REGULATION AND SUPERVISION OF FINANCIAL INSTITUTIONS IN THE NAFTA COUNTRIES AND BEYOND

REGULATION AND SUPERVISION OF FINANCIAL INSTITUTIONS IN THE NAFTA COUNTRIES AND BEYOND

edited by

George M. von Furstenberg Rudy Professor of Economics

Indiana University Bloomington, Indiana, U .S.A .

.... " Springer-Science+Business Media, LLC

Library of Congress Cataloging-in-Publication Data Regulation and supervision of financial institutions in the NAFT A

countries and beyond / edited by George M. von Furstenberg. p. cm.

Includes bibliographical references (p. ) and index. ISBN 978-94-010-6259-6 ISBN 978-94-011-5374-4 (eBook) DOI 10.1007/978-94-011-5374-4

1. Financial institutions--Lawand legislation--North America. 2. Free trade--North America. 3. Financial institutions--Lawand legislation--United States. 4. Financial institutions--Lawand legislation--Canada. 5. Financial institutions--Law and legislation--Mexico. 1. Von Furstenberg, George M., 1941-KDZ260.R44 1997 346.7'0821--dc21 96-52830

CIP

Copyright © 1997 Springer Science+Business Media New York Originally published by Kluwer Academic Publishers in 1997 Softcover reprint ofthe hardcover Ist edition 1997

AH rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher, Springer-Science+Business Media, LLC.

Printed on acid-free pa per.

CONTENTS CONTRIBUTORS VII

PREFACE XVII

ACKNOWLEDGMENTS XXIII

PART!: Sound Finance, Deposit Insurance, and Systemic Risk

1. Sound Finance and the Wealth of Nations -HANS J. BLOMMESTEIN and MICHAEL G. SPENCER 2

2. Lessons for Transitional and Developing Economies from u.s. Deposit Insurance Reform - GEORGE G. KAUFMAN 16

3. Systemic Risk in Banking: Concept and Models -MICO LORETAN 36

PART II: Global and European Approaches to the Powers and Constraints Placed on Banking and Finance Institutions

4. International Agreements in the Area of Banking and Finance: Accomplishments and Outstanding Issues - WILLIAM R. WHITE

5. Regional Financial Integration in Europe: A Blueprint for North America? - BIRGIT HOFER and GEORGE M. VON FURSTENBERG

PART III: International Regulatory Competition: United States and Canada

6. Competition and Convergence of Bank Regulation in NAFTA

48

82

- MICHELE FRATIANNI 126

7. Trade in Financial Services in NAFTA: A Public Choice Approach - JOHN C. PATTISON 144

8. Integration and Globalization of the Canadian and U.S. Banking Industries: A Modest Role for NAFTA? - DANIEL E. NOLLE 158

9. Regulatory Issues Arising from Financial Integration - NICHOLAS LE PAN 168

PARTlY:

CONTENTS VI

U.S. Financial Reform Legislation and the Model for NAFTA

10. The Evolving U.S. Legislative Agenda in Banking and Finance - EDWARD J. KANE 180

11. Financial Conglomeration: Issues and Questions -ANJAN V. THAKOR 194

12. A Financial System that Strengthens Market Forces: What Is Most Needed? - HARVEY ROSENBLUM 210

PART V: Reform of the Mexican Banking System and Its Regulatory, Supervisory, and Payment Relations with the United States

13. Consolidated Supervision of Cross-Border Banking Activities: Principles and Practice in the NAFTA Context -MICHAEL G. MARTINSON 216

14. Mexico's Banking Crisis: Origins, Consequences, and Countermeasures -JAVIER GAVITO, AARON SILVA, and GUILLERMO ZAMARRIPA 228

15. Efficiency and Risk in Small-Value, Cross-Border Payments: The North American Case - JEFFREY C. MARQUARDT, BRUCE J. SUMMERS, and KIRSTIN E. WELLS 246

CONTRIBUTORS

HENDRIKUS (HANS) J. BLOMMESTEIN is a Senior Financial Econo­mist at the Organization for Economic Co-operation and Development (OECD), Paris, France. He is also the CSCE Professor of Economics, Depart­ment of Public Administration and Public Policies, University of Twente, Enschede, The Netherlands.

Blommestein participated as Advisor in many IMF missions to Cen­tral and Eastern Europe and to the former Soviet Union. Before joining the OECD, he served as Deputy Head of the International Monetary Affairs Division of the Netherlands Ministry of Finance and as a personal assistant and advisor to Dr. H. O. Ruding, Chairman of the Interim Committee of the IMF. He has been the Netherlands member of the OECD Committee on Capital Movements and Invisible Transactions (CMIT) and a temporary alternate Member of the Monetary Committee of the European Commission. Prior to that, he held positions as Associate Professor of Economics at the University of Twente, Visiting Professor at the University of Akron, and Visiting Scientist at the Smithsonian Institution.

MICHELE FRATIANNI is AMOCO Faculty Fellow and Professor of Business Economics and Public Policy at the Graduate School of Business of Indiana University in Bloomington, Indiana, U.S.A.

Fratianni has taught at the Catholic University of Louvain, the Universita Cattolica of Milan, the Universita Sapienza of Rome, Marquette University, and the Free University of Berlin. He has been an Economic Advisor to the European Commission in Brussels (1976-1979), Senior Staff Economist with the U.S. President's Council of Economic Advisers (1981-1982), and Advisor to the Italian Ministry of the Treasury, Italian Ministry of the Budget, the Bank of Italy, and the Confindustria. He is the recipient of the Medal of the President of the Italian Republic for scientific achievements (1982), the Pio Manzu Center Gold Medal (1982), the Scanno prize in Economics (1991), and the St. Vincent prize in economics (1992). Fratianni is also managing editor of Open Economies Review and a member of the review board of several economics journals. He is author of 13 books and approximately 100 articles dealing with macroeconomics, monetary eco­nomics, international finance, and public choice.

CONTRIBUTORS

VIII JAVIER GAVITO MOHAR has been Vice Chairman of Financial Analy­

sis and Development of the Mexican National Banking and Securities Commission (Comision Nacional Bancaria y de Valores, CNBV) since 1994.

From 1980 to 1994 he was a Professor at the Instituto Tecnologico Autonomo de Mexico (ITAM), becoming the Antonio Carrillo Flores Profes­sor of Finance in 1990. He was also Head of the Academic Department of the School of Business and Coordinator of the Finance Department of ITAM. Though his interests are broad, several of his most recent articles deal with the development of financial services and institutions and the impact of NAFTA.

Gavito has an M.B.A. with a concentration in Finance from Tulane University.

BIRGIT HOFER has been a Director in the Banking Supervision and Competition Policy Department of the Federal Association of German Banks (Bundesverband deutscher Banken e.V.) in Cologne since 1994. She is in charge of capital adequacy, credit and market risk, and derivatives issues that concern the Association.

From 1988 to 1993 she was a senior analyst, assistant manager, and trainer in the Division of International Credits of Westdeutsche Landesbank in Dusseldorf, Germany, specializing in corporate and bank credit risk and derivatives credit risk analysis. As manager of a special project for Westdeutsche Landesbank, she prepared position papers on the European Commission's Capital Adequacy Directive in 1993-1994. One of her principal responsibili­ties has continued to be the evaluation of bank regulations proposed at the German and European-Union levels and by the Basle Committee on Banking Supervision, whose secretariat is at the Bank for International Settlements (BIS).

Among Hofer's academic credentials are an M.A. in Economics from Indiana University (1987) and advanced studies in international economic policy research at the Kiel Institute of World Economics.

EDWARD J. KANE is the James F. Cleary Professor of Finance at Boston College.

He occupied the Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University from 1972-1992. Previously, he taught at Boston College, Princeton University, and Iowa State University. He has held visiting professorships at Istanbul University, Simon Fraser University, and Arizona State University. He has consulted for the American Bankers Association, the World Bank, and several government agencies, including the Federal Deposit Insurance Corporation, various components of the Federal Reserve System, and the Congressional Budget Office. He is a past president of the American Finance Association and a former Guggenheim

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IX

fellow. Besides authoring three books, he has published widely in profes­sional journals and serves on seven editorial boards. Kane is a member of the Shadow Financial Regulatory Committee and a Research Associate of the National Bureau of Economic Research.

Kane received his B.S. degree from Georgetown University in 1957 and his Ph.D. from Massachusetts Institute of Technology in 1960.

GEORGE G. KAUFMAN is the John F. Smith, Jr. Professor of Finance and Economics at Loyola University in Chicago, where he has taught since 1981.

He was a research fellow, economist, and research officer at the Federal Reserve Bank of Chicago from 1959 to 1970, and has been a consultant to the Bank since 1981. From 1970 to 1980, he was the John B. Rogers Professor of Banking and Finance, and Director of the Center for Capital Market Research in the College of Business Administration at the University of Oregon. During part of this time he also has been a visiting professor at leading universities in California and has served as Deputy to the Assistant Secretary for Economic Policy of the U.S. Treasury in 1976.

Kaufman's teaching and research interests are in financial economics, institutions, markets, regulation, and in monetary policy, and he has published extensively and edited numerous books in these fields. He has served on the board of directors of the American Finance Association (1977-1980), and as president of both the Western Finance Association (1974-1975) and the Midwest Finance Association (1986-1987). He is presently co-editor of the Journal of Financial Services Research and has served on the editorial boards of a number of major professional journals. He has been a consultant to numerous government agencies and private firms, including being a member of the Federal Savings and Loan Insurance Corporation Task Force on Reappraising Deposit Insurance (1983), the American Bankers Association Task Force on Bank Safety and Soundness (1985), the American Enterprise Institute Project on Financial Regulation (1987), and the Brookings Institution Task Force on Depository Institu­tions Reform, whose report was published under the title Blueprint for Restructing America's Financial Institutions (1989). He is co-chair of the Shadow Financial Regulatory Committee, a group of independent banking experts who analyze and comment on economic, legislative, and regula­tory factors affecting the financial-services industry, and he serves on the Steering Committee of the Financial Economists Roundtable. He has testified before Congress on numerous occasions.

Kaufman received his B.A. from Oberlin College (1954), M.A. from the University of Michigan (1955), and Ph.D. in Economics from the University of Iowa (1962).

CONTRIBUTORS

X NICHOLAS LE PAN has been the Assistant Superintendent (Policy),

Office of the Superintendent of Financial Institutions, since 1995, where he is responsible for the Office's input into legislative development, and for the preparation of regulations and guidelines, identification and analysis of both precedents and emerging issues, and various international and Canadian regulatory coordination efforts.

Le Pan has worked for the Department of Finance Canada since 1974. He has been a Special Advisor to the Deputy Minister, Department of Finance, in 1995, leading a task force charged with preparing a government white paper on the supervisory, deposit insurance, and policyholder-protection regime, and securing legislative implementation of its recommendations. From 1987-1994, he was the Assistant Deputy Minister, Financial Sector Policy Branch in the Department of Finance, responsible for regulatory policy affecting feder­ally incorporated financial institutions. This involved leading major legislative reform efforts and the NAFfA financial-services negotiations. In addition, he was responsible for federal debt management, relations with capital markets and various loan guarantee, and project finance efforts. His work continues to include extensive relations with financial institutions and financial market participants in analyzing and developing options and achieving solutions, and close contact with parliamentarians and the policy-making process, and with provincial regulatory bodies.

Le Pan received his B.A. (Hons., 1973) in Economics at Carleton Univer­sity, his M.A. in Economics at the University of Toronto (1974), and he attended the advanced management program at the Canadian Centre for Management Development.

MICO LORETAN has been an Economist at the Division ofInternational Finance of the Federal Reserve Board in Washington, D.C., since 1994.

He was a Visiting Assistant Professor of Economics at the University of Virginia, Charlottesville, from 1993 to 1994 and Assistant Professor of Economics at the University of Wisconsin, Madison, from 1990 to 1993. Professor Loretan's research and publication fields include time-series econo­metrics, mathematical statistics of heavy-tailed distributions, artificial-intel­ligence methods in economic analysis, and applied finance.

Loretan received his Ph.D. in Economics from Yale University in 1991 and his B.A. in Economics from the University of Zurich, Switzerland, in 1984.

JEFFREY C. MARQUARDT is Assistant Director for Payment Studies as well as for Payment System Risk and Net Settlement in the Division of Reserve Bank Operations and Payments Systems at the Board of Governors of the Federal Reserve System in Washington, D.C.

CONTRIBUTORS

XI

Having previously worked in the Division of International Finance, he is now responsible for the Board's payment system risk program and for a variety of special projects dealing with the economic analysis of payment and banking system risk and efficiency. This work has led to service on international working groups responsible for analyzing payment and settle­ment issues in the international financial system, and to providing, in conjunction with the International Monetary Fund, technical assistance on payment-system reform to countries such as the Russian Federation.

Marquardt holds a Ph.D. (Economics) and a J.D. from the University of Wisconsin.

MICHAEL G. MARTINSON has been Assistant Director, Banking Supervision and Regulation, at the Federal Reserve Board of Governors in Washington, D.C., since 1986. He directs the supervision of the foreign activities of U.S. banks and U.S. activities of foreign banks. He also reviews and analyzes the types of activities U.S. banks are permitted to conduct abroad.

Martinson is the Federal Reserve Board's representative on the Inter­agency Country Exposure Review Committee, which is the interagency group that determines the assessment of the quality of foreign debt for bank­examination purposes. In this capacity, he also deals with other issues concerning the country risk exposure of U.S. banks. While at the Federal Reserve Board, he has held the positions of Project Manager, International Activities from 1982-1985, Senior Foreign Banking Analyst from 1978-1982, Foreign Banking Analyst from 1973-1978, and Assistant Review Examiner in 1972. He has also been an advisor at the Institute of Interna­tional Finance in Washington (1985-1986).

Martinson received a Master ofInternational Affairs degree from Colum­bia University and his B.A. from Grinnell College.

DANIEL E. NOLLE is a Senior Financial Economist in the Bank Research Division of the Office of the Comptroller of the Currency, the regulator of national banks in the United States. He is responsible for research and policy advice on international banking and banking structure issues. Current topics include a comparison of banking industry structure, performance and supervision in G-10 and European Union countries, the activities of foreign banks in the United States and U.S. banks abroad, and consolidation and structural change in the U.S. banking industry.

Prior to joining the occ in 1991, Nolle taught international eco­nomics at Middlebury College, Vermont, for four years. Nolle was an Economist at the Federal Reserve Bank of New York from 1984-1987,

CONTRIBUTORS

XII where his work focused on forecasts and analyses of U.S. trade and current account balances, and macroeconomic issues in the G-7 countries. He also served as an economic analyst at the Foreign Exchange Desk of the Federal Reserve Bank in New York. He has published articles on international trade, international finance, the Canada-U.S. Free Trade Agreement, international banking, and banking structure in the United States.

Nolle has a B.A. and M.A. in Economics from the University of Missouri at St. Louis, and a Ph.D. in Economics from Johns Hopkins University.

JOHN C. PATTISON is Senior Vice President, Compliance, at Canadian Imperial Bank of Commerce, where he has previously held positions as Managing Director, CIBC Limited (London, England), and Vice President, Finance. His activities involve managing regulatory risk on a global basis in order to ensure adherence to laws, regulations, and the by-laws of self­regulatory bodies, such as stock exchanges, in accordance with sound corporate governance of CIBC.

Pattison was a faculty member of the School of Business Administration, University of Western Ontario, and an economist at the OECD in Paris, France. His books and articles have been published in Canada, the United States, Switzerland, Germany, Italy, the Netherlands, and the United King­dom. He has been at various times a Director of CIBC subsidiaries in Canada, England, France, the Channel Islands, and Australia.

HARVEY ROSENBLUM has been Senior Vice President and Director of Research of the Federal Reserve Bank of Dallas since 1985. In this capacity he serves as the Chief Economic Policy Advisor to the Bank's president and as Associate Economist for the Federal Open Market Committee, which formulates the nation's monetary policy.

He began his career with the Federal Reserve System in 1970 as an economist with the Federal Reserve Bank of Chicago, advancing through the ranks to Assistant Vice President (1976), Vice President and Eco­nomic Adviser (1979), and Vice President and Associate Director of Research (1983). In addition to his current duties with the Federal Reserve Bank of Dallas, Rosenblum is a Visiting Professor of Finance and Economics at Southern Methodist University, teaching courses in Com­mercial Bank Management, Contemporary Issues in Monetary Policy, and in Financial Institutions and Markets. He also chairs the Business Executives Advisory Council to the Department of Economics of Dedman College, Southern Methodist University, and serves on the Board of Directors of the National Association of Business Economists.

CONTRIBUTORS

XIII

AAR6N SILVA NAVA is Director of Special Projects at the Mexican National Banking and Securities Commission (CNVD), having been its Deputy Director for Development previously.

In 1992-95 he was Deputy Director of Financial Planning at the Ministry of Finance, and he has also been a special lecturer in public finance and financial planning at the National Public Administration Institute (INAP) and at the Latin-American Center for Monetary Studies (CEMLA).

Silva has two bachelor's degrees, in Accounting and Economics, from ITAM.

MICHAEL G. SPENCER has been an economist in the International Monetary Fund since 1990. He is currently in the Emerging Markets Studies Division after having served for five years in the Capital Markets and Financial Studies Division.

At the IMF he has contributed to the International Capital Markets reports, which have examined the 199211993 European Exchange Rate Mechanism crisis, asset-quality problems in the Japanese banking sector, the Mexican devaluation of 1994 and its aftermath, and developments in international banking supervision and regulation. He has published re­search papers on dynamic hedging and the interest rate defense of a fixed exchange rate, the financial sector impact of capital flows to emerging markets, financial sector reforms in transition economies, currency reform, and exchange rate target zones.

Spencer holds a Ph.D. from Queen's University at Kingston, Ontario, Canada.

BRUCE J. SUMMERS is Senior Vice President and Chief Financial Officer of the Federal Reserve Bank of Richmond. He is responsible for all the Bank's credit-granting activities, reserve accounts, accounting and con­trol, financial planning, and the Community Affairs Department.

Since joining the Reserve Bank as an economist in 1974, Summers has held a number of official positions in various operating departments of the Bank. He served as the Federal Reserve's first Electronic Payments Product Manager from 1983 to 1987, and in 1989-1992 was Deputy Director of the Division of Reserve Bank Operations and Payment Systems at the Board of Governors of the Federal Reserve System in Washington, D.C. While at the Board, he was responsible for payment-system policy development and for overseeing the banking operations of the twelve Federal Reserve Banks. Summers has participated in a number of international banking initiatives of the G-1 0 central banks through their committees, which meet at the Bank for International Settlements in Basle, Switzerland. He continues to be engaged in collaborative efforts with the International Monetary Fund, the World Bank, and the Russian-American Bankers Forum, aimed at reform of the

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financial and banking systems of emerging market economies. Summers has written extensively on payment-system matters and is the editor of The Payment System: Design, Management, and Supervision, published by the IMF in 1994.

ANJAN V. THAKOR is Edward J. Frey Professor of Banking and Finance in the Department of Finance of the University of Michigan Business School.

He was previously NBD Professor of Finance and Chairman of the Finance Department at the School of Business, Indiana University, Bloomington. He has also served on the faculties of Northwestern University and UCLA. His research and teaching interests are in corporate finance and financial inter­mediation. He has published over 70 research papers and monographs on a variety of issues, including regulation of financial institutions, deposit insurance, loan commitments, securitization, credit rationing, security de­sign, capital structure, dividend policy and stock repurchases, and corporate capital allocation decisions. His papers have appeared in leading academic journals, and he has co-authored a textbook, Contemporary Financial Intermediation, with Stuart Greenbaum, which was recently published by Dryden Press. Thakor is an editor of The Journal of Financial Intermedia­tion and an associate editor of The Journal of Banking and Finance, The Journal of Financial Research, Financial Management, and The Journal of Small Business Finance. He has taught at the undergraduate, M.B.A., and Ph.D. levels and has won teaching awards. He is experienced in executive education and corporate consultancy.

Thakor obtained his Ph.D. degree in Finance from Northwestern Univer­sity in 1979.

GEORGE M. VON FURSTENBERG, contributing editor to this volume, is Rudy Professor of Economics at Indiana University, Bloomington, special­izing in macroeconomics and international finance.

Several years of work at the International Monetary Fund (Division Chief, 1978-1983) and at various U.S. government agencies, such as the Department of Housing and Urban Development (HUD, 1967-1968), the President's Council of Economic Advisers (Senior Economist, 1973-1976), and the Department of State (1989-1990), have alternated with his academic pursuits. In Washington, he has also been a resident fellow, economist, or advisor at both the Brookings Institution and the American Enterprise Institute. A prolific writer, his current work assesses how international capital movements and domestic financial infrastructure can affect eco­nomic growth, stability, and efficiency. As first holder of the Bissell-Fulbright Professorship in Canadian-American Relations at the Centre for Interna-

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tional Studies, University of Toronto (1994-1995), he started a research program on monetary union and financial integration in North America. This is the program from which the May 16-17, 1996, Toronto conference on "Monetary and Financial Integration in an Expanding (N)AFTA," which yielded this volume, ultimately resulted.

von Furstenberg'S Ph.D. in Economics is from Princeton University (1967).

KIRSTIN E. WELLS is currently a Financial Services Analyst in the Payments System Risk Section of the Division of Reserve Bank Operations and Payments System at the Federal Reserve Board of Governors in Washington, D.C. In that capacity, she is respc:msible for conducting research and participating in policy matters regarding risk in large-dollar payments systems and assisting the Federal Reserve Banks in implementing the Board's payments system risk policy.

Wells began her career in the Federal Reserve system as a Statistical Analyst at the Federal Reserve Bank of Chicago, analyzing data collected from depository institutions that are used in the construction of the mon­etary aggregates. In 1991, she joined the Financial Reports Section at the Board of Governors, and in 1993, she moved to the Payments Division.

Wells has an M.A. in Economics from Virginia Polytechnic Institute and State University.

WILLIAM R. WHITE has been Economic Adviser and Head of the Monetary and Economic Department of the Bank for International Settle­ments (SIS) in Basle, Switzerland, since 1995, after having been appointed Manager of that Department in 1994.

From 1969-1971, he worked at the Bank of England as an economist, joining the Bank of Canada in 1972. During his first six years at the Bank, he worked with the Department of Banking and Financial Analysis, first as an Economist and finally as Deputy Chief. In 1978 he was Deputy Chief of the Research Department becoming Chief of the Department in 1979. White was appointed Advisor to the Governor in 1984 and Deputy Governor of the Bank of Canada in September 1988. In that last position, his responsibilities included the analysis of international economic and financial developments, and operational matters pertaining to the Bank's activities in foreign ex­change markets.

White received a Bachelor of Economics and Political Science Degree (Hons.) from the University of Windsor in 1965 and was also awarded the Governor-General's medal. He then attended the University of Manchester

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on a Commonwealth Scholarship, where he earned both an M.A. and a Ph.D. in Economics (1969).

GUILLERMO ZAMARRIPA ESCAMILLA is General Director of Devel­opment and Economic Research at the Mexican National Banking and Securities Commission, CNBV, having been its General Director of Develop­ment previously.

He has written on financial and economic topics, among them "Deregu­lation and Privatization of Commercial Banking," published in 1995. Among his professional activities, he has been an auditor at KPMG Peat Marwick, an economic and financial analyst at Valores Finamex, S.A. de C.V., a brokerage house, and comptroller at S.D. Indeval, S.A. de C.V., the central securities depository of Mexico. He been a Professor of Economics and Finance at ITAM since 1989 and has taught there on a part-time basis since 1994.

Zamarripa earned an M.B.A with a specialization in Finance from the University of Chicago. His bachelor's degrees, in Economics and Account­ing, are from ITAM.

PREFACE

Since the North American Free Trade Agreement (NAFTA) took effect at the start of 1994, production and trade in goods and services have become ever more integrated in the region. Banking and financial systems thus also must increasingly inform, adjudicate, transact, invest, insure, and intermedi­ate all across North America. Presently, however, there is no single, or up­to-date source of information on the banking and finance systems of the current NAFTA countries-Canada, the United States, and Mexico.

Relying on top specialists from international financial organizations, central banks, regulatory authorities, and universities, this and a companion volume together bridge that information gap. The focus is not just on description but on regulatory and institution-building challenges posed by the opening up of domestic financial markets, and on the political economy of reforms. The ultimate goal is to enhance the process of safe and efficient integration by policies, regulations, and private initiatives that contribute to the welfare of people in North America and beyond.

This volume goes into essential detail in assessing banking and finance regulations, supervision, and prudential and operating standards in the NAFTA countries in a global context.

The present volume thus is more specialized-less descriptive and more analytical-than its companion, entitled The Banking and Financial Structure in the NAFTA Countries and Chile. While that volume provides much-needed background information on the past and prospective evolution of banking and financial systems within the economies of these countries and on the basic policy options being debated in each, the present volume goes into specifics of laws, regulations, and operations. It thus addresses issues such as the fairness of national treatment accorded to foreign financial institutions, regulatory competition between agencies and system approaches, and the efficiency effects of financial conglomeration. There is an underlying concern with the control of systemic risk and moral hazards that arise in the financial sector, as well as in the payment and settlement system, and from deposit insurance.

While many of the issues are quite technical, they bounce about in the domestic political arenas of NAFTA countries who face issues of competition and harmonization of standards between them and with the rest of the world. NAFTA has intensified trade relations in North America. And it is true that finance and capital movement invariably accompany, and often pre-

PREFACE

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cede, investment, production, and purchase planning that leads to trade in goods and services. Yet the agreement itself has done relatively little to advance regional financial, regulatory, or supervisory integration directly. Rather, each country has tried to reform existing laws and institutions to meet the global competition in increasingly open financial markets.

In view of the interplay of global standards and national politics, this volume gives an overview of global and European-Union (EU) approaches to sound finance (Parts I and II) before taking up regulatory competition and harmoniza­tion within and between the NAFTA partner countries (Parts ill to V).

GLOBAL PRINCIPLES OF FINANCIAL INTEGRATION

There are two basic ways of analyzing the contributions of banking and finance to economic development. One is positive and oriented toward growth. The other is negative or preventative; it is concerned with stability and the avoidance of major crises. The positive approach investigates how various indicators of financial deepening, and the building of financial intermediary structures and institutions correlate with improved efficiency and economic growth. The negative approach examines whether the finan­cial system is adequately fortified against becoming either a major source or propagator of economic crises.

The growth approach is well represented by Blommestein and Spencer's lead article, but the emphasis in the other articles of Part I is on crisis prevention. Disturbances, both external and internal to the financial sector, can go so far as to give rise to systemic risk, disrupting the chain of payments and settlements. In addition, financial institutions may choose to live danger­ously when given the wrong incentives. Kaufman shows how early problem detection and reporting, leading to structured early intervention, corrective action, and least-cost resolution by the regulators, can keep problems from building up until they reach fiscally or even macroeconomically disturbing proportions. By contrast, a poorly designed, implicit insurance system that lets banks assume that their deposits, perhaps even their institution, are covered, perversely encourages banks to take actions that increase fragility.

Loretan searches for a definition of systemic risk that is based on catastrophic consequences of behavior or regime change in a gathering crisis. In a fully rational world with complete information, a low-probability catastrophic event that could be insured against by taking certain costly actions would surely be covered by insurance if financial markets were complete and costs were interpreted as infinite should such an event occur. But instead of dismissing the problem by defining it away, Loretan searches

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for micro-foundations in bounded rationality that allows for contagion effects and changes in behavior and decision rules. Such changes can turn an isolated set of events into a series of disastrous actions leading to systemic crisis. For an operational definition of systemic risk, Loretan settles on the possibility that an unexpected withdrawal of deposits-a funding shock, whatever its cause­cannot be covered by the banking system as a whole. Dynamic decision-rule simulations then need to determine whether there is a realistic model that includes the possibility of a systemic crisis as an event that, while extremely rare, cannot safely be dismissed from policy consideration.

Part II establishes a record of what international agreements in the area of banking and finance have accomplished and surveys the most urgent unfin­ished tasks ahead. This is done by White from the vantage point of the Bank for International Settlements (BIS). Through its secretariat for the Basle Committee on Banking Supervision, the BIS develops proposals and initia­tives on behalf of the Group-of-Ten (G-lO) countries that playa leading role in setting the institutional, regulatory, and competition parameters of the international financial order. The G·I0consists of the Finance Ministers and central bank Governors of the better known G-? countries plus Belgium, the Netherlands, and Sweden, and, since 1984, Switzerland. As functional, institutional, and geographic barriers to financial activities have continued to shrink, the Basle Committee has begun to forge ties with securities regulators and insurance supervisors of the G-lO countries to cope with financial conglomeration and internationalization.

The second paper in Part II, by HOfer and von Furstenberg, focuses on regional financial integration in the European Union and what lessons it may hold for NAFTA down the road. It compares two sets of countries at different stages of development, Poland in relation to Germany and its international currency (DM, then Euro), and Mexico in relation to the United States and the U.S. dollar. Drawing in part on EU directives for financial institutions and activities, the study recommends convergence of institutions, supervision, and regulations to a common model-and perhaps monetary union-to help overcome some of the financial instability and the high currency risk faced by countries that are saddled with a low-credibility currency.

A COMPATIBLE FINANCIAL FRAMEWORK FOR THE NAFTA COUNTRIES

Financial integration is most secure between countries if regulatory competition is subject to clear parameters. Agreement on common minimum standards and entitlements in each other's market can help prevent market

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XX

failures. Without harmonization, giving foreign institutions "national treat­ment" by subjecting them to the same rules as domestic institutions can be highly discriminatory. In Part III, Fratianni and Pattison note that since banks in the United States face higher regulatory burdens than in Canada, Mexico, or the European Union, the host-country principle of national treatment is not comparable to reciprocal treatment. Fratianni recommends the home-country principle, already applied in the EU, to speed the process of financial integration. According to that principle, the home-country authorities regulate the financial institutions they have licensed regardless of where they operate. If these regulations meet the minimum common standards agreed to, national regulatory standards are mutually recognized. As each country seeks to level the playing field with entitled actual or potential entrants, competitive forces produce a process of convergence of national regulations.

The contradictory urges of wanting to do much financial business in and for foreign markets while denying foreigners reciprocal opportunities at home lie at the heart of the political economy of regulation explored in Part III, particularly in and between Canada and the United States. Using a public­choice approach, Pattison points to the disproportionate representation of small banks in the United States to explain the dense tangle of financial regulations and barriers to entry. Nolle appraises some of the results for the presence of Canadian and U.S. banks in each other's market and concludes that the direct impact of any liberalization of trade in financial services appears to have been modest. Le Pan focuses on the influence of financial integration on regulation rather than the other way around. A greater demand for regulatory cooperation and reliance among partner countries and for more effective international rule setting are among the effects.

The U.S. legislative agenda comes into even more distinct focus in Part IV, led by Kane's paper. Shining a strong light into the crevices of regulations and judicial exemptions, he finds both stalemate on the main legal front of banking legislation and strong movement on some unprotected flanks. For instance, he notes that the 1996 Telecommunications Act makes banks freer to sell data-processing services and makes telecommunications firms freer to offer, on their open networks, financial services whose production and delivery do not require a bank or thrift charter.

Business-powers issues-the types of trust, securities brokerage, under­writing, insurance, and pension fund business banks can get into and in what form of corporate organization, ownership, and capitalization-are often viewed as more a matter of domestic interest-group politics than of eco­nomic substance. Rosenblum shares this view as long as market forces are

PREFACE

XXI

allowed to surpass regulatory forces and the benefits of foreign competition are not denied. After all, the fact that a particular type of organization may not extend its operations to a particular type of business need not imply that this kind of business does not get done efficiently, provided there is compe­tition from other actual or potential entrants.

However, Thakor's chapter in Part IV shows that this competition has often been restrained in the past. For instance, for many decades, the regulatory structure in U.S. banking encouraged the building of overcapacity. Then when capital-market innovations started to take both borrowers and savers away from banks and interstate branching restrictions were lifted, banks sought to merge and to expand the scope of their activities to protect profits. Thakor sees U.S. banks as poised to enter the phase of "expansion of scope and overreaching" as they press into lines of business for which they may not have an efficiency or information advantage. The search for the optimal competitive organization and regulation of the financial sector is therefore continuing, with failure to adapt potentially more costly than unsuccessful experiments in this area.

Part V focuses on regulatory and bank-supervision matters of concern to Mexico and the United States. Martinson assesses supervisory issues arising from cross-border banking activities and foreign establishment and how they are handled between the regulatory bodies of the two countries. Gavito, Silva, and Zamarripa explain what Mexico itself is doing to strengthen bank supervision and regulation in the wake of the recent disasters. Marquardt, Summers, and Wells, finally, document the unsatisfactory state of payments and settlement relations between Mexico and the United States, especially for check clearing and small-value payments. Financial integration with Mexico obviously still has a long way to go before it comes down to people.

The poorly organized and costly settlement and collection of small-value claims across the U.S. border with Mexico remind us that finance and banking are the brains of the economy, and payments and settlement its life blood. If the banking system cannot achieve prompt finality of settlements across borders, or hold down systemic risk at low cost, a tax is imposed on cross border transactions just as surely as if tariffs between NAFTA partner countries had never been removed. An efficient and robust financial infra­structure thus is vitally important.

ACKNOWLEDGMENTS Three groups have contributed most to the success of the 1995-1996 research and

conference program that is reflected in the present volume and in the companion volume, entitled Integrating Economies: Banking and Finance in the NAFTA Coun­tries and Chile:

The home institution, Indiana University, particularly the Department of Eco­nomics, the Center for International Business Education and Research (CIBER) of the Indiana University School of Business directed by Professor John D. Daniels, and the Dean of International Programs, Professor Patrick O'Meara;

The host institution, the Centre for International Studies (CIS) of the University of Toronto, chaired by Dr. Sylvia Ostry and directed by Professor Leonard Waverman;

The remaining sponsors, among them two foundations and three members of the financial and legal services industry:

• The German Marshall Fund of the United States, Peter R. Weitz, Director of Programs;

• The Tinker Foundation, New York, Nancy Sherwood Truitt, Senior Advisor; • The Canadian Bankers Association, Helen K. Sinclair, past President, and

Shawn S. Cooper, past Vice President; • Tory Tory DesLauriers & Binnington, Toronto, James C. Baillie, Senior Partner

and Chair of the Executive Committee, and Sidney P. H. Robinson, Senior Partner; • Royal Bank of Canada, Bryan P. Davies, Senior Vice President, Corporate

Affairs, and Dr. John McCallum, Senior Vice President and Chief Economist.

The Federal Reserve Board of Governors in Washington, the Federal Reserve Banks of Dallas and of Richmond, the Bank for International Settlements in Basle, and the Banco Central de Chile kindly contributed by letting high-level staff participate without cost to the organizers.

Special and most sincere thanks from the editor go to five more people:

Dr. Edward P. Neufeld, who advised and helped with the design and financing of the research and conference project in crucial ways from the start and also contrib­uted importantly to the companion volume.

Professor Edward J. Chambers of the University of Alberta, editor of the North American Journal of Economics and Finance, who allowed me, as special editor, to publish separately a series of project-related studies, concentrating on the payment and settlement systems of the NAFTA countries, in the Fall 1996 (vol. 7, no. 2) issue of his journal.

Mary Lynne Bratti, the conference secretary at CIS, who did an unfailingly outstanding and dedicated job with all the arrangements and as liaison to all the international participants.

Stephanie G'Schwind, style editor, and Mary J. Blizzard, designer/compositor, who worked very hard to make this volume a masterpiece.