Regional President Speech

New Rules for a New Game: Financial Regulation in the 1990s Remarks by Silas Keehn, President, Federal Reserve Bank of Chicago before the Robert Morris Associates 1988 Fall Conference Chicago, Illinois October 18, 1988 FEDERAL RESERVE BANK OF CHICAGO Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis I am extremely pleased and honored to have been asked to address the Robert Morris Associates, a group that has had a major role in banking over the years, and certainly one with a very important heritage in our nation's fi nancial history. Robert l\,forris played a central role in developing our country's first financial system. He founded the first successful commercial bank, acted as an invest ment banker to the goyernment, and worked with Alexander Hamilton to de ,·elop the initial federal policy toward banking. The Morris-Hamilton system has been overhauled three times: first in the 1830s, then in the 1860s, and then, of course, in the 1930s. Each of these major restructurings came in the wake of a significant political or economic upheaval. I think we are once again at a point where another restructuring is both necessary and very appropriate. And, once again, restructuring is being pre ceded by a certain amount of upheaval; the problems of the thrift industry, the continuing high number of bank failures, the declining profitability of tradi tional bank services, and the tremendous expansion of merchant and investment banking activities give the appearance that the whole structure of commercial banking, at least in a traditional sense, seems to be coming apart at the seams. From a safety and soundness point of view, the commercial banking system continues to be sound. Yet, by other measures, the current regulatory system doesn't seem to be working all that well. Bank failures are continuing at a high level and the losses that have been and are being absorbed by the deposit in surance funds are comparable to the losses suffered by depositors during the Great Depression. Clearly, the time for change has come. The status of deregulation We had every reason to expect a bank bill this year. Now, apparently having fallen short in 1988, I think it's reasonable to ask whether the new Congress will be willing to take this issue on yet another time in 1989. But even without additional federal legislation, a great deal of deregulation has already taken place. Geographic deregulation, at least in a legislative sense, is all but completed. At this point regional compacts are well-formed, and how fast we actually move toward nationwide banking will be determined primarily by market factors, subject only to antitrust restraints and capital adequacy re quirements. But while some significant consolidation in the industry seems both inevitable and appropriate, I always like to make the point that, in this changing environment, there are splendid opportunities for small and medium-sized banks. With regard to powers, there has already been a considerable blurring of boundaries between banking and the rest of the financial services industry. Banking organizations, as all of you well know, have been very active in offering Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis investment banking services, while investment banks are increasingly involved in traditional banking activities. So far, the expansion in activities has been accomplished through the devel opment of services that were not covered by the existing regulatory framework (for example, swaps, loan sales, and securitization); the reinterpretation of ex isting statutes that put discount brokerage, investment advisory services, and a whole host of other activities on the permitted list; or legislation at the state level which has permitted insurance, securities underwriting, and a variety of real estate activities. Despite this progress, there is a compelling case for further expansion of ser vices that may be offered by banking organizations. As the remaining barriers between banking and the rest of the financial services industry are pulled down, competition will further intensify, and cost savings will be realized. The point to remember is that the public stands to benefit from this increased competition. Banks already play an important role in underwriting private domestic placements, municipal revenue bonds, and certain Euro-securities. Where banks are permitted to compete and there are many participants, competition is intense and margins are thinner. Where banks are barred, there are fewer participants and fees can be quite sizable. While it's difficult to assess with any degree of accuracy the benefits to be derived from expanding bank powers, there have been a number of estimates that appear reasonable. They suggest that bank entry into underwriting could lower fees on investment banking services by as much as $1 billion a year and that bank entry into insurance sales could lower insurance fees by as much as $5 billion a year. There is little doubt that additional powers would give commercial banks additional profit opportunities. But again the important point is the public interest in all of this, the public benefit which sometimes gets lost in the rhetoric. While the case for eliminating the current barriers within the financial in dustry seems clear, the benefits of breaking down the barriers between banking and commerce seem much less compelling. Studies are inconclusive on the benefits of conglomerate mergers. At the very least, the advantages are quite difficult to quantify. While the fears about the concentration of economic and political power can be dealt with, the abolition of the barrier between banking and commerce doesn't seem a necessary first or even an early step, and it is certainly not a necessary ingredient to the broader powers issue. Restructuring and the safety net Having made the case for broader powers-and for this audience, even this early in the day, it has to be the easiest sale that I'll ever make-the next question is how best to structure, regulate, and supervise the resulting entity which will be engaged in a wide array of very disparate financial activities. 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis There have been a number of proposals regarding this restructuring question by bankers, public officials, and trade organizations. I am really delighted to have the opportunity this morning to offer my comments, as well as to suggest the broad outline of a proposal that my associates at the Bank and I have been contemplating. I'm not quite sure what Robert Morris would have suggested were he faced with our current situation, bu_t given his tradition of public service, it is safe to say that he would have attempted to balance two very distinct, competing needs: first, the need for free and fair competition, and second, the need to regulate a function so essential and critical to our economy as banking. Having been both a banker and a regulator myself, I can fully appreciate both the dif ficulty and necessity of this balancing act. Central to all this is what we commonly refer to as the "safety net." By this, I mean access to the Federal Reserve's discount window, the protection offered by deposit insurance, and the guarantees offered by the Federal Reserve's large dollar electronic payments system. These, I feel, are absolutely essential fea tures of the financial landscape that must be preserved. Anyone who thinks that deregulation can be taken so far as to eliminate these elements of the safety net is not being realistic. Similarly, anyone who thinks that we can add ex panded bank powers onto our existing supervisory system without incurring additional costs is being equally unrealistic. The powers that are available to banking organizations should not- indeed, must not-be expanded without significantly modifying the concept and the use of the safety net. As we permit banking organizations to participate in higher risk segments of the financial services industry, we must make sure that these risks are not borne by the safety net. The risks as well as the rewards of the business should be for the account of the stockholders, not the public. Unless we are careful, expanding the activities of banking organizations will raise the cost of the safety net by facilitating the spread of regulation to other parts of the economy, by extending the coverage of the safety net beyond the banking system, and by making it more difficult to deal with troubled banks on a stand-alone basis. These costs can be controlled by shaping and enforcing the appropriate corporate structure and by redesigning the safety net, but it would be a mistake to go at this process on a piecemeal basis. Corporate structure The first element of our proposal deals with the structure and regulation of financial firms. As a start, the activities of commercial banks should be nar rowly defined to include lending, deposit taking, and activities that are clearly incident to the business of banking. This limitation should not be onerous since bank holding companies will be free to pursue a broad array of nonbank fi nancial activities through their other holding company subsidiaries. 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Nonbanking financial act1v1t1es should be conducted in subsidiaries of the holding company, not in the bank or its subsidiaries. There is always the risk that if there are losses in a subsidiary of the bank, they will flow through to the bank itself. By separating these activities, this risk is alleviated. This kind of a structure begins to establish the basis for clearly separating bank services from the other financial activities included under the corporate umbrella. In this structure, "fire walls," an increasingly common term, are an abso lutely crucial element. lnteraffiliate transactions are and must continue to be covered by Sections 23(a) and (b). My somewhat cynical view is that, in the past, these fire walls have worked when we haven't needed them, but they haven't worked when we really did need them. It's fair to say, however, that the enforcement of the fire walls and monitoring of these transactions may have been a little bit spotty. For fire walls to be effective, it is absolutely essential that we be able to separate the bank from the rest of the holding company if that becomes neces sary. While not an exhaustive list, the following elements are essential to maintaining this separability: • First, directors and officers of nonbanking subsidiaries must be separate from those of the bank. The overlapping of officers and directors simply creates too many possibilities for conflict of interest. • Second, the holding company, or any part thereof, must be prohibited from issuing debt with covenants that could restrict the ability to separate the bank from the holding company. • Third, the bank's directors must be able to demonstrate that the bank can operate on a stand-alone basis. However, we believe that it is important that banking organizations be allowed to take advantage of certain im portant synergies. We would permit the sharing of information and joint marketing of products, as long as they did not threaten the bank's ability to operate on a stand-alone basis. We would also permit the use of similar corporate names and logos in different parts of the organization. • Finally, if fire walls are to work, the cost of transgression should be high. Managements have typically felt that it would be unthinkable to allow any part of the organization to fail. There has been an almost moral moti vation to walk through the fire wall. Managements must accept the fact that the resources of the bank will not be available to shore up the rest of the organization. But, even with these regulations in place, bank holding companies will have strong incentives to evade and weaken these barriers in order to gain access to the cheaper funding provided by FDIC-insured deposits or to shore up a failing affiliate. Again, the cost of transgression must be high. 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Modifying the safety net The second part of our proposal deals with the operation of the safety net. Here, I would comment on three aspects of the safety net: discount window policy toward nonbank subsidiaries of the holding company; the pricing and coverage of deposit insurance; and, finally, access to the payment system, par ticularly the transfer of large dollar payments through the electronic system. The discount window has traditionally been the lender of last resort to banks and, more recently, to all depository institutions. It is crucial that the avail ability of the discount window not spread to nonbanking activities. With the increased competition that will result from bank entry into other financial ser vices, it is likely that the failure rate among financial firms will rise. As this process takes place, it is inevitable that there will be growing pressures on the Fed to broaden access to the discount window. This is something we should resist. The integrity of the system must be maintained. Moving to deposit insurance, it seems apparent that our approach to pro viding protection for the depositor needs to be substantially modified. The policy of extending protection to uninsured depositors has weakened market discipline. The problems of the thrift industry and its insurer only magnify the difficult question of how best to provide protection for the depositor yet avoid the abuses that we have been and are currently experiencing. Over the last decade, the deposit insurance funds have paid out something like $30 billion, to say nothing of the problems currently facing the FSLIC. The loss of market discipline as a result of extending deposit insurance to uninsured depositors could make the system even more expensive in the future. The egregious abuses related to brokered deposits at insolvent institutions are just another aspect of this question. The problem of deposit insurance pricing is widely acknowledged to be very difficult. But, even at the most superficial level, the current system of deposit insurance pricing makes little sense. Technically, of course, only domestic de posits under $100,000 are insured, although premiums are levied on the entire domestic deposit base; in practice, coverage has been extended to all depositors. But the problems with deposit insurance extend beyond the occasional logical inconsistency. Put bluntly, the incentives in the current system are bad. Because institutions pay the same premium regardless of risk, they pay less attention to risk than they should. Banks and S&Ls that, in the absence of deposit insurance, would have had trouble staying open, have not only been able to continue operating but, indeed, have been able to expand their deposit base. In many cases, they have chosen to invest in high-risk activities. Flat rate premiums are particularly worrisome in view of the shift toward de facto cov erage of all depositors. One solution would be to implement risk-based deposit insurance premiums. Despite the difficulties in implementing this kind of a scheme, the concept of 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis risk-based deposit insurance seems to be a good one, and would introduce a much needed element of market discipline. Now let me move on to the payment system, the financial pipeline through which most of our economic transactions flow. The Federal Reserve's large dollar payment system is moving enormous amounts of money; volume is in creasing almost geometrically and velocity is steadily rising. Because aber rations can have a very big impact on the functioning of markets, access to this electronic system should be limited to supervised participants. We simply can not afford to expose this essential part of our economic infrastructure to partic ipants that are not a part of the supervised network. As an aside, the Fed is making progress in controlling daylight overdrafts on the EFT systems. As a consequence of recent changes, the level of daylight overdrafts is actually beginning to decline in an absolute sense, making the de crease in relative terms even more dramatic. In the future, controlling daylight overdrafts may well lend itself to pricing as opposed to the current, highly mechanistic approach. The need for an additional buffer-subordinated debt So far, I have outlined the proper corporate structure and some modifica tions to the safety net. These changes should enhance the soundness of our fi nancial system. But to be truly effective, any reform proposal has to increase market discipline in the banking industry. The increased level of capital and the move toward measuring capital on a risk basis are important steps in the right direction, and they are a vast im provement over the approach that we have been using. By 1992, many banks will have raised substantial amounts of additional capital, making it much less likely that they will become insolvent. But should a bank become insolvent, it will remain difficult to resolve the problem without setting off runs or requiring outlays by the FDIC. This is one of the key deficiencies of today's supervisory system. Our proposal would alleviate this deficiency by introducing a required market-related buffer between the stockholder and the depositor, in the form of subordinated debt. Under this concept, banks- not holding companies- would issue subordinated debt in specified amounts. As the bank's losses increased, equity capital would be extinguished, but the subordinated debt would provide continued protection for depositors while bank reorganiza tion and recapitalization plans were being developed. During this process, control of the bank would shift to subordinated debtholders. This part of the process would be critical to making subordinated debt an effective buffer. While not fail-safe, this approach offers the potential of a financial version of the soft landing and might avoid the types of deposit runs and traumatic closings or regulatory rescues that we have been experiencing. Although the use of subordinated debt to fill this function raises questions that certainly need 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis to be answered, the more my associates at the Bank and I think about this idea, the better we like it. It seems to offer a good solution to the problem by putting more of the cost of insolvency back in the private sector, which we think is an entirely appropriate placement. I am convinced that if banks had had a buffer of subordinated debt in place in the 1980s, our approach to bank failures-and certainly the market response-would have been entirely different. Supervisory structure One can't leave the issue of restructuring without at least a quick reference to the supervisory structure necessary to deal with large national, indeed inter national, highly diversified financial entities. Our current supervisory structure is hardly dynamic, and certainly has more to do with the politics 50 or 100 years ago than the current situation. But, as the system now stands, the Fed, the Comptroller, the FDIC, and the state agencies all have important and critical supervisory roles. Somehow this very fractionalized system will have to be rationalized. If it is not, we could create a regulatory nightmare for bankers as new activities are added to the holding company structure and possibly reduce the efficiency of supervision, and even our ability to cope with systemic problems. We must be particularly careful to allocate clearly the responsibility for maintaining the separability that is critical to the structure that I have highlighted for you this morning. While a functional approach to supervision seems logical and would be pol itically acceptable, coordination and cooperation will be essential. U nfortu nately, I think the record at times has been less than perfect. Finally, there is the issue of the Federal Reserve's role as a central bank. The Fed needs access to information when confronted with the prospect of a financial crisis. Indeed, we really need to have that access long before the crisis develops. We have always had the ability to consult and exchange information with the various members of the financial system on a continuing basis. While this has been a somewhat informal process, it has been an essential part of ful filling our central banking responsibilities. I have no reason to expect that this informal process will not work as well in the future as it has in the past. But, I raise it because it is an issue that we need to keep our eye on as we go through this restructuring process, not after it has evolved. Conclusion To conclude, I think the industry can travel down one of two roads, but regardless of the route, the case for broader powers remains very compelling. What distinguishes the two roads is the approach to regulation. The easy choice, the easy way out, would be simply to apply our existing system of bank and bank holding company regulation to the problems of tomorrow's diversified 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis financial organization. This approach will not only stifle innovation in the fi nancial services industry, but it may further reduce market discipline. The harder path, the tougher way to go, would require us to face up to the problems in today's banking system and correct them by containing the bank safety net along the lines that I have suggested and by increasing market disci pline in the banking industry. While corporate separateness is crucial in this effort, it will not be sufficient to correct the existing problems. Market discipline can only be restored if the current level of exposure to the safety net is reduced. The current system of risk-based capital is certainly a good start, but it is not the complete solution. The increased use of subordinated debt may prove to be a particularly effective vehicle for reintroducing market discipline. Opportunities to change the system don't present themselves often. As I mentioned at the outset, during our history, banking has gone through only three major restructurings. We now have the opportunity to go through a fourth. If we don't act soon, we may lose this opportunity and be overwhelmed by events. If we make the right choice and act on it, the next few years can be a very rewarding time for the industry. If we make the wrong choice, or fail to act, we are only going to face bigger and bigger versions of the problems we face today. To me, and I am sure to this group, the choice is clear: we must not, should not, take the easy road. The structure that evolves will probably be in place for a long, long time; we are at one of those marvelous junctures where we really do have the opportunity to shape our financial destiny. I admit to a bias of optimism, but I have a hunch that we're going to do it right and that we are embarking on a very exciting part of our nation's financial history. And on that very optimistic note, let me conclude by again expressing my great appreciation for this opportunity to address you this morning. Thank you. 8 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Silas Keehn (1988, October 17). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19881018_silas_keehn

@misc{wtfs_regional_speeche_19881018_silas_keehn,
  author = {Silas Keehn},
  title = {Regional President Speech},
  year = {1988},
  month = {Oct},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19881018_silas_keehn},
  note = {Retrieved via When the Fed Speaks corpus}
}