The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy

he traditional banking business has been to make long-term loans and fund them by issuing short-dated deposits, a process that is commonly described as “borrowing short and lending long.” In recent years, fundamental economic forces have undercut the traditional role of banks in financial intermediation. As a source of funds for financial intermediaries, deposits have steadily diminished in importance. In addition, the profitability of traditional banking activities such as business lending has diminished in recent years. As a result, banks have increasingly turned to new, nontraditional financial activities as a way of maintaining their position as financial intermediaries.2 This article has two objectives: to examine the forces responsible for the declining role of traditional banking in the United States as well as in other countries, and to explore the implications of this decline and banks’ responses to it for financial stability and regulatory policy. A key policy issue is whether the decline of banking threatens to make the financial system more fragile. If nothing else, the prospect of a mass exodus from the banking industry (possibly via increased failures) could cause instability in the financial system. Of greater concern is that declining profitability could tip the incentives of bank managers toward assuming greater risk in an effort to maintain former profit levels. For example, banks might make loans to less creditworthy borrowers or engage in nontraditional financial activities that promise higher returns but carry greater risk. A new activity that has generated particular concern recently is the expanding role of banks as dealers in derivatives products. There is a fear that in seeking new sources of revenue in derivatives, banks may be taking risks that could ultimately undermine their solvency and possibly the stability of the banking system. The challenge posed by the decline of traditional banking is twofold: we need to maintain the soundness of the banking system while restructuring the banking industry to achieve long-term financial stability. A sound regulatory policy can encourage an orderly shrinkage of T The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.