Activity-based regulation would mean a more competitive financial system

In the corporate world, banks occupy a unique niche. They are hybrid entities—unlike most single-purpose corporations, banks offer products which are both liabilities and assets (or deposits and loans) as products. The bank’s balance sheet reflects this basic function. The bank’s assets are primarily various types of loans expand, financing everything from cars and homes to businesses and entrepreneurial ventures. Their liabilities, on the other hand, are funds entrusted to them by their depositors, classified as long-term investments or easy-access checking accounts.

This unique ability, both to accept deposits and to make loans, is no longer sufficient to guarantee banks a dominant position in the financial system. Competition is growing across the entire spectrum of their offerings. Lenders outside the banking sector have emerged, offering everything from quick payday advances to complex, structured corporate loans. The return of interest rates has allowed broker-dealers to introduce attractive, interest-bearing money market accounts, competing directly with traditional bank savings products. Perhaps the most disruptive force has come from the rise of fintech companies. These nimble players are particularly adept at capturing a new generation of customers with innovative payment solutions,

Banks are probably the most heavily regulated institutions in the United States. These regulations, while sometimes perceived as a burden, play a critical role in maintaining the stability of our entire financial system. Nonbank entities that offer similar services to the general public often operate under a lighter regulatory approach. This can be a significant advantage for them in the short term.

However, this advantage comes with a trade-off. Unlike banks, nonbank lenders typically do not have access to certain benefits, such as the ability to use insured deposits, deposit excess reserves with the Federal Reserve, or access the Fed’s discount window or payment systems. These unique capabilities that banks enjoy are important factors to consider when assessing the competitive landscape.

One proposed solution to this uneven regulatory landscape is to establish consistent activity-based regulation across the financial system, regardless of the institution offering the service. This approach could serve as a foundational principle for a more balanced regulatory framework.

However, implementing such a system raises additional questions. How will different categories of activity be defined and regulated? One potential solution involves a three-level approach.

The first level would include actions currently restricted to banks due to the inherent risks. These actions would continue under existing (or slightly adapted) regulations.

For the second tier of activity, where non-bank entities currently have an advantage due to lighter regulations, the rules will be adjusted to create a level playing field between banks and non-bank entities.

Finally, a third tier could encompass activities where banks have a significant advantage. These activities could be cautiously opened up to non-banks under new, carefully crafted rules to encourage competition while preserving stability.

Building on the proposed three-step approach to regulation, let us look at specific examples of its application.

The first level focuses on protecting insured deposits through limited activities, such as traditional lending. These activities would likely remain the exclusive domain of banks, subject to existing capital, liquidity, and risk management requirements. Maintaining prudent management of insured deposits is crucial to the stability of the financial system.

However, innovation is possible at this level. Entities outside the traditional banking model can access the insured deposit market without directly collecting deposits. This may be a positive development, but such entities would still be subject to the same safeguards as existing banks.

The second level aims to create a level playing field, allowing banks to compete in currently unregulated or lightly regulated markets, such as proprietary trading and private equity. Banks, under stricter regulation, face restrictions in these areas.

As long as banks operate in this space solely with investor funds (uninsured deposits), they can be permitted to do the full range of things that non-banks do. Furthermore, if the market finds the rules on doing business beneficial, they can be applied uniformly across all institutions.

The third tier aims to expand access by allowing nonbanks to compete in areas where banks have an advantage, such as payment services and consumer deposit aggregation. However, this access would be subject to the same conditions as banks, including similar screening to ensure overdrafts and general operations are controlled.