Economic Policy Review

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

July 1995Volume 1, Number 2
JEL classification: G1, G21

Authors: Franklin R. Edwards and Frederic S. Mishkin

In recent years, the traditional business of banks—making long-term loans and funding them by issuing short—dated deposits-has declined. This development has raised concerns that more banks will fail or be forced to assume greater risk to remain profitable. This article first examines the economic forces responsible for banks’ reduced role in financial intermediation. The authors then consider whether banks may be jeopardizing the stability of the financial system by extending riskier loans or engaging in derivatives dealing and other 'nontraditional' financial activities that bring higher returns but could carry greater risk. The authors conclude that because most nontraditional activities expose banks to risks and moral hazard problems similar to those associated with banks’ traditional activities, the new activities can be regulated as effectively as the old.

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