Safety and Soundness of Financial Intermediaries: Capital Requirements, Deposit Insurance, and Monetary Policy

by Richard W. Kopcke
November/December 1995

More than two-thirds of the $25 trillion of financial assets held in the United States is managed on behalf of investors by financial intermediaries, ranging from trusts, mutual funds, and mortgage pools to insurance companies, pension funds, and banks. Because of their importance, governments have long regulated the activities of these intermediaries to ensure sound financial markets, a foundation of secure economic development. Currently, regulators both here and abroad are considering reforms that not only might foster more efficient domestic financial markets, but also might prepare the way for more equitable global markets.

When not all investors are fully informed about the prospective returns on all assets, the cost of funds for financial intermediaries depends on savers' state of confidence in their investments. Because the regulations that govern intermediaries affect the price of risk in financial markets and because this influence varies with economic conditions, the actions of regulators, like those of the monetary authority, may need to adjust with economic conditions in order to foster the prudent valuation of assets. The prompt enforcement of fixed, risk-based capital requirements, for example, might diminish the ability of financial intermediaries to cope with economic shocks. Because capital ratios measure neither the insurance inherent in intermediaries' balance sheets nor the capacity of this insurance to contend with different risks, more revealing assessments of the safety and soundness of intermediaries should consider how their earnings and cash flows might change with economic conditions.

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