as a burden, play a crucial role in maintaining the stability of our entire financial system. Nonbank entities, offering similar services to the public, often operate under a lighter regulatory touch. This can be a significant advantage for them in the short term.

However, this advantage comes with a trade-off. Unlike banks, nonbank lenders typically lack access to certain benefits, such as the ability to leverage insured deposits, deposit excess reserves with the Federal Reserve or access the Fed’s discount window or payment systems. These unique capabilities enjoyed by banks are important factors to consider when evaluating the competitive landscape.

One proposed solution to this uneven regulatory landscape is to establish consistent activity-based regulations across the entire financial system, regardless of the institution offering the service. This approach could serve as a foundational principle for a more balanced regulatory framework.

However, implementing such a system raises additional questions. How will the different activity categories be defined and regulated? One potential solution involves a three-tiered approach.

The first tier would encompass activities currently limited to banks due to inherent risks. These activities would continue under existing (or slightly adjusted) regulations.

For a second tier of activities, where nonbanks currently hold an advantage due to lighter regulations, the rules would be adjusted to create a level playing field for both banks and nonbanks.

Finally, a third tier could encompass activities where banks possess a significant advantage. These activities might be cautiously opened up to nonbanks under new, carefully crafted regulations to foster competition while maintaining stability.

Building on the proposed three-tiered approach to regulations, let’s delve into some concrete examples of its application.

The first tier focuses on safeguarding insured deposits through restricted activities, such as traditional lending. These activities would likely remain exclusive to banks, subject to existing capital, liquidity and risk management requirements. Maintaining prudent management of insured deposits is critical for the stability of the financial system.

However, innovation is possible within this tier. Entities outside the traditional banking model might access the insured deposit market without directly gathering deposits themselves. This could be a positive development, but such entities would still be subject to the same safeguards as existing banks.

The second tier aims to create a level playing field by allowing banks to compete in currently unregulated or lightly regulated markets, like proprietary trading and private equity. Banks, under stricter regulations, face limitations in these areas.

As long as banks operate in this space solely with investor funds (not insured deposits), they could be permitted the entire range of activities allowed by nonbanks. Additionally, if the market deems conduct regulations beneficial, these could be applied uniformly across all institutions.

The third tier seeks to expand access by allowing nonbank entities to compete in areas where banks hold advantages, such as payment services and consumer deposit aggregation. However, this access would be subject to the same conditions as banks, including similar examinations to ensure control over overdrafts and overall operations.