Regional President Speech

Housing Roundtable, board of directors Robert T. Parry, President San Francisco, CA Federal Reserve Bank of San Francisco 12:00 Noon POT, June 6, 1991 BANKING REFORM: A PERSONAL PERSPECTIVE I. Introduction A. Banking reform is one of the most important items on the current legislative agenda. 1. The deposit insurance system and bank powers restrictions that made sense 1n the 1930's, when they were conceived, don't seem to be working well today. B. I'd like to talk to you about: 1. Why the problems arose, and why reform is important; 2. What has been proposed, in the form of the recent Treasury proposal; 3. And close with my assessment of what is likely to come out of the reform debate. II. Why reform of the bank safety net is important Raauve Bank A. ~~·t.~rance was conceived with a worthy.goal: ~~~1on of runs on banks by nervous depos1tors. 1Jni%t~unately, 3.-.JWN under our system of deposit insurance, banks can hold little capita~, and do l-~D~II~ri~ky things, without affecting their cost ~s1t funds. B. The banking system reacted to these incentives right away, with bank capital ratios falling from 15% to 6 or 7% within a few years. 1. But the serious consequences of this "moral hazard" problem lay dormant for many years. 2. This changed in the 1970s. a. Keener domestic and international competition depressed bank charter values. b. Economic conditions hit bank and thrift portfolios hard, reducing the equity they had 1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis at risk. c. In this undercapitalized state, US banking organizations exploited the moral hazard built into the D.I. system. III. Deposit Insurance Reform A. Earlier this year, the Treasury released its plan for reforming the deposit insurance system and bank powers regulation. 1. Let me address the D.I. proposals first. B. The Treasury proposal has much to commend it in this area: 1. It recognizes that capital plays an important role in controlling the moral hazard problem, 2. And that market discipline needs to be enhanced. 3. It recognizes the need for more timely action by regulators, proposing stages of prompt corrective action when banks' capital becomes deficient. C. The shortcomings of the Treasury reform proposals are not in its sentiments, but in the specifics of the execution. 1. For example, the Treasury proposal calls for increased reliance on minimum capital standards and prompt corrective action; the actual execution, however, leaves too much to the dis~retion of the regulators. a. There are great pressures on a regulator to wait and hope for recovery in the fortunes of a weak bank. Heavy reliance on mandatory action is needed to give the regulator sufficient resolve to avoid forbearance. 2. Likewise, the Treasury's proposals on handling the too-big-to-fail problem are basically correct, but suffer somewhat in the details. a. Although the proposal does not endorse the TBTF policy, it gives the Treasury and the Fed wide latitude in making exceptions when they are concerned about "systemic" effects. b. In my view, TBTF actually helps create the 2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis potential for systemic problems: (1) With TBTF, the interbank deposit market has evolved without concern about the riskiness of big banks. (2) This means that there are more, unmonitored relationships in this market than there would be if big banks were not TBTF. Hence, more systemic risk. c. I recommend putting greater restrictions on TBTF than are included in the Treasury proposal. (1) By singling out large banks for special treatment, TBTF policy creates a bias against small banks. (2) If the Treasury wants to prevent a particular closure because of its systemic effects, the financial burden should be borne by Treasury, not the DI fund or the industry. 3. The Treasury proposal also makes an effort to increase discipline by cutting back on coverage, an effort I applaud. a. It would reduce coverage of multiple accounts, as well as eliminating coverage of pass-through and brokered deposits. b. I think the elimination of the latter two are more important than reducing coverage on individual accounts. (1) Little additional discipline is likely to be gained from individual depositors. c. Moreover, cutback's of coverage of "small" depositors may be politically unrealistic, since the security of the small depositor's funds is paramount politically. d. In addition, equity and subordinated debt holders and the insurer would be sources of discipline. 4. Improving insurer discipline requires not only prompt intervention, but also improvement in our ability to mark bank portfolios to market. 3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis a. The Treasury is uncomfortable with the practical aspects of market value accounting. b. But a closer approximation to market values is possible. c. And it is necessary if the value of claims against the DI funds are to be known before it is too late. 5. The DI funds could use this information either to modify their corrective action thresholds, or to price deposit insurance more sensibly. a. As Mark Levonian, one of our economists, has concluded, a simple two-level system of deposit insurance premiums, based on capital levels, would be effective in controlling moral hazard incentives. IV. Powers Reform A. I don't think that powers reform is a make-it-or-break-it sort of issue like deposit insurance. 1. Nonetheless, this is an area where reform has the prospect of making banks healthier. B. In the area of securities underwriting, the Treasury proposal suggests relaxation of current Glasa-Steagall restrictions. 1. This makes a lot of sense to me, since banks have monitoring and evaluation expertise that could be useful in the investment banking area. 2. Therefore, investment banking and commercial banking appear to be kindred functions. C. The Treasury also recommends eliminating restrictions on interstate branching. 1. I believe that banks should be able to choose the organizational form that is most cost-effective and revenue-effective for them. 2. That may, in some cases, be branch networks, rather than networks of affiliated banks. a. After all, that seems to be the chosen form 4 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis in countries that don't have prohibitions against this form. 3. I doubt, however, that national branching will do as much for the bottom line as some bankers seem to think. a. Work in our Bank on the effects of interstate banking (Laderman and Pozdena) suggests that it depresses bank profitability: the heightened price competition more than offsets the cost-savings from any scale economy or diversification effects. b. So, by analogy, although national branching offers potential administrative cost savings, it also makes entry easier and heightens local competition. The result may be lower, not higher, bank profits. D. The Treasury position on mixing commerce and banking powers is one that raises, perhaps, the most interesting questions. · 1. The Treasury would permit commercial firms to own banks, but not vice versa. 2. The idea of having commercial firms own banks is an effort to bring capital to the banking system. a. My guess is that the effect of this would be small; it's not clear that this prohibition has been a serious barrier to the flow of capital to banks. b. More importantly, are there compelling economic reasons why a commercial firm would want to own a bank? (1) They can always make diversified investments in the banking sector via the stock market. (2) And I certainly hope that it would not be seen as a way of getting underpriced deposit funds. 3. The prohibition against banks holding commercial or real estate equity, on the other hand, is a significant feature. a. The Treasury's position represents an 5 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis increase in regulatory restrictions, since, statutorily at least, commerce restrictions previously applied only to national banks. (It would now be applied to state-chartered banks, as well.) b. Such commerce powers are enjoyed de jure or de facto by our major competitors, Japan and Germany, and several other European countries. (1) And the EC banking directive may have the effect of having this so-called "universal" form of banking propagate throughout Europe in 1992. c. Two of our Bank's economists (Kim and Pozdena), have offered the theoretical arguments in favor of universal banking. (1) I'm not sure I'm as convinced as they are, but when both empirical evidence and theory point in the same direction, it is worth some consideration. V. Conclusion: Where things stand now. A. Of course, we're still in the very early stages. But I think there's a reasonable chance that some real reform may be forthcoming: 1. I hope, for example, that we will modify TBTF as a policy. a. This was one of the most roundly-c~iticized limitations of the Treasury proposal, and Chairman Greenspan recently spoke critically of TBTF. 2. In addition, I think it is likely that a policy of prompt corrective action will be embraced. a. In a recent American Banker survey, for example, all 11 bank trade groups surveyed were in favor of (or at least neutral toward) a firmer capital test. b. The ABA recently even offered tentative backing to FFIEC's proposal to use market value accounting in certain areas of bank portfolios. 6 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3. I also expect that, since liberalization of interstate branching made it through the House sub-committee without much trouble, it should be passed by the full committee. 4. The Glass-Steagall barriers, however, are not very likely to fall. a. For many policymakers, powers expansion is seen as risk expansion. b. Therefore, we may have to go through DI reform before we make progress here. B. Overall, then, I'm cautiously optimistic that significant reform will occur this year. C. I'm less optimistic that our banks will be ready for the challenges of competing internationally, particularly with European banks in 1992. 7 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Robert T. Parry (1991, June 5). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19910606_robert_t_parry

@misc{wtfs_regional_speeche_19910606_robert_t_parry,
  author = {Robert T. Parry},
  title = {Regional President Speech},
  year = {1991},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19910606_robert_t_parry},
  note = {Retrieved via When the Fed Speaks corpus}
}