Jane D'Arista and Tom Schlesinger's paper on the "parallel banking system," summarized in a comment in the April 2 American Banker, does a special service for those of us who study the U.S. banking system and its regulation.

The authors have presented a useful comparison between traditional banking's performance over the past dozen years and that of finance companies, the commercial paper market, and money market mutual funds.

This parallel system has exploited certain natural advantages over the fully regulated banking system.

Equal Regulation Proposed

Ms. D'Arista and Mr. Schlesinger conclude that the parallel banking system should be regulated like commercial banking to eliminate the inequalities.

But I believe the conclusion should be the opposite. We should learn the lessons of efficiency taught by the parallel system and amend the regulation of bank holding companies to permit them to achieve some of the same efficiencies.

By freeing holding companies from limits on the types of business they can do, we could release significant creative financial energy.

The Parallel System

In the parallel banking system, finance companies (GE Capital, GMAC, etc.) make loans to businesses that banks otherwise might make. Their terms are more favorable than the banks can afford, in part because the finance companies and their funding sources bear a lesser regulatory burden.

The finance companies fund themselves by issuing commercial paper, much of which is bought by money market mutual funds. The banks assist in the process by providing backup lines of credit for the finance companies'commercial paper.

Neither the finance companies nor the mutual funds have to maintain reserves at the Fed, pay deposit insurance premiums, or comply with the Community Reinvestment Act or the full array of prudential bank regulatory requirements. They also do not have the expense of retail branches.

Ms. D'Arista and Mr. Schlesinger express a number of concerns about the parallel system, beginning with the Federal Reserve System's ability to conduct monetary policy.

If so much banking is done outside the "real" banking system, they ask, will the Fed have insufficient control over the flow of money to be able to conduct monetary policy?

Second, in the absence of supervision, surprise events could trigger a breakdown. The development of a "thickly tangled web" of bank guarantees ensures that a future "confidence-shaking, crisis would precipitate systemic consequences," the report says.

This would lead to the third worrisome consequence: These unsupervised issuers of commercial paper would have access to the Fed's discount window through the back'door of the bank lines of credit that support their commercial paper.

Finally, the parallel banking system's unfair competition is eroding the regular banking system. And ownership of finance companies by industrial companies leads to conflicts of interests and a tendency toward tying arrangements.

Spreading the Risk

To me, the D'Arista-Schlesinger study described a remarkable system that has managed to spread formerly concentrated risks widely. Rather than being more dangerous than the banking system, the parallel system seems to me to be safer.

Money market mutual funds? liabilities are significantly different from - and safer than - the bank's deposits. In fact, they are not liabilities at all; the shareholders' interest in money market mutual funds are, like the interests of all stockholders of mutual funds, equity interests.

Therefore, as long as there are liquidity mechanisms to Support the money market mutual fund - though a fund theoretically might have to "break the buck," which no money fund has done in 20 years of existence - it would not, fail, no matter what losses it sustained in its portfolio. Twenty years ago runs on money funds generically were theorized. Today, these seem unlikely.

Protected by Diversification

Also, the money market funds are quite diversified. Even those that should be perceived as riskiest - the ones that invest heavily in commercial paper - are, by law, diversified.

The failure of no single issue held in portfolio could cause more than a couple of percentage points of loss, and this potential loss is backed by banks' lines of credit to the issuers.

The fact that in most cases a failed finance company would be eligible for Chapter 11 treatment is a distinct advantage over the banking system because the assets stay out of the government's hands and the liquidation takes place in whatever way the private sector creditors believe will maximize the ultimate values.

Monetary Implications

To D'Arista and Schelsinger, the monetary policy implications of the parallel banking system present the most important reason to regulate that system.

From my humble position as a relatively innumerate noneconomist, it appears that the genie is out of the bottle. To regulate for the sake of monetary policy would merely push a new parallel banking system in some other direction, all at the cost of the U.S. institutions' place internationally and American companies' ability to obtain short-term financing.

In addition, the parallel banking system is far from unregulated. Several of the leading finance companies are supervised by the New York State Banking Department as Article 12 companies. The mutual funds are overseen by the SEC. And the banks that provide the backup lines are, of course, regulated.

Functional Regulation

Though it is the kind of catch phrase that should naturally be suspect, functional regulation is a practical way to regulate financial markets in the interests of fair competition and competitive pricing.

Here I agree with D'Arista and Schlesinger Regulate a pool of capital that is sold to the public the same way (under the Investment Company Act), regardless of who sells it or who manages it. Regulate sales practices the same way, regardless of who is doing the selling. And carry out these examples wherever the principle works.

But banklike "prudential" rules need to be imposed only on enterprises that present themselves as safe repositories for the public's funds but in fact make their profits by taking risks with those funds.

Safeguarding the Public

Prudential regulation of banking is necessary because banks take deposits from the public. It is this public protection goal (coupled with the need to protect the deposit insurance fund) that leads to examination and supervision, capital requirement, and all the rest. Banking is "special."

The public cannot evaluate the safety of a bank. And because banks have "other people's money," history shows that banks present terrible temptations.

Is issuing commercial paper special? No, it is not. Just as lending is not special and does not require similar regulation. Anyone can make a loan to anyone else without consequences to the system.

The issuer of commercial paper does not hold itself out as a safe repository of the public's funds. The issuer says, "I promise to repay." But that promise is subject to the same limitations as any other promise to pay that is made in the society.

Measures of Soundness

The purchaser is relying not on the status of the issuer or on the protections afforded by a regulatory system but on the issuer's financial strength, as determined either by direct observation of financial information or by the evaluation of the rating agencies. There is nothing "special" here.

We should be removing unnecessary barriers to bank competition, not erecting new ones. Regulate the disclosures required of all lenders the same. Regulate the community obligations of all lenders the same. Regulate the duties of all similarly situated fiduciaries the same.

But don't impose capital requirements and prudential restraints on entities that do not hold themselves out to the public as being a type of institution with which safety is automatically associated.

Banks, insurance companies, and pension funds hold themselves out as having a strength on which the public can rely, but the public has no means of determining whether the strength in fact exists. Therefore those entities need to be regulated so that the public trust will be justified.

Benefits of Specialization

But holding companies do not fall into this category. They really are more a part of the parallel banking system than a part of the banking system itself.

The new systems involve less risk and deliver services at lower cost not only because they have regulatory advantages but also because they encourage functional specialization and spread risks broadly.

The banking system therefore should be freed to perform more like the parallel system. This means freeing holding companies to engage in other businesses, eliminating restrictions on holding companies' strength or activities that do not involve their banks, and freeing the banks to act as agents in a variety of types of businesses, including securities sales, mutual funds, and all types of insurance.

The parallel system has that freedom, with no apparent dangerous consequences despite the extreme financial pressures of the last dozen years.

Strength Above All

If the depository system shrinks and intermediates less, that may not be a bad thing - even for banks. The point is for banks to stay strong, not necessarily big or even at some set percentage of the country's financial assets.

If banks' owners - holding companies - also participated in less regulated intermediation, that would hold promise for providing credit at the lowest possible cost.

We therefore should encourage bank holding companies to become part of the parallel banking system, not discourage the parallel system from continuing its innovative role in the financial marketplace.

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