Dr Ewa Miklaszewska
Cracow University of Economics
Dept. of Finance
The Wolpertinger Meeting, Siena:
Market Discipline versus Public Regulator:
A Search for an Adequate Regulatory Regime
International financial markets are govern by the interplay between public regulations,
private regulations and the environmental changes. Thus, the paper concentrates on the
question to what extend the evolution of market and regulatory regimes has been inducing
banks to a more socially desirable behaviour and what are the regulatory lessons for Poland
from the global trends. Does the tendency to replace past strategy of mounting public
regulatory requirements by giving more weight to banks’ self-regulation or private
regulations lead to a more efficient, welfare-maximising framework? Does it lead to less
conflicts of interests and more ethical financial environment. To answer these questions,
the paper looks first at the investment bank, where conflict of interests is currently a key
issue, and then analyses the problem from a commercial and universal bank perspective.
1. „Importance of Being Good”
Recently in financial literature we can observe a discussion on ethics, stimulated by the
Enron scandal. The Banker in April (2002) opens with a paper entitled: „Importance of
being good” arguing that unethical banks will not survive in today competitive environment
and that financial sector must adhere to a strict code of conduct. The Economist (May 4,
2002, p. 75) discusses the results of SEC investigation into conflicts of interests in the US
financial market. As a result, first public apologies for ethical breaches are given by well
known banks, such as Merrill Lynch, which has been accused of misleading advice given by
its analysts. As a reaction to the crisis, some firms are considering separating research from
investment activities, others like Morgan Stanley have decided to abandon issuing
recommendation (buy, hold, sell) altogether. Soon after abolition of Glass-Steagall Act,
which separated lending from capital market activities (replaced in 1999 in the US by
Financial Modernisation Act, known as Gramm-Leach-Bliley Act), similar regulatory
proposals are being suggested, such as separating auditing from consulting, or research from
trading, all in order to avoid the biggest plaque in investment banking: the conflict of
For an investment bank, unethical behaviour constitutes in a long run a major threat, as the
investment banking business is based mostly on reputation. There are many instances from
the past to illustrate it, such as:
- the collapse of Drexel Burnham Lambert in 1989,
- Salomon Brothers scandal in 1990-91,
- Bankers Trust problem with corporate culture in the mid 1990s,
- currently, Arthur Andersen scandal with the handling of the Enron case.
Drexel Burnham Lambert, instrumental for developing a junk-bond market and starting the
LBOs revolution in the 1980s, end up in bankruptcy in 1989, soon after its creator Michael
Milken was sentenced guilty for fraud (Santomero, Babbel 1997).
The scandal of Salomon Brothers, a prime investment bank, cheating on Treasury paper
auctions in the early 1990s was probably the first major scandal involving a major
investment bank. After investigation, the bank admitted several illegal bids in auctions for
government securities in 1990 and 1991, in order to monopolise the market, force up prices
and squeeze the competition (Walter, Smith 1999). As a result, the bank had to change its
entire management and culture, compensate the investors and the Treasury and in the long
rung the blow to its reputation was hardly reparable (including 30% drop in its share price
after reviling the scandal). The firm was saved by the new director, Warren Buffett, but 80
years of reputation for integrity and fair dealing were lost. In the long run, Salomon did not
survive as in independent firm and today is a part of Citigroup investment arm: Salomon
Smith Barney. A side effect of the Salomon scandal was that it convinced the major US
business schools to introduce business ethics as an important teaching subject.
Bankers Trust, which in the 1980s transformed itself from a mediocre commercial bank into
a prime-rated, creative global wholesale institution, discovers the early 1990s that the
transformation was probably too fast, and its culture too aggressive. In 1994 the bank was
accused by clients of misleading them on the nature of risk of financial leveraged
instruments. It lost in court, was fined by SEC and warned of lack of transparency by other
regulators. As a consequence, the bank has lost its public image as a market leader
(Euromoney, April 1995). In 1999, it was sold to Deutsche Bank.
Recently, Arthur Andersen will probably cease to exist as an independent firm, as a
consequence of its handling of the Enron case. Enron, until last year the world’s largest
energy-trading company, had been prized by financial analysts and stock market for its
aggressive strategy, based on the new opportunities in the deregulated energy market.
Beyond its core natural gas business, it tried to enter electricity and water markets, and even
hedge London weather. „Creative accounting” and lack of transparency undermined its
credibility and in October 2001 its shares and credit rating plunged to a junk status. In
December 2001 it filled for bankruptcy and many of its employees lost their savings in
addition to their jobs. Andersen, Enron’s accountant, which has been accused of negligent
auditing, distorted tons of papers related to Enron case. The public opinion was shocked at
the way how auditors, banks, rating agencies and regulators ignored the deterioration of
Enron returns. Neither the sophisticated capital market analysts, nor Enron banks: Citigroup
and J.P. Morgan Chase, nor even the outsiders paid to monitor the firm did alert the market
until it was too late (the Economist, Jan 11,2002). The behaviour of Andersen, Enron’s
auditor, was particularly shocking, displaying the instances of incompetence and corruption.
It has been approving Enron’s accounts despite concerns about the transparency and then
tried to undermine the public investigation. Andersen’s behaviour may be partially
explained by the conflict of interest: in 2001, Enron paid them $25m. for audit and $27m.
for consulting. Enron has also been a generous political contributor .
The examples discussed above were the clear instances of investment banks or firms which
were unethical and unsuccessful and as a consequence lost their reputation, market and
sometimes even existence. Prime firms live in the spotlights hence any ethical problem has
an immediate consequence. For unethical but successful deals, the lessons are less
straightforward. For commercial banking, the direct links between reputation, social
responsibility (ethics) and financial results are even more complex.
2. Strategic Evolution in Commercial Banking
Looking at the issue of ethical dealings, or social responsibility, from a commercial bank
perspective, the message is complex. For years, those banks have enjoyed monopolistic
position on the financial market and have traditionally been accused of being big and
powerful, making excessive profits or ignoring social needs. Typical complaints against
commercial banks could be categorised under 10 main headings:
- the big banks have too much power,
- their profits are excessive,
- their charges are extortionate,
- they have not lent readily enough,
- they have rent too freely,
- they are too big,
- there is scant sympathy for the needs of smaller business,
- human interest has disappeared from our dealings,
- there is too much red tape in the administration
which is out of touch with local feeling and local needs,
- bank buildings are too extravagant.
Source: "Banking Ain't Fun Any More”
The Institute of Bankers' Presidential Address of Mr F.L. Bland (1933).1
These accusations, formulated in 1933 and applicable for the following half the century,
today no longer seem adequate and the transformation of the banking industry after the
deregulation of the 1980s has been well documented. Competition in the financial market
reduced dramatically the profit margins (table 1) and forced banks to reshape their
strategies, giving rise to the assertion that traditional bank is dead (Rajan 1998).
Deregulation of financial markets, technological progress and globalisation of financial
services have changed the economic powers and position of the banking industry (table 2).
In consequence, the strategic behaviour of banks has altered, resulting in a focus on
efficiency, rather than on extracting monopolistic rent or fighting for regulatory capture
(Vives 2000; Gordon 1998).
Table 1: Interest Margins of Commercial Banks:
1Quoted by B. Pearse (1993) Towards 2000: Challenges and Imperatives. London: The Institute
of Bankers, Presidential Adress.
Average margin on demand deposits (%)
(Current short-term rate minus interest paid on deposits)
Country 1980-85 1987-92 1994-95 1996-98
Belgium 11.2 8.7 5 3
Denmark 16.2 9.0 NA NA
France 11.7 9.7 6.1 3.5
Germany 6.5 7.2 4.8 3.4
Spain 14.5 6.0 3.6 0.6
The UK 10.8 7.0 3.6 3.6
Source: J.Dermine (1999).
Table 2: Share of Assets of Financial Institutions in the US (% of total)
1910 1948 1960 1980 1993
banks 65% 56% 38% 35% 25%
institutions 15% 12% 20% 21% 9%
companies 17% 24% 24% 16% 17%
companies Na 1% 3% 4% 15%
funds 0% 3% 10% 17% 24%
Other 3% 4% 5% 7% 9%
Source: H. Rose (1998), p. 369.
3. Regulatory Response to the Changes in Banking Markets
Banks have strong externalities on the economy and in the last instance a public regulatory
organ pays for the banking crises or problems in large banks. Banking crises bring damage
to employment, income and economic growth. The efforts to limit banking risk are
therefore more than justified and the stability of the financial system has always been an
important macroeconomic policy goal and regulatory priority. The main objective of
banking regulation is stability, trust and panic avoidance. For years, public regulatory
organs have performed those functions fairly well in the stable international environment.
Most of systemic regulations was introduced in the '30s, in response to massive bank
failures. These acts, together with deposit protection, ensured long-term stability of the
banking market. Market efficiency, transparency and rights of the investors were scarified
for the sake of the safety and stability of the banking industry. Consequently, a failure of a
bank constituted to a large extent a failure of the regulatory and supervisory organ, which
encouraged a moral hazard behaviour. The typical safety net for crisis prevention is
Table 5: Typical Crisis Prevention Safety Net
Evolution of Financial Crisis Regulatory Safety Net
Bank assumes excessive risk Should be prevented by prudential
(economic expansion) supervision
Bank's solvency in doubt Bank should be closed before this
Run on bank Should be prevented by deposit
Abrupt closure of bank, Should be prevented by tender of last
losses to depositors resort
Runs on “similar” banks Should be prevented by deposit
Liquidity- related failures Should be prevented by lender of last
Contraction of the reserve base Should be prevented by monetary
Moral hazard effect Licensing authority should bar
Incentive to take excessive risk imprudent,
incompetent and dishonest banks
Source: R.Smith and I.Walter (1990) Global Financial Services. New York: Harper
However, the operation of the safety net created problems of inefficiency and fairness, i.e.
how to distinguish between institutions that is too big to fail and those which are too small
to save? The authorities did not intervene promptly when there was a danger of insolvency,
but usually when it was too late. They also did not prevent herding behaviour, described by
J.M. Keynes in 1931 in the following way:
" a sound banker is not one who foresees danger and avoids it, but one who, when
he is ruined, is ruined in a conventional way along with his fellows so that no one
can really blame him"2.
The regulations have contributed to the moral hazard problem: bank managers, knowing
that they are likely to be bailed out, behave in a less risk-averse manner. These are the
prices paid for greater financial stability. Moreover, the safety net has been in many cases
too successful in protecting depositors, who therefore did not have the incentive to monitor
and discipline banks. Consequently, depositors frequently do not know exactly about the
extent of insurance coverage, assuming that the government would always bail out large
banks in the last resort. Finally, the regulators and authorities may have the same bias as the
bankers. They restrict diversity, making banks more vulnerable.
4. Too big to fail
Recent wave of mergers and acquisitions (M&A) poses new regulatory challenges. In
Europe, the number of depository institution has declined from 12000 to 9000 between
1985-97 (Dermine 2000), and in the US from 12000 to 7000 between 1979-97 (Danthine
1999). Concentration has been particularly dramatic in the mega-banking segment: in the
US, banks with assets above $100 bn increased their market share from 9% to 19% (Rajan
2 Quoted in R.Herring (1998), p.387.
1998) and recent mega transactions like mergers between Deutsche Bank and Bankers
Trust, Swiss Bank Corporation and UBS, Banco Santander and BCH or Citibank and
Travelers, all involving assets around $800 bn, are cases in the point (Walter 1999). Among
the largest global banks, the top ten exceeds assets of $500 bn (table 3).
Table 3: The World’s Largest Banks by Assets, billions of dollars
Bank Assets in 1999
Deutsche Bank, Frankfurt 845
Citigroup, New York 717
BNP Paribas, Paris 702
Bank of Tokyo-Mitsubishi, Tokyo 697
Bank of America, Charlotte N.C. 632
UBS, Zurich 614
HSBC Holdings, London 569
Fuji Bank, Tokyo 552
Sumitomo Bank, Osaka 509
Bayerische Hypo Vereinsbank, Munich 505
Source: American Banker online
Mergers and acquisitions have been very actively sought, although the empirical evidence
on economies of scales and scope in banking are controversial and non-conclusive. Many
studies proved that economies of scale have limited relevance in banking and are being
exhausted in the middle range scale - for assets below $100 millions. Above $5 bn are not
relevant at all (Walter 1999). On one hand, merging banks believe in merger-related cuts
in operational costs or in increase in efficiency due to synergy, know-how and
technological advance. On the other hand, economic studies of past mergers show that
much of expected merger-related efficiency have not materialised and gains were mainly
related to the reduction in employment (Scherer 1998), which also rises some ethical
Studies in so called „happiness research” found that that the strongest influence on
happiness is employment. Work is sometimes considered a burden, but being unemployed,
even when receiving the same income as when employed, decreases significantly people’s
wellbeing. Unemployment seem to be to a large extend involuntary, and happiness depends
strongly on low inflation and employment. Income promotes happiness only till some
point, and in richer countries the relationship is irrelevant (Frey, Stutzer, 2001). Hence, if
merger-related gains are mainly due to cutting employment, they lead to a suboptimal
Regulatory authorities in the major countries were active in safeguarding competitive
structure and in the past actively prevented overconcentration. However, recently the
preventive regulatory actions, particularly against megamergers, have been rare. The newly
created global megabanks may have significant impact on domestic macroeconomic trends
and public wellbeing, both by their economic impact, lobbying power or becoming too big
to fail. The biggest banks in some European countries, such as Switzerland or Holland,
have equity capital equal to 5-8% of their GDP. In case of failure, the costs of rescuing
them would constitute a sum difficult to comprehend. Polish main banks are still far from
posing this threat, having capital in the range of 0.5% of GDP. However, consolidation
processes among top banks have only started.
Table 4: Concentration in the Banking Markets
Country/bank Equity(book value; Bank equity/GDP
billions of Euro)
HSBC (UK) 29 2.1%
RBS-Natwest 16 1%
Barclays 13 1%
Credit Agricole 26 1.8%
BNP-Paribas 23 1.6%
Societe Generale 12.5 0.9%
UBS 20.5 8%
Credit Suisse 17.5 6.9%
Deutsche Bank 19 0.9%
Bayerische Hypo 15 0.7%
Dresdner 13 0.6%
ABN Amro 17 5%
Rabobank 15 4%
ING Bank 13 3%
Santander-SCH 13 2.6%
Fortis 7 3%
KBC 5 2.3%
Bank of America 47 0.5%
Citigroup 41 0.5%
PeKaO S.A. 1 0.6%
Bank Handlowy 0.8 0.5%
PKO-PB S.A. 0.7 0.4%
Source: Data based on Dermine (2000); for Poland, author’s estimates.
5. Evolution towards Private Banking Regulations (Basel II)
The deregulation of banking services in the 1980s has resulted in much poorer record of the
public regulatory organs (i.e. banking crises in the US in the ‘80s or in Asia in the ‘90s).
The regulatory organs turned out to be reluctant in closing insolvent banks, particularly the
large ones, and prone to industry capture. Public regulations have bias towards protecting
the industry and not the market (Ryan 1998). Moreover, instances from relatively
unregulated markets showed that regulation alone do not ensure stability. Unregulated
euromarket has been functioning for the last 30 years as a multi-trillion dollar market
without a major incident, similarly stock exchanges and OTC-markets are mostly self-
regulatory rather than externally regulated and function smoothly, as high standards and
credibility are important for their profits (Kroszner 1998).
Capital market regulations focus on protecting investors’ interests rather than the stability
of the institutions. They are based on both public and private regulatory rules. In private
regulatory system (such as closed clubs or private rating agencies) the question of
credibility is largely preventing the possibility of industry capture and unethical deals
(Kroszner 1999). Issues such as transparency of the market, fair treatment of investors, fair
market competition and open market access should then constitute a regulatory priority also
in the banking industry. Consequently, deregulation and globalisation of financial markets
have forced banks and the regulators to rethink what constitutes the basis for the
competitive advantage of the banking industry. Bank efficiency has emerged as an
important policy variable also from a regulatory point of view. Responding to those
pressures, regulatory thinking has been evolving towards adoption of some of the capital
market's attitudes and considerations. The current regulatory reform, so called Basel II,
aims at introducing better risk management practices. It is centred on giving more weight to
banks’ self-regulation and private regulation (such as that of rating agencies), as opposed to
mounting public regulatory requirements, particularly for large global banks.
Basel II is a new version of the 1988 Capital Accord which serves as the basic capital
requirement for banks around the globe. The so called capital adequacy ratio requires banks
to hold capital equal 8% of their risk-weighted assets. Although the Basle Committee on
Banking Supervision, established by the regulators from G-10 countries under the auspices
of the Bank for International Settlements, has no supranational authority, more than 100
countries have adopted the standards set in 1988 accord. The accord served international
community well, however after the deregulation it has become increasingly less adequate
for risk management in the global and very competitive international framework. In the
new framework large banks will be able to use internally generated models such as VAR or
IBR systems, to determine the adequate capital base. For other banks the importance of
private regulations (rating) will dramatically increase. Hence, private rating or self-
regulation will replace the past tendency to mount public regulatory requirements, making
the system more transparent and efficient.
As for the new proposals, banks will be able to choose among three methods for
determining the risk weights on their credit assets (The McKinsey, 2001).
- a standardised approach, where risk weight will depend on the type of borrower for whom
the rating is given by private, independent agencies such as Moody’s and S&P. For
example, loan to AAA-rated corporation will receive a 20% risk weight and require 1.6
cent of capital for each dollar lend, as opposed to current 100% weight (8 cents). A loan to
a BBB-rated sovereign, such as Poland, would receive a 50% risk weight, as opposed to 0%
- two approaches based on internal credit-rating systems (IRB): foundation and advanced.
Under foundation IRB approach banks will calculate their capital requirements using
internal estimates of default probabilities together with regulator-assigned values. Under
the advanced IRB, few selected banks will be able to calculate capital by using their own
estimates for key variables
Basel II also proposes capital requirements for banks’ operational risks. The banks will be
required to disclose the composition of their credit portfolios by risk ratings and banks
using IBR approach will have to publish their individual risk parameters (The McKinsey,
6. Bank Regulation as an Outcome of Interest Groups’ Battle
The regulatory outcomes can also be largely explain as a result of competition among the
main interest groups: large banks and small banks, commercial, investment and insurance
firms and the government and public agencies. According to R. Kroszner, main forces
behind the regulatory change are:
- public interests: correction of market failures and prevention of externalities, even at
the expense of welfare-maximisation,
- private interests: well organised groups lobbying for rules which benefit them,
- dominant ideology (like Glass-Steagall Act in 1933, based on belief that large banks
were responsible for overheating the economy of late 1920s),
- existing political and institutional set-up (including accountability and transparency of
public institutions, tax consideration, etc.)
Public interests concentrates on stability of the system, while private interests of banks on
their efficiency and incomes. Competition among the various groups, particularly intra
industry rivalry within the banking system, contributes towards the optimal regulatory
outcome (Kroszner). Rival banks have incentive to battle each other, and not only the
government or consumers. Although banks will always have incentives to provide
disinfomation, the ability to voice their position will benefit all, by educating the public
regulator. Hence, deep and transparent financial market with a number of independent
institutions should promote the optimal regulatory outcome.
7. The Regulatory Lessons for Poland from Global Tends
Currently, the Polish banking system consists of 72 banks. State ownership still influences
banking industry, although it has dramatically declined (table 6).
Table 6: Relative Share of Particular Groups in the Total Number of Banks.
Number of banks 1993 1995 1998 VI 2001
1. Commercial 87 81 83 72
1.1 with majority 29 27 13 7
public sector equity
1.2 with majority 58 54 70 65
1.21 with majority 10 18 31 47
2. Cooperative banks 1 653 1 510 1 189 663
Source: NBP, GIBS (Sept. 2001) Summary Evaluation of the Financial Situation of Polish
Bank profitability is still high: 15% RoE on average in 2000, although diminishing, due to
adverse macroeconomic conditions. Majority of banks fulfil the risk-based capital
requirements. The worrying symptom is high cost/income ratio and growing portfolio of
non-performing loans (average of 16% of irregular loans in banks’ portfolios).
After 1989 banking reform, Polish regulatory regime entered initially liberal stage
(1991-92). Then, banking crisis in 1992-93 changed the regulatory perspective. Justifiable
fears connected with transitory phase resulted in 1992 in new legal amendments, aimed at
stability and protection against failures. Consolidation of banks was encouraged and
internal protection of the financial system implemented (mounting formal and informal
requirements for getting banking license by foreign institutions). Since mid 1990s,
however, the regulatory regime has been constantly evolving towards a better framework of
conducting banking activities. New Banking Law of 1997 implemented the EU standards as
to the limits on bank total exposure, bank investment in non-bank economic units or risk
weighted capital adequacy ratio. The privatisation is almost completed and foreign banks
are freely admitted.
After a decade of transformation, the banking market is largely market oriented and
centred on efficiency and its current evolution is largely decided by market processes.
Currently, Polish banks are undergoing a rapid process of consolidation or changes in the
ownership base. As aggressive growth is no longer possible in a relatively stable
macroeconomic environment, mergers and acquisitions and investment activities are the
best strategy for expansion and growth. Regulatory institutions in Poland have been
encouraging mergers and acquisitions among the top banks, as a safeguarding measure
against the future more competitive environment. However, on the global market banks'
face hostile competition from non-bank financial intermediaries, hence the growing
concentration in banking is not dangerous from the welfare point of view. In less develop
and liquid markets, like the Polish one, strong concentration and merging among the top
banks may lead to redistribution of profits among banks with negative effect on customers’
satisfaction, economic welfare and banks' efficiency. For the future, the threat is that large
universal banks will be the group with too much of political power. The concentration in
Polish banking is not excessive, however the small, specialised banks are almost non-
existent (4% of market share for co-operative banks).
Another frequently voiced concern is the dominant position of foreign banks (over 70% of
financial assets and capital). However, foreign banks are less politically connected and less
interested in regulatory capture and offer less potential for moral hazard behaviour.
Negative effect may be the opposite: that they may exert too little pressure for the
regulators for continuation of the financial reform.
Conflict of interests is a plaque for the international financial system. However, Polish
banks are predominantly commercial in nature. Polish banks were even accused in the past
of the „progress with a wrong model”. The wrong model, i.e. the separation of activities,
spared us some scandals and conflict of interests, which may be illustrated by the bank
BRE SA, the most aggressive and investment oriented in the Polish market. Its president
have tended to be described as a role model for the industry. Recently, when the bank is
active in hostile takover bids against its former clients, popular press describes him as a
„wolf dressed up as bank president” (Rzeczpospolita 30.03.2002)
The future is ethical, says The Banker (April 2002). The recent banking scandals have
attracted attention of public and private regulators to the behaviour of financial firms. The
quality of a financial product is difficult to establish, hence the reputation is a key factor
for a long run success of a financial firm, both investment and commercial, and the
corporate culture in the long run must be based on values. However, we cannot forget that
banks are profit maximising firms. R. Kroszner (2002) quotes a famous US bank robber,
who when asked why he robbed banks, replied: „because that’s where the money is”. This
may also be a public motivation for interest in banking industry. However, bank money is
depositors’ money and bank main social responsibility is to conduct transactions in a safe
and efficient manner. As Milton Friedman once observed, the biggest social responsibility
of business is to increase its profits.
The regulatory regimes should ensure that the market, the depositors and the investors
have efficient and stable institutions with transparent accounting and strategies, which are
not too big to fail. The main regulatory objectives of :
• stability of the system,
• bank transparency and proper conduct,
• competition in the banking market,
can be ensured by a mixture of public and private regulations, with growing importance of
the latter. Respecting social norms and behaviours can to a large extend be imposed by a
competitive market structure. However, public overregulation is as dangerous as lack of
any regulatory interference in this respect.
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