Edited by FRANK MILNE and EDWIN H. NEAVE. Montreal and Kingston: McGill-Queen's University Press. 2005. Pp. 248. $29.95 (paper); $75.00 (cloth)

This volume makes available the proceedings of the Fourth National Conference on Financial Regulation, held in Toronto in May 2004. The conference

The opening paper by Professor Ingo Walter of New York University is rifled "Regulatory Targeting: Financial Services Strategies across Borders and Sectors." This somewhat confusing title is better defined in one of his early sentences: "This paper assesses the factors which appear to be driving the structural reconfiguration of the financial services sector." Walter leads off by demonstrating the extraordinary decline in the share of market of commercial banks. In the United States, the decline from 75 per cent in the 1950s to 25 per cent today stands out, although the data do not make entirely clear whether the definition of "commercial bank" includes investment bank subsidiaries.

Walter notes that "vastly improved technology" has enabled "ultimate savers" to bypass traditional financial intermediaries. This seems to be one of the very few references in the conference to the critical impact of the computer on the financial services industry. This reviewer has long felt that banking is mainly the collection, storage, and retrieval of information. Until the mid-1970s, the banks were slow to grasp the impact of the computer, not just on their own institutions but on the ordinary consumer. The paying of daily interest on deposits, for example, was impossible before the late 1970s. In the following two decades, bank computerization gathered steam slowly at first, and then with a rush. The required skill level of bank employees changed enormously, and the educational composition of the workforce in financial services was revolutionized.

In a sense, the spinoff of new institutions such as mutual funds and more recently hedge funds was a by-product of the new technology. Financial asset management was done before the computer, not very competently, by scores of clerical workers in trust companies and the like. The saver was not well served. And of course financial regulators in all countries have had to scramble to keep up with this critical change. A paper on the role of the computer in financial services regulation would be a useful addition to a future conference.

Walter's paper offers many valuable insights into the diversification of financial services, into the nature of competition, economies of scale, concentration of power, conflicts of interest, and the management of risk.

Some of his observations are very timely in view of the recent revival of interest in the question of bank mergers in Canada. Walters notes that "there is very little evidence so far of scale economies in the case of banks larger than $5 billion" and "except for the very smallest among banks and non-bank financial firms, scale economies seem likely to have little bearing on competitive performance." Later on, he notes that "a number of studies have found large disparities in cost structures among banks of similar size, suggesting that the way banks are run is more important than their size." The urge to merge is further challenged by his conclusions that "there has been long-term erosion of return on capital invested in the wholesale banking industry" and "the largest [financial services firms] by whatever measures are used in the major industry segments are not necessarily the most valuable."

While the data presented do not support these conclusions, there is plenty of evidence in the market place that many of the largest global banks do not earn a consistent rate of return on equity as high as that of the big six Canadian banks. Severe competition among very large institutions for huge global deals has frequently led them to assume inappropriate risks for marginal returns. Why membership in this club is considered desirable is somewhat baffling.

In the discussion on Walter's paper, Professor Neave made the useful observation that the measurement of national concentration rates in the financial services industry "can be a very misleading measure of the extent of competition in local markets ... Canada appears to have a highly competitive financial system, and consumers appear to be at least as well served here as they are anywhere else." These points bear repeating in the upcoming round of debate about financial legislation. The oft-cited fact that the United States has some eight thousand commercial banks compared to Canada's dozen overlooks the reality that thousands of U.S. banks are actually local monopolies, until 1994 protected by state legislatures and community pressures from competition.

The rapidly concentrating structure of U.S. commercial banking is placed in context in the second paper by James. V. Houpt, from the board of governors of the Federal Reserve System. This chapter is one of the best in the volume, providing many illuminating comments on the evolving role of supervisors. Mr. Houpt addresses the constructive role which regulatory capital standards have played: "It is perhaps surprising how important the role of regulatory capital standards has become in promoting sound banking practices, both in the United States and worldwide, especially when considering there was NO capital standard--at least in the United States-roughly 20 years ago." He wonders why, "if risk models were so great, that market forces themselves had not provided large institutions with sufficient incentives to invest in the necessary information systems."

In this observer's opinion, there was a steep learning curve for commercial bankers, especially when the computer arrived. For two generations, bankers lived in a world of low interest rates and fixed exchange rates, and knew nothing of monetary policy. Bank liquidity was not understood until the 1960s, and capital adequacy was not on the agenda until the excessive lending to the developing world in the 1970s.

A long technical chapter on catastrophic risk concludes that cyclical forces are important determinants of both catastrophic and operational risk. But the problem is actually to determine the strength and direction of cyclical forces, something which has given central banks great difficulty in recent years.

The chapter by J. David Cummins from the University of Pennsylvania will be of special interest to Canadian policy-makers as the issue of mergers in banking and insurance unfolds. It would seem that the great strides made in the past two decades in the quality of bank regulatory standards, the degree of investor oversight, and the quality of bank management, have made catastrophic risk in commercial banking highly unlikely. But in the case of the insurance industry, catastrophies have been recurrent, primarily due to extreme weather. Merging banks and insurance companies will weaken banks. This points to the need to securitize very large lumpy risks to a wide range of investors.

Nick LePan's short paper on "Prudential Regulation" is a model of clarity in plain English. As chairman of the Accord Committee, he is well placed to explain the weaknesses in the Basel I agreement of 1988, and the principles governing the changes proposed for Basel II. This paper will be useful as a teaching aid in banking courses.

The next paper deals with "macro-prudential" risk. The attention given to this subject seems misplaced, since the chances of system-wide distress are not likely to come from the private sector. In the last fifteen years, the serious risks of system-wide distress have been generated by governments. The list is long, but the case of Japan is obvious. Currently, the appalling fiscal policies of the United States, and to a lesser extent the European Union, are clearly the source of major danger to global financial stability.

The final section deals with bank mergers. A paper on the U.S. experience since 1985 is interesting but not relevant to Canada, where we are talking about the process of merging four or five banks into two or three. James Baillie, in the discussion session, focuses on the issue of how to proceed with bank mergers, rather than whether. His entertaining comments demonstrate the high hurdles which must be jumped in the merger process. But this reader is puzzled as to why the big five would want to expose themselves to the micro-management by the House of Commons Finance Committee and the federal bureaucracy which will surely come when they are three in number.

Robert M. Macintosh is a former president of the Canadian Bankers' Association.