Technological Change, Financial Innovation, and Financial Regulation: The Challenges for Public Policy

Abstract

The two technologies that form the heart of the financial services industry—data processing and telecommunications—have experienced rapid improvement and innovation in the United States in the past few decades. In the heavily regulated financial services industry, technological innovation and improvement may pose significant problems and challenges, both for the industry itself and for the government regulators and public policy makers. In this paper, the author provides an overview of the interactions between financial innovation and regulation. The author first makes a distinction among types of financial services firms that is essential to an understanding of financial services regulation. Institutions such as banks and insurance companies that hold financial assets and issue liabilities are known as financial intermediaries. A company that extends trade credit to its customers acts as a lender and is therefore a financial intermediary. The second category of financial services firms comprises firms like stockbrokers and investment bankers who facilitate financial transactions between primary issuers of financial liabilities and the investors who purchase these instruments. These firms are known as financial facilitators. Although there are firms that act both as intermediaries and facilitators, the distinction is an important one in understanding the interaction between technological innovation and financial regulation in the U.S. The author next turns to an analysis of the four major underlying causes of the recent technological changes in financial services. First, data processing and telecommunications have become both more powerful and inexpensive, allowing improved data collection, risk assessment and wider geographical reach for products. Second, less restrictive and protectionist laws and regulations have paved the way for greater competition and allowed outside innovators to enter the financial services market. Third, the shift from a relatively stable to a risky economy beginning in the 1970s created a demand for futures and options that would protect investors from risk. Finally, as a reaction to a strict regulatory environment, financial institutions developed innovative ways to circumvent cumbersome regulations. One of these developments, for example, was the money market mutual fund. Recent easing of restrictions has also encouraged financial innovation. The author turns to a detailed discussion of financial regulation, explaining the distinctions between the three major categories of: 1) economic regulation; 2) health-safety-environment regulation and; 3) information regulation. He then covers the specifics of regulations affecting: 1) banking; 2) securities and related instruments; 3) insurance; 4) pension funds; 5) mortgage conduits and; 6) finance companies and leasing companies. He then reaches the following conclusions based on his evaluation of the environment within which financial regulation operates: 1) the widespread nature of financial regulation is not accidental; 2) of the three categories enumerated above, information regulation extends most widely across the financial sector; 3) safety regulation applies most directly and strongly to those financial intermediaries who have the most widespread liabilities and; 4) economic regulation applies most extensively to banks and other depositories. He next explores the interaction between innovation and regulation and concludes that regulation has both negative and positive effects on innovation, this determination particularly depending on the critic's perspective on the regulations. The main effects of innovation on regulation now and in the future should involve the following issues: 1) more federal centralization of regulation, and less state regulation; 2) more international markets for financial products; 3) greater efficiency of financial markets due to increased competition; 4) development of regulations for new financial instruments; 5) differential regulatory treatment of risky financial instruments and; 6) stored value cards and smart cards and other electronic based innovations; 7) new privacy policies resulting from increased gathering of personal information from electronics-based instruments; 8) increased flows of funds through EFT systems and; 9) new interactions between computer software and hardware as well as with outside institutions as financial services transactions depend more on electronics-based instruments. The author concludes that a major task of public policy must be to ensure that financial regulation does not stifle innovation while it responds appropriately to challenges posed. This paper was presented at the Financial Institutions Center's conference on Performance of Financial Institutions, May 8-10, 1997.