After a 28-year academic career at Wharton, Anthony M. Santomero is getting a chance to practice what he preaches.

On July 10, Santomero, 53, became president of the Federal Reserve Bank of Philadelphia, where he oversees a staff of about 1,200, including bank examiners, economists and check processors. Most importantly, he also will take part in Fed decisions about such critical economic issues as interest rates, regulation and oversight of the financial markets.

Such matters are right up Santomero’s alley. In three decades in the academic world, most recently as director of Wharton’s Financial Institutions Center, he has studied banks, brokerages, insurance companies and other financial concerns overseen by the Fed.

What does Santomero think about regulatory matters? His most recent views were expressed in a paper delivered at a conference called Specialization, Diversification and the Structure of the Financial System, sponsored by the New York Federal Reserve Bank on June 9. Co-authored by graduate student David L. Eckles, the paper is titled, "The Determinants of Success In The New Financial Service Environment: Now that Firms Can Do Everything, What Should They Do And Why Should Regulators Care?"

Santomero is a regulatory moderate – inclined to let market forces and competition determine how the financial services industry will evolve, but nonetheless acknowledging that regulators should step in if necessary to protect the public interest.

"Regulators are important in creating a level playing field," he said in an interview July 27 with Knowledge at Wharton. The regulator’s chief function is to assure that financial markets remain competitive enough to provide customers a wide choice of affordable products and services.

Santomero also noted that "the financial-services industry is supposed to provide funds effectively and at reasonable prices. To the extent that one observed a situation of substantial decline of availability of funds for particular sectors, or a substantial rise in the cost of funds, or, conversely, lower yields to savers in an environment where they are not justified by the obvious state of the market, one would be led to question what is going on in the market."

In their paper, Santomero and Eckles suggest that a number of regulatory issues are being raised by the generally beneficial changes overtaking financial services industries today.

Following the stock market crash of 1929, Congress enacted the Glass-Steagall Act of 1933 to keep different types of banking, brokerage and insurance companies separate. The idea was to prevent a financial crisis in one industry from contaminating the others.

"During the ensuing 65 years, this landmark piece of regulation slowly has become both outdated and untenable," Santomero and Eckles write. "Technological innovation, regulatory circumvention, and new delivery mechanisms all have conspired to make the restrictions of the Act increasingly irrelevant." Today, for example, mortgages written by banks are bundled into securities that are traded by securities firms, while brokerages offer money-market funds that work like checking and credit-card accounts.

The Financial Modernization Act of 1999 has knocked down many of the walls that had prevented different types of financial firms from getting into one another’s business, making possible the development in the United States of the kind of "universal bank" found in some other countries. That has raised questions about how these industries will evolve and whether the public will benefit when an individual company can deliver the whole spectrum of banking, investment and insurance products.

"To the policy maker who claims indifference to the impact of these changes on the institutions that deliver financial services, a word of caution is in order," the authors say. "The social value brought to the real economy by the financial sector is delivered by the firms and institutions that make up the industry. The impact of change on these entities can be ignored only at the policy maker’s peril. If firms cannot function, indeed flourish, the industry will not deliver on its essential role in the real economy."

Some firms are likely to become more efficient as they grow bigger and eliminate duplication. A universal firm, for instance, might be able to sell a variety of banking, brokerage and insurance products to the same customers, describing all three accounts on one statement instead of three. But such cost savings could be outweighed by other inefficiencies if a large, diversified company becomes unwieldy, bureaucratic and too slow-moving to innovate.

It has long been argued by some that a large, diversified universal bank would be more stable than a smaller, more specialized company because problems in one area of business would be counterbalanced by strengths in others.

"However, these arguments in favor of scale can be taken too far," Santomero and Eckles write. Brand name is so important in financial services that a problem in one area could undermine the entire firm’s reputation. A setback in the insurance unit, for instance, could hurt the banking and brokerage units as well. Moreover, a variety of regulators are likely to descend upon a universal bank in response to any problem, increasing regulatory costs.

"It is quite possible that a financially distressed subsidiary will cripple the entire entity," the authors say.

This would be an especially serious concern if the financial services industry comes to be dominated by just a few behemoths. But Santomero and Eckles think that unlikely, as some firms will prefer to specialize, leaving plenty of room for competition and giving customers many choices. Still, some universal firms will be so big that their welfare will be of widespread public concern.

"In short, something is likely to go wrong somewhere in the franchise, and this could be destabilizing to the firm, the entire sector and the economy at large," the authors say. Several years ago, they note, a financial crisis that started in Thailand had dramatic effects throughout Asia and the rest of the world, demonstrating how financial systems can contaminate one another.

"For this reason, regulators have been concerned legitimately about the growth of large universal firms and their effect on macroeconomic stability," Santomero and Eckles write. "The solution, of course, is central bank intervention."

However, intervention itself can cause problems, they note, recalling how it triggered the savings and loan scandal of the 1980s and a bailout at enormous taxpayer expense. In addition, if regulators come to view some universal firms as so influential in the economy that they cannot be allowed to fail, those firms may take excessive risks in the belief the government will rescue them if things go wrong. At the very least that would give these firms an unfair advantage over small competitors.

As a regulator, Santomero seems likely to keep a sharp eye as the financial markets evolve, but he appears inclined to leave the markets alone barring real problems. On balance, he and Eckles say, the efficiencies and innovation likely in universal firms should be good for the economy and the public, and there probably will be enough opportunities for smaller, specialized firms to preserve competition and customer choice.

"Inasmuch as various members of the financial community are expanding their product array, one should expect that these new entrants will seek profit opportunities no matter where they are," the paper concludes. "As long as the consumer and small business markets are open, there appears to be little reason for concern."