Licensing banks: still necessary?

Lecture by Tommaso Padoa-SchioppaMember of the Executive Board of the European Central BankWashington D.C., 24 September 1999

TABLE OF CONTENTS

I. INTRODUCTION

1. Financial and technological innovation is fostering competition in the supply of services once provided only by banks. Both facts and ideas are moving towards an erosion, if not an abandonment, of the "licensing principle". The entry of new players in the business of supplying bank-like products and the increasing reliance on electronic channels for their distribution is challenging the belief that strict controls over entry into the banking business are really needed.

Two different mottos are currently creeping into the debate. The first, "no regulation", views technological developments as depriving banks of their special features. It implies that no specific dividing line should be drawn between banks and other corporations, so that any entrepreneur should be left free to enter the market without any public regulation and/or safety net influencing his/her behaviour and ability to innovate. The Cato Institute, together with George Benston and George Kaufman, can be taken as champions of this line of thought. The second motto, "let things happen", can perhaps be inferred from the words of no less influential a person than Alan Greenspan: "Government action can retard progress but almost certainly cannot ensure it" and "…our regulatory roles are being driven increasingly toward reliance on self-regulation similar to what emerged in more primitive forms in the 1850s in the US". According to this view, the rationale for bank regulation should not prevent the private, non- banking sector from trying out new solutions, with a greater role to be played by self-regulation. Both mottos suggest that a new free banking era seems to lie ahead of us.

2. In this lecture, I shall argue that the licensing principle should be both restated and strengthened. It has to be restated in order to limit as much as possible public interference in the process of financial and technological innovation, and to ensure that end users will enjoy the full potential benefit of the process. However, it has also to be strengthened and implemented on a global scale in order to preserve the ability of our financial architecture to deal with systemic tension and to ensure competitive equality among market participants.

At this point I should like to summarise, and anticipate, my conclusion in the following way: a regulatory approach mindful of the public interest at stake and friendly to market calls for a combination of two elements. First, reserving for licensed and supervised institutions the core banking activity, which I perceive as the provision of liquidity on demand, allowing for both credit and debt positions. Second, refraining from placing any binding constraint on the range of activities that these institutions are allowed to perform.

I shall begin this lecture by examining events and conceptual developments relating to increased non-bank involvement in the activities traditionally dominated by banks. I shall then discuss the arguments which support the special role of bank licensing. After that, I shall try to define what constitutes the essence of banking, which should remain licensed, and I shall discuss the appropriate scope of other permissible activities for licensed banks. At the end, I shall explore the options for maintaining viable bank licensing.

II. FACTS AND IDEAS

3. Traditionally, banking has been seen as a cluster of products and services, whose joint supply implied taking a set of different, but tightly bundled, risks. Deposit-taking and the provision of payment services have generally been considered as a fundamental element of banking activity. Moreover, the ability to meet the financing needs of a wide variety of customers, through day-by-day contacts enabled by a network of branches, has long been interpreted as a special feature of banking organisation. Now, we are being increasingly driven by financial innovation and technological change in a world in which such long-standing pillars no longer seem to hold. A number of events demonstrate the entry of non-banks into the business of supplying banking services and the revolutionary change in the features of the network. An evolution of ideas and attitudes has paralleled the factual developments.

4. Looking at the assets side first, we see that new financial contracts (such as derivatives) or modifications of traditional contracts (such as securitised loans) have allowed financial intermediaries to unbundle products and risk profiles that were previously found on the bank balance sheet. While bank loans can be embodied in securities and exchanged in organised markets, credit and market risks can be traded separately from their underlying assets. The traditionally strict correspondence between the type of financial contract, the type of risk and the type of institution managing it has become more and more blurred. Relevant portions of what was previously considered core banking business are now disentangled from banking and can be found in a much larger set of institutions. The evolution of credit derivatives and asset-backed securities, particularly in the United States , provides examples of new ways to disentangle and trade credit risks. As another example, the French Fonds communs de créances sell units of a composite portfolio of bank loans, thus separating illiquid assets from sight or very short-term forms of funding, such as deposits.

5. Turning to the liabilities side, we see that deposit-like products are increasingly supplied by non-banks, which in many cases also provide payment services. Money market mutual funds are just one example. In many countries they offer an explicit or implicit par value clause, so that the subscriber is sheltered from adverse market movements. Furthermore, even if the fund needs to rely on a bank to provide cheque-writing and payment services, its products are increasingly perceived as strict substitutes for banking services. These institutions cannot, as far as I know, open credit lines or supply funding facilities to customers. It is not too difficult, however, to think of complex financial contracts, incorporated in negotiable securities, that would deliver the same service. While money market mutual funds are generally subject to detailed regulations, listing precisely the type of securities in which they can invest, there is nothing preventing a de facto supply of banking services. I therefore tend to agree with Ernest Patrikis' view that they should be viewed as "over-regulated, under-supervised banks with no capital”.

Another development pointing in the same direction is that of non-financial companies, such as supermarkets or department stores, supplying accessory financial services to increase the attractiveness of their basic business. The cards and the credit facilities offered by such companies are one example of how it has become possible to move into areas of deposit- like products together with payments services and overdraft facilities.

6. The event that poses the greatest challenge to the licensing principle is perhaps the diffusion of non-bank means of payment and settlement. Even though payment instruments and the service of settling transactions by transferring assets are still predominantly supplied by banks, no major technical obstacle prevents the future entry of non-banks into this market. Electronic money, used for either face-to-face or Internet transactions, has materialised in the two forms of closed and open circulation. While with closed circulation the (electronic) money always returns to the issuer after use, with open circulation holders use it to settle an indefinite array of transactions, very much as happens with notes and coins. The main difference between the two arrangements concerns the frequency and value of settlement, which is greatly reduced under open circulation. However, in both cases the issue of electronic money by non-banks challenges the role that banks have traditionally played in providing payment instruments and final settlement of transactions. In some countries in the European Union (the United Kingdom , Finland and Luxembourg ), and in the United States , electronic money is currently also issued outside the banking system. Closed circulation is adopted in many national electronic money schemes, while the

Mondex scheme is a paramount example of open circulation, one that could suddenly spread if it finds favour with the public.

7. In some countries the flourishing of finance companies also seems to contribute to the blurring of the distinction between banks and non-banks. On the assets side, finance companies act as a sort of specialised credit institution, often supplying short-term funding to the corporate sector. As for the liabilities side, while this used to consist mainly of own funds, bank loans and commercial paper, more recently newer and newer funding instruments have been developed. The survey of finance companies conducted by the Federal Reserve shows, for instance, that by 1996 such traditional liabilities only accounted for 33.7% of the total (49.5% in 1990), while "debts not elsewhere classified" amounted to 39.3% (32.3% in 1990). The growth of new sources of financing is of course a positive sign of innovative capabilities, and probably the bulk of these liabilities comprises medium-term notes and asset-backed securities. However, once again, these developments seem to foreshadow a scenario in which finance companies come very close to carrying out full-blown banking activity.

8. Last but not least, the revolution in the network. The traditional branch is no longer the only place where the bank meets its clients. Customers are increasingly able to access financial services electronically, via computers, mobile telephones and the television. For the bank, the geographical location of the premises gradually becomes irrelevant, and economies of scale are dramatically increased due to the size of capital investments required to keep pace with technology and to provide adequate security.

Today banks outsource some of their activities to technology companies, in order to fully exploit the opportunities offered by electronic access. Such companies are gradually developing the infrastructures and the skills that could be used to offer banking services autonomously. At the end of this path, it is quite possible that the master is replaced by the servant, as the latter has superior technological skills, the control over the means of electronic access, and is not burdened by the cost of entertaining both a branch and an electronic infrastructure. Firms supplying and controlling access to the Internet (such as Yahoo, Excite and Microsoft) can significantly drive future market developments.

In addition, the so-called customer relationship, i.e. the special assistance that can be provided to customers thanks to the intimate knowledge developed through repeated contacts, can no longer be considered a distinctive feature of traditional banking. There are already fields of electronic commerce in which sophisticated data-processing capabilities have been developed to the point of allowing the service supplied via the Internet to be personalised. The customer is recognised, and he/she is offered a menu of choices based on his/her preferences.

9. Do these factual developments point at a gradual disappearance of the traditional notion and organisation of the core banking activity, namely, as I have said, the provision of liquidity on demand, allowing for both credit and debt positions? I would argue that this is indeed the case. The very term "non-bank banks", that is currently used in the debate, signals that full coincidence between the set of activities performed and the licence granted has already been disrupted.

There are already non-bank institutions that actually or potentially provide core banking services or their close substitutes, but I recognise the main counter-argument that, still, the liquidity provision function is dominated by banks. This is not, in my view, the main point, however. Of course, the non-banks still rely largely on the provision of liquidity by a licensed bank, because this entity has access to central bank liquidity. However, the crucial point is that this licensed entity can be very small in comparison with the activity as a whole, since the "laws of large numbers and netting" mean that the final settlement need can be only a small fraction of the entire customer credit and debt positions. Hence, this small entity can support a large amount of non-licensed, de facto banking services. This practice is already quite significant, and the public perception is that core banking services are produced by non-bank entities. I will return to the implications of this issue later on.

10. Not only facts, but also ideas are challenging firm adherence to the licensing principle. The conviction that we are heading towards an unregulated industry for banking services, where every individual or company can freely enter the market and supply any type of financial contract without undergoing special supervision, is starting to spread. Since Bill Gates identified branch banking with dinosaurs, many have foreseen a future in which banks, especially the smaller local and traditional ones, are driven out of business by unfettered competition from companies which fully exploit the new technological opportunities for efficient collection, management and transmission of information.

11. As I have said, two types of liberal attitudes are developing. Let me examine them briefly.

The extreme supporters of the "no regulation " motto think that there is no longer any special feature that distinguishes banks from other financial companies or, for that matter, from any commercial firm. Hence, they suggest that the licensing principle should be abandoned together with the extensive public regulation and the safety net.

This new generation of free bankers often refers to the experiences of the 19 th century as a model for the future evolution of the banking system. In doing so they seem to neglect the fact that in the actual experiences of free banking the special nature of banking had always been recognised. Even though no specific licensing requirements were in place, specific rules concerning the responsibility of owners in case of insolvency, the need to deposit securities with a state agency, and sometimes even capital and reserve requirements were adopted.

A less extreme version of the "no regulation" motto is adopted by those who advocate a re-evaluation of some successful free-banking experiences, such as those of Scotland and of some States of the American Union . From this standpoint, historic free banking can help to provide an understanding of what may happen when financial and technological innovation erases the exclusive role of central banks as suppliers of high- powered money. Mervyn King has recently argued that due to developments in computing power and electronic transfers of wealth "there is no reason ... why final settlement could not be carried out by the private sector without the need for clearing through the central bank". Moreover, in a world of competing private payment instruments, very much resembling a pure exchange economy, there is no room for a monopolist, i.e. the central bank, to decide who should be allowed to access the business.

12. A more pragmatic approach follows the "let things happen" motto. This approach focuses on the risks of regulatory interference in the innovation process. Followers of this approach seem to be enjoying growing support for the idea of letting new products and distribution channels develop freely and of relying as much as possible on the ability of market participants to adopt self-regulation. In order not to distort private incentives, so they say, public regulation should be seen as an ex post intervention, to be activated only if and when systemic problems arise. In Alan Greenspan's view "the private sector will need the flexibility to experiment, without broad interference by the government". Therefore, non- banks should be allowed to devise new solutions and to compete with banks as far as possible, without strict implementation of the licensing principle.

III. WHY LICENSING?

13. At the end of the path foreshadowed by these facts and ideas bank licensing would vanish. It is somewhat surprising, to my mind, that public debate, in both academic and political circles, has so far devoted only limited attention to a careful appraisal of the advantages and disadvantages of this ultimate implication. In order to appreciate whether it is desirable to advance further towards such a situation, let me turn from the facts and ideas working towards an erosion of the licensing principle to the arguments in favour of firmly preserving it.

14. In order not to be misled about the direction that public regulation and supervision should take, we must first understand whether current trends are really altering the peculiar position of banks in the financial system, or simply offering new and more efficient tools for accomplishing a basically unchanged function.

15. Ideological disputes, in which free traders and supporters of public intervention are set against each other, do not help when addressing this issue. As a matter of fact, I am convinced that the regulatory framework that has gradually developed in the last ten to fifteen years is not so distant from the "historic free banking" experiences. As I have already mentioned, in those experiences the special nature of banking activity was also widely recognised as a rationale for their specific regulation. The key instruments then introduced to limit the effects of bank failures were not so far away from present ones.

In historic free banking banks were generally required to deposit high quality bonds as collateral to redeem their liabilities at par value in case of difficulties. This constituted a sort of compulsory insurance aimed at protecting note holders, much along the same lines of present deposit insurance arrangements. Another pillar of free banking regulation was some form of unlimited, or partially limited, responsibility of bank shareholders. These arrangements stemmed from the acknowledgement that bankers have incentive to gamble with depositors' money, especially when business perspectives start to look bad, since limited responsibility would protect them from excessive losses. Modern capital requirements accomplish the very same function, aligning the incentives of bank owners and managers with those of shareholders and ensuring that a sufficient buffer of own funds shelters the bank from unexpected losses.

Of course, the difference, certainly not an irrelevant one for the purpose of this lecture, is that in historic free banking entry in the market was not regulated, and banking institutions had no access to the liquidity support of central banks.

However, if we take a closer look at the free banking experiences, we see that in many cases private arrangements have spontaneously emerged to fulfil the same function. To economise on liquidity needs and to cope with liquidity strains, associations were frequently created (clearing houses) to clear cheques and provide emergency liquidity assistance to members. These associations extended membership only to banks with an adequate capital and required an admission fee. They monitored the behaviour of their members through regular audits, used sanctioning powers on imprudent behaviour that was damaging to other members, and had the power to expel members. Thus a sort of procedure of "licensing plus supervision plus liquidity support" emerged as a natural device to cope with the typical problems encountered by banks because of their special role.

The problem with these club-type arrangements was that, being collusive in nature, they artificially created a tiered system ranging from first class banks running the clearing house, then other minor members, to the "underworld" of non-members. Hence, as Fred Hirsch, for example, has argued, in a system without a central bank there seems to be a tendency towards concentration and an oligopolistic structure, which can generate anti-competitive behaviour. Furthermore, the high number of cases in which the suspension of convertibility had to be declared indicates that their ability to cope with major liquidity needs in times of stress was limited. Thus the advent of public involvement in the licensing process was a way of preserving the function of the clearing houses, while amending the drawbacks arising from their private nature.

The licensing principle emerged historically as a fundamental tool to identify the institutions that were granted access to the liquidity support of central banks. This evolution gradually produced a layered financial architecture, a sort of pyramid with the central bank at the top, licensed banks subject to specific regulation on the next level down, and other financial, non-supervised institutions one further level down. Thanks to this organisation, the financial system proved increasingly able to take up a greater amount of risks, while limiting the scope of systemic disturbances.

16. It is true that in the aftermath of the crises of the 1930s banking legislation was redesigned to help to establish an oligopolistic structure in which a sufficient generation of extra profits would cushion the industry from losses. Moreover, a variety of public goals were pursued, heavily influencing the allocation of credit and the structure of the financial system. The ample reliance on conduct regulations, such as price and interest rate controls, credit ceilings, restrictions in the set of permitted activities, and limits to branching seriously affected the business opportunities of financial institutions. In most countries these controls involved an external assessment of the needs of the markets and a sort of social planning that impaired competition and artificially raised banks' charter values.

We now know that in the long run this approach proved costly and inefficient, and also proved to be increasingly ineffective, as market participants found ways to circumvent restrictions. However, in recognising the drawbacks of past regulatory approaches and amending their inefficient components we should be very careful not to lose other components the validity of which remains intact. We should not, as the saying goes, throw the baby out with the bath water.

17. Very recent experiences show that, notwithstanding the impressive progress that we have recorded in financial practice, systemic crises are still a real threat. The development of new instruments, such as OTC derivatives and structured notes, has greatly increased the ability of financial institutions to leverage up capital positions. The episodes involving highly leveraged institutions, like LTCM, and more generally the disturbances that took place last year after the Russian crisis, show that high leverage may well exacerbate the adverse impact of a shock.

In the aftermath of the most recent crisis, many observers have advocated an extension of regulation and supervision, and a specific licensing procedure for highly leveraged non-bank institutions. Others have taken the view that banks, as licensed and regulated "core" intermediaries, can deal with the problems posed by highly leveraged institutions, supplying liquidity when needed and carefully monitoring their non-bank counterparts. Without going into the details of this debate, it seems clear that it has confirmed the need for a regulated and supervised set of institutions.

Plenty of examples show that adverse movements of financial market prices have determined stress at non-bank financial institutions, with the banks acting as lenders of next-to-last resort to channel liquidity where it was most needed. This is exactly what gives banks a special position in the financial structure and explains why bank stability is so relevant.

If we look back to the episodes of turbulence of the last decade, a striking regularity is that difficulties assumed systemic relevance only when and where the banking system was fragile. When a turbulence arose outside the banking system it could be managed if banks were in a position to support the liquidity needs of other intermediaries, letting those that were insolvent face their own destiny and countering the risk of the whole market collapsing. Crises not involving banks or a disruption of the monetary process, what Anna Schwartz has called "pseudo crises", have had few systemic implications. The collapse of the junk bond market or the standstill in the commercial paper market, to give just two examples, did not jeopardise the overall functioning of the financial system. When, instead, the banking system itself comes under strain, we still face a strong need for public intervention.

There is thus a unique role to be played by the central bank. Indeed, only the central bank can act as the ultimate provider of liquidity because commercial banks and the banking system may in certain circumstances become unable to generate liquidity. Whether they are due to unexpected shocks or to a co-ordination failure in the interbank market, circumstances may arise in which the insurer cannot be a private agent since they cannot generate unlimited funds.

18. If the licensing principle were abandoned or seriously eroded, public regulation and supervision would not survive. The organisation of the financial system around different levels of institutions, with the central bank providing ultimate insurance against the risk of meltdown, would be put at stake. One of the very foundations on which market economies have prospered for about a century would be undermined and the resilience of such economies to serious financial stress would again become doubtful.

When a central bank grants access to its liquidity, it has the option of screening the eligible institutions and, hence, of limiting the "second level" liquidity provision to the licensed banking system. This means that the central bank has another "key to the door", so that it could even maintain stricter principles than the regulators when they grant a bank licence. However, this is not enough if much of the de facto banking activity is in the non-bank parts of a group that has only a small licensed bank entity to fulfil the licensing requirement for access to central bank liquidity. In this case the licensing regime would be too lax.

This construction would leave the greatest part of the de facto banking activity outside the proper banking regulation. It would also limit the burden of regulation, which makes this option attractive for the firms in the market. Moreover, under this construction, a central bank liquidity guarantee, and hence a public safety net, would be unduly extended outside the scope of regulated and supervised institutions. On the basis of the well-known moral hazard arguments, there is a clear public interest in there being adequate regulation and supervision when a safety net is provided. Most importantly, the general public clearly perceives this kind of non-bank banking activities as carried out by entities that are not licensed or supervised as banks. This could lead to a lack of confidence in the financial system.

19. Self-regulation is necessary and desirable, but cannot be a substitute for public regulation and supervision.

Today we can see the efforts that are being made by the industry to promote best practices for risk management among market participants. A most recent example is provided by the recommendations of the Counterparty Risk Management Policy Group, concerning the management of market, credit and liquidity risk. I am strongly convinced that these initiatives are useful when they anticipate and complement public policy measures. Indeed, regulators should rely as much as possible on the self- defences market participants can devise. Self-regulation, however, does not supply sufficient protection against systemic disturbances, and its deepening, welcome as it is, cannot allow supervisors to relinquish their responsibilities. Ultimately, public regulation and supervision are made necessary by a market failure that simple, voluntary co-ordination among market participants is unlikely to amend. As a matter of fact, the recent reform of financial supervision in the United Kingdom was also a correction of the shortcomings of a fragmented world of self-regulatory bodies.

20. At the same time, public regulation and supervision must maintain and strengthen the market-friendly attitude that they have adopted in recent years. Substantial progress has been made in devising regulations that mimic market functioning and rely on incentives instead of forcing a particular market outcome. Prudential and information requirements have gradually become the pillars of the regulatory framework: the former including, for instance, capital requirements and large exposure limits, and the latter defining the types of information to be provided to market participants in order to improve market discipline.

Regulation and supervision have also been geared towards ensuring efficient risk management by the banks themselves. The complexity of the risk profile of each institution and the high speed at which the positions of financial markets and banks change make uniform and simple regulatory formulae, increasingly ineffective and even distortionary. The "internal models" approach, adopted by the Basel Committee on Banking Supervision for market risks in 1997, was a significant step away from controlling transactions and risk positions towards monitoring the way business activity is conducted.

21. Strict adherence to the licensing principle is fully conducive to the promotion of competition and wide access for new entrants. Indeed licensing does not have to be, and should not be, intended as a public rationing device. It is true that the rationing of new licences has been a practice in many countries for many years. However, today, controls on entry into the banking market are increasingly focused on minimum initial capital requirements, and on an assessment of the quality of the managers and relevant shareholders. The screening of the quality of shareholders and managers is similar to that practised in other professions, such as architects or medical doctors, where the customers are unable to assess the qualifications of the supplier. If properly exercised, these controls do not prevent any sound banker from entering the market.

22. To sum up, licensing is an essential prerequisite of public regulation and supervision. It is consistent with a policy aimed at enforcing good market practice and limiting moral hazard related to the safety net. Finally, as the experience of the last decade shows, it is not an impediment to financial innovation.

I do not advocate defensive regulation, erecting insurmountable barriers to entry for new players in an attempt to save banks from extinction; my point is simply that, when they conduct banking business, they need to be licensed as banks. Any attempts to block evolution would also likely to be ineffective, since customers may well access suppliers located in remote places with no or lax supervisory regimes.

IV. WHAT IS SPECIAL ABOUT BANKS?

23. Up to this point, I have spoken about licensing banks as if there were no controversy about what a bank is. We all know, however, that this is not the case. Of course, it would be impossible to be strict on licensing if there were no clear and enforceable definition of a bank. Thus, before discussing the options available to ensure appropriate licensing, we obviously need to be more precise in defining the activity that needs a bank license. In this context, two questions need to be distinguished. First, what is the essence of banking, that is, what is necessary and sufficient for a business to be considered a bank and, therefore, to be subject to a licensing procedure? Second, what is the appropriate scope of banking, that is, what other activities should a bank be allowed to do?

24. First, the essence of banking. The academic state of the art has evolved strongly over time on this question. Anyone, who has examined this topic, has probably noticed that the individual pieces of literature often capture only a part of the issue, and that the whole picture appears so complex and changing that it does not distil a clear-cut definition. Yet, what I see emerging from the academic debate is an agreement that the joint supply of deposits and loans puts banks in a unique position to provide liquidity on demand. This feature strikes me as a durable one.

It was first recognised in the early 1970s that banks are not like intermediaries in other industries that just buy goods, in this case money, from those in excess supply and sell them to those in excess demand, generating savings in transaction costs in between. If banks did only that, they would probably face extinction because the progress in telecommunications and computers is greatly reducing the costs of exchanging information between lenders and borrowers. Applying the progress in the economics of information, it was acknowledged that banks transform financial contracts and securities in such a way that overcomes informational asymmetries between lenders and borrowers, which are of a fundamental nature and exist despite technological advances.

There are three basic conclusions from this literature. First, as originally pointed out by Douglas Diamond, banks supply the basic economic services of processing information about borrowers and monitoring their actions, but end up with opaque assets due to the non- marketability of the loan contracts. Second, as shown by Douglas Diamond and Philip Dybvig, banks provide liquidity insurance to depositors, but the maturity mismatch between deposits and loans makes them vulnerable to runs. Third, the possession of private information by banks generates a logical link, strongly connecting the assets and liabilities sides of bank activity, which puts banks in an unique position to supply liquidity on demand. This function, however, entails systemic risk, since instability at a single bank can spread via contagion, which in turn is the basic justification for the safety net, regulation and supervision. As there is a clear consensus that liquidity provision is the core economic activity of banks, one could go on arguing that an institution could not function as a bank unless there is ultimate liquidity support from a central bank. Nevertheless, this connection can be organised, as I have argued, by dedicating a small part of the entire activity to this purpose.

Finally, a definition of non-bank financial activity follows almost tautologically from the definition of bank activity: non-bank financial institutions would be institutions that, for their liquidity needs, have to rely on the support of a bank.

25. It may be interesting to note that the theoretical discussion is broadly in line with a sort of a minimum common denominator of the existing legal definitions of banking activity. Indeed, any legislation in the world would define an institution granting loans and collecting deposits from the public as a bank. This may not be a necessary condition, but it is certainly a sufficient one. Also the First Banking Co-ordination Directive of 1977 adopted this definition and prescribed objective criteria for the granting of a bank licence. This Directive started the long process of harmonising the key prudential provisions in the European Union; and the fact that harmonising licensing was the starting point demonstrates the central role of this piece of regulation.

26. Can we expect institutions supplying liquidity on demand to remain in place in the foreseeable future? Or, as the "no regulation " motto suggests, will innovation on both sides of banks' balance sheets, non-bank settlement through electronic means and competing payment instruments annihilate the special role of banks, and, with it, the need for regulation and supervision, not to mention central banks' monetary control?

My clear answer is that no annihilation is in sight. To explain why, I should like to refer to the fundamental step forward in the history of financial markets that John Hicks calls the passage from an "auto- economy" to an "overdraft economy". That was the passage from an economy in which agents' financing needs can be satisfied only if savings have been previously accumulated to one in which access to liquidity is granted on demand at pre-set conditions through debt instruments. The flaw in the reasoning underlying the "no regulation" motto, consists, in my view, in overlooking the fact that such passage was economic in nature, not technical. New technologies may modify the modus operandi of the overdraft economy, but would not represent an effective progress if they drove us back to a situation in which overdraft facilities were no longer possible and no institution could offer liquidity on demand to agents needing it. For example, the impressive growth of bond markets and the diffusion of securitisation in the United States , even of small-business loans, have supplemented, and not replaced, the demand for checkable deposits and credit lines by banks. Even in Fischer Black's thought-provoking world without money, where all transactions are settled, maybe electronically, on privately held accounts, banks are identified as institutions allowing their customers to switch freely from credit to debt positions. This is the essence of liquidity provision. The economic need for it will not be wiped out by computers.

27. To conclude: providing liquidity on demand will remain indispensable for the functioning of a market economy; it is the core activity of institutions that we should continue to call "banks"; it continues to entail systemic risk. Since it is not possible to supervise an activity without referring to an economic agent that carries it out, the essential step is to identify such an agent via a licensing procedure and to supervise it carefully. Finally, the whole scope of the activity should be regulated and supervised as a bank, not just the "tip of the iceberg"; namely, the ultimate settlement with central bank money.

28. I turn now from the essence to the scope of banking. Somewhat surprisingly, this second issue has not been as actively researched as the first. Recently, Robert Merton and Zvi Bodie have argued that in order to eliminate the systemic risks involved in banking we should impose a narrow bank model, breaking up the maturity transformation and, hence, the two- sided liquidity provision function carried out by banks. In so doing they follow the suggestion of a "100 per cent reserve" banking, put forward by James Tobin and Milton Friedman years before. The "narrow bank", only investing in liquid and safe assets, would be closely supervised. The remainder of banking and financial activity should be completely free of any licensing and supervision arrangement.

I know that it is difficult to argue against a proposal supported by three, and perhaps more, Nobel prize-winners. Yet, on the basis of actual experience and the function of supervising banks, I would advise against following the narrow bank model. In my view, such a restriction would damage the basic economic rationale of banks and break up the present synergies, leading to efficiency losses. This view has also academic support. For instance, Anil Kashyap, Raghuram Rajan and Jeremy Stein demonstrate that, since deposit-taking and providing credit lines can be regarded as manifestations of the same liquidity provision function, there are synergies between the two. Namely, the need for liquid reserves and other resources would be greater if the two services were produced separately. Moreover, the way in which financial activity is now structured in complex organisations of financial groups or conglomerates would make it attractive and easy for firms to circumvent this regulation. Finally, if there is a strong demand for "narrow banking service", a corresponding supply should emerge in the market place. In fact, money market mutual funds investing only in liquid and safe instruments could be taken to represent such a service.

Paradoxically, adoption of the narrow bank model could lead to a financial environment in which non-bank banks develop even further and uncontrolled and unsupervised risks spread even more. This is so because, although the core function of banks can be clearly identified, a definite dividing line between traditional banking and other activities cannot easily be drawn. The defence of this frontier would not resist the endless, and in some respects even socially useful, attempt to bypass regulatory restrictions. In an ideal regulatory arrangement we would indeed offer intermediaries a wide menu of choices that range from an all-encompassing banking licence to more limited charters, with supervisory requirements graduated according to systemic concerns raised by each item on the menu. I fear, however, that this ideal arrangement would be very difficult to attain.

V. ESSENCE AND SCOPE

29. The facts reviewed at the beginning of this lecture show that some toothpaste has already gone out of the tube, or is in the process of doing so. While the ability of non-bank financial institutions to compete with banks on specific product lines is a positive development, allowing the core banking service to be supplied by non-licensed, non-supervised entities would seriously impair the resilience of the financial system. To avoid this undesirable development an effort is called for to focus on the essence of the banking business, and not on the practical instruments, organisation or technology used for performing it. The sooner the supervisory community acts, the lower the costs of the transition will be, and the smaller the probability of having to come back to a heavily regulated environment in order to restore public confidence.

30. Can a strategy be identified to tackle this problem? Even though there is no single and simple "silver bullet" definition of banking activity, common principles can and should be identified and the options narrowed down. Hence, let me now go from the theoretical discussion to a more pragmatic review of the options available with respect to defining the essence of banking and the scope for allowed other activities. In my view three options can be identified, representing different combinations of the possible answers to the two questions concerning the essence and the scope. I shall call them the narrow-narrow, broad-broad and narrow-broad options respectively, depending on whether there is a narrow or broad approach to the two dimensions.

The narrow-narrow option identifies banks as providing liquidity on demand and lists a limited range of other activities that they can undertake. According to this approach the licence is seen as a great competitive advantage for banks, which is balanced by restricting the scope of business. The United States banking legislation implemented in the 1930s, and partially relaxed only in recent years, is the major example of this approach.

In the broad-broad option no specific attention is devoted to confining the essence of banking to deposit taking or to the joint provision of more than one service and the scope of banking activity includes a wide range of financial services. In the extreme case, all providers of financial services have to be licensed and supervised as banks, irrespective of their liability structure. French banking law and German legislation before the recent amendments are the closest examples of this approach, even though not as far-reaching as to include securities dealing among the set of services that only banks can perform.

The narrow-broad option entails a definition of banks as institutions which couple deposit taking with the supply of loans, but it does not restrict the possibility of offering the whole range of financial services. In contrast with the first option, the attention is focused on identifying the activities that only banks can perform, rather than the business barred to banks. Banks co­ exist and compete with non-banks in a number of markets, but the joint supply of deposits and loans is reserved for them. They remain the only providers of liquidity for the financial system and the economy at large. The prominent example of this option is the legislation of the European Union. The combination of a narrow essence with a broad scope is achieved by separating the definition of bank (Article 1 of the First Banking Co­ ordination Directive) from the indication of a list of activities (an Annex to the Second Banking Co-ordination Directive) that (narrowly defined banks) can be allowed to conduct by different national legislators. Although it is referred to as following a universal banking model, this approach accommodates differences in national definitions, which can span from narrow-narrow to broad-broad.

31. The three options can be evaluated on two main grounds: impact on the innovation process and docility to public control. The narrow-narrow model is argued to be strongest on the former and the weakest on the latter, the broad-broad model representing the opposite case. The narrow-broad option would be an intermediate one on both grounds.

Critics of a strict approach claim that, if every company introducing new ways of doing old things already had to fear the scrutiny of public authorities and forced absorption into the banking system, it would have weaker incentives to innovate. As I have argued, regulations and supervisory tools can be and have been devised to be "market friendly", interfering little with the innovation process. However, the US-type narrow- narrow approach is more exposed to the risk of losing the public control of banking activity, since it constrains banks' activities, but does not prevent non-banks from providing banking services. The EU-type narrow-broad approach is more effective in attributing to banks their specific role in the architecture of the financial system. Under any approach, the appropriate response to the supply of banking services by non-banks that rely on methods not contemplated in the current legislation is to update the definition of banking so as to include these new methods. The proposal of a EU Directive specifying that the issuance of electronic money should be subject to bank-like licensing and prudential controls, is an example of including in the realm of supervised business all the new tools for delivering de facto banking services. In the United States , this has been regarded as falling outside the area that requires a bank licence.

My inclination toward the composite, EU-type, may not surprise you, as I took an active part in the long debate that led to the adoption of this model for the European Union. The model has enough flexibility to deal with the new forms of banking, but it also has the advantage of supporting the level playing-field and it is less prone to circumvention. The problem with the broad-broad approach is that it does the job of guaranteeing public control even too effectively. It can expand the supervisory responsibilities and the scope of the safety net too far, amplifying the moral hazard problem and endangering the effective monitoring of all licensed institutions.

32. A legislative definition of banking activity is of no help if customers can freely access the services of non-chartered banks incorporated in countries where the licensing principle is not rigorously followed. This is why a degree of international co-operation is clearly called for. Otherwise breaches in the licensing requirements would be open and general public would not be assured that those offering banking services in the narrow, "essence" definition, are actually chartered - and regulated and supervised - as banks.

The risk of an international route of circumvention is growing as new technologies progressively allow bank customers to look for the best source of service all around the world, including retail banking services. The "Core Principles" issued by the Basel Committee on Banking Supervision are the first step in the direction of attributing global reach to the basic principles of the licensing procedure. However, we must go farther on this route, agreeing on the "essential" elements of banking activity, continuously updating the definition of the contractual and technical means of fulfilling this function and, above all, sharpening the instruments to enforce a strict implementation of the licensing principle.

Of course, stipulating an international agreement about the scope of banking activities would be a much more difficult task. In fact, I do not think we really need a monolithic notion of the list of financial services in which banks can be involved. Not even the EU felt that this was necessary for its highly integrated Single Market. Actually, regulatory competition can be fruitful in adapting the scope of activities as financial innovation and technological progress open new frontiers in market practices. In any case, what recent experience shows is that if regulators have a restrictive attitude towards the scope of permissible activities, banks can easily circumvent national provisions by opening subsidiaries in other jurisdictions.

33. As my final point, I would like to stress that one needs to be strict when enforcing any adopted licensing principle. What do I mean? I mean that there needs to be adequate sanctioning of "abusive banking". When there is a case of misusing a license, or there is apparent circumventing behaviour, strict sanctions should be imposed.

VI. CONCLUSION

34. In conclusion, we can see that two possible attitudes can be adopted in the face of the challenges posed by technological change and financial innovation. The first is to step back and limit the scope of the safety net to a narrowly defined set of institutions with narrow restrictions on the composition of the assets and liabilities. The second is to adopt a definition of banking that would allow the licensing and supervisory framework to recognise as a bank every firm performing, with whatever technical means, organisation and contracts, what in economic terms is a banking function.

All the arguments that I have tried to put forward in this lecture suggest that the second solution is preferable. The fundamental strengths of the present financial architecture should be preserved, while moving towards regulation that does not prevent us from reaping the benefits of financial innovation.

For some, my argumentation may have a strong continental European flavour, allowing economic activity to take place only after explicit permission from the public authorities. In the United States , the approach has been to intervene only when a public interest is clearly injured. I am an admirer of the US system, which is in many senses a superior system in terms of promoting freedom of enterprise. I think nevertheless that in such a systemically delicate area as banking, we cannot afford to adopt the attitude of "letting things happen".

The task of regulators, of course, is not to prevent Darwinian selection in the financial system. Dinosaur banking should not be protected from extinction, but rules have to be laid down to avoid ruthless experiments of genetic manipulation leading us into a world in which no certainty exists about the quality of the product delivered and the reliability of the firm supplying it.

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