Regional President Speech

Financial Modernization: Implications for the Safety Net Remarks by Thomas M. Hoenig President Federal Reserve Bank of Kansas City Kansas City, Missouri Conference on Deposit Insurance Session on Deposit Insurance and Financial Modernization Federal Deposit InsuranceCorporation Washington, D. C. Janua1y 29, 1998 1 Financial Modernization: Implications for the Safety Net It's a pleasure to be here today as pa1t of this panel on deposit insurance and financial modernization. Over the past 20 years, the world of finance has changed dramatically. During this period, we have seen phenomenal growth of new types of securities and derivatives markets, the globalization of finance and capital flows, and a bluning of the distinction between banks and other financial inte1mediaries. These changes in financial markets have led to public debate among Congress, financial regulators, and financial industry pa1ticipants about the appropriate role for banks, the so called "financial modernization" debate. Much of this discussion has centered on the question, Should we expand bank powers? I believe, however, that this question is not ve1y useful to us as policymakers. Modernization and expanded powers are clearly necessa1y to allow banks to adapt to the changing financial world. In my view, a more relevant question is, How does the expansion of bank powers affect the exposure of the deposit insurance system and the other components of the safety net? The main point I want to make is that the path that banks are allowed to take in expanding their powers has impo1tant implications for the exposure of the safety net. In my remarks this morning, I would like to address four questions. First, why do we need a safety net? Second, why should we be concerned about extending the safety net? Third, in light of concerns about the structure of the safety net, is it feasible to ref01m the safety net? Finally, how does the approach to financial modernization affect the exposure of the safety net? Why do we need a safety net? Let me begin by defining what I mean by the safety net. The component of the safety net that receives the most attention is, of course, deposit insurance. The safety net, however, also includes the Federal Reserve's lender oflast res01t function and guaranteed final settlement on Fedwire, the Federal Reserve's large dollar interbank settlement system. As we think about the impact of new activities on the exposure of the safety net, I think it is impo1tant that we keep all three components in mind. The safety net for the banking system has been put in place because of the unique role that banks play in the financial system-that is, because banks are, and will continue to be thought of as, "special." Banking is special because, unlike other industries, disrnptions in ce1tain banking activities have negative external effects that extend beyond banking and into other sectors of the economy. Indeed, banking problems can have a wide-ranging impact on overall economic activity. To limitthe negative externalities associated with banking problems, most countrieshave chosen not to leave the fate of the banking industry solely in the hands of the market and to establish some f01m of a safety net for banks. While banks have lost market share in business lending in recent years, one reason they are special is they still play a vital role in satisfying the credit needs of many sectors of 2 the economy. Even when banks do not directly make the loans themselves, they often provide letters of credit and other guarantees that ultimately stand behind nonbank f01ms of credit. While the health of any single bank may have little impact on overall economic activity, broader problems in the banking sector can lead to a credit crunch and reduce economic activity at the regional, national, and even international levels. One need look no farther than the cunent banking crises in Southeast Asia to see how disrnptions in bank credit flows can threaten not only the health of domestic economies, but also the health of economies in other pa11s of the world. Closer to home, we all saw how the banking problems in Texas and the Midwest in the 1980s and New England and California in the early 1990s reduced credit availability and slowed economic activity. A second reason banks are special is their role in the payments system. A well functioning payments system is essential to the workings of a modem economy because serious disrnptions to the payments system impair the ability to complete transactions and adversely affect economic activity. The payments system has always revolved around banks since bank demand deposits serve as the principal non-cash means of payment. In addition, banks perform the function of clearing and settling almost all non-cash payments. The potential for systemic problems arising from payments failures, particularly payments failures in large-dollar payments systems, suggests that pa11icipants involved in clearing and settlement operations must be subject to greater scrntiny than other institutions. Thus, due to the crncial role of banks in credit markets and the payments system, some fo1m of safety net seems imp01tant and necessa1y. Why should we be concerned about extending the safety net? Given the presence and significance of the safety net, my second question is, Why should we care if the safety net is expanded when new bank activities are pe1mitted? The answer is that while the safety net helps protect the economy from the externalities associated with banking problems, it has its own unique side effects that are costly to the economy. The most often mentioned problem is the moral hazard that banks will take excessive risks to the extent that explicit or implicit government guarantees remove the incentive for depositors and other creditors to monitor banks. Inparticular, the guarantees and reduced privatesector monitoring mean that the cost of risk taking is lower for banks than for other financial institutions. To the extent they are allowed to do so, some banks will fund investment projects that might not othe1wise be viable in the sense that the expected returns on the projects are too low. As a result, the moral hazard problem leads to a misallocation of credit, which is costly for the economy as a whole because it reduces economic efficiency. The increase in risk taking combined with the reduction in private monitoring leads to an obvious reaction-namely, greater reliance must be placed on regulat01y discipline. Regulato1y discipline has its own cost for banks as it increases regulato1y burden. Beyond banks, however, it is also costly for regulators who must keep up with the increasing complexity of ever changing bank activities and for the economy to the extent that regulatory rnles and decisions lead banks to operate less efficiently. 3 As banks expand their activities, it is at least possible that the exposure of the safety net will rise. The concern for policymakers is that the additional costs associated with an expansion of the safety net will be greater than the additional benefits. Indeed, some believe the costs of the safety net as it is cunently strnctured are already greater than the benefits. Can we reform the safety net? Given the concern about the costs of the safety net, it is natural to ask whether it is possible to reduce the exposure of the safety net by either reforming its structure or scaling it back. Proposals for changing the safety net have tended to focus on deposit insurance reff ormSome of the options that have received the most attention include scaling back deposit insurance coverage, using subordinated debt to reduce the moral hazard problems associated with the safety net, relying on private insurance systems, and creating nanow banks. Conceptually, I have considerable sympathy for ref01ming the safety net. The difficulty with changing the safety net, of course, is that it increases the potential for the systemic problems that the safety net was designed to prevent. I have argued elsewhere that safety net reform would be more feasible if we shift our regulatory focus from protecting individual banks to preventing problems at one or a few banks from spreading throughout system. By protecting the banking system in this way, individual institutions could fail without necessarily threatening the financial system. To the extent that systemic risk does decline, we could reduce the scale of the safety net and place greater reliance on market discipline because individual failures would be less threatening to the economy. From a practical standpoint, however, I wonder whether we can realistically reform or scale back the safety net in the near term for two reasons. First, I do not see a public mandate for reducing safety net coverage. Second, even apart from whether an attempt to scale back the safety net would be politically feasible, it is unlikely that a reduced safety net would be credible. Recent experience in the U.S. and other industrialized and developing countriessuggests that governments are inclined to bail out both depositors and other creditors to preserve stability in times of financial crisis even when there are no explicit guarantees. Again, the cunent events in Southeast Asia illustratejust how intense the pressure is to contain a crisis, even when it means some depositors and creditors might be protected. With the globalization of financial markets, few countries are willing to allow banking problems to jeopardize their reputation and access to international capital markets At the same time, other countrieshave an incentive to lend assistance to prevent significant disrnptions in trade and capital flows. Thus, while fundamental safety net reform should remain our long-term goal, the realities of the economic environment make such reform difficult to achieve. 4 How does the approach to financial modernization affect the exposure of the safety net? If we assume then, that the safety net will remain basically as we know it today, how will financial modernization affect the exposure of the safety net? The answer depends on the approach banks are allowed to take in adopting new powers. One approach is to pe1mit new activities to be conducted within the bank itself. The key policy issue raised by this approach is that it necessa1ily increases the exposure of the safety net to the new activities. As a result, the new activities would have to be regulated and supervised the same way as other bank activities. Whether this is the best approach to financial modernization depends on the relative benefits and costs of allowing the bank to directly conduct the new activities. On the benefit side, allowing banks to engage in new activities that have synergies with existing activities may be efficient for the economy as a whole. In addition, while new activities may be risky, modern p01tfolio the01y suggests that what matters is not the risk of individual activities but the risk of the overall p01tfolio of activities. Thus, it is possible that allowing banks to directly engage in new activities will reduce their overall 1isk through greater diversification. On the cost side, allowing banks to directly conduct new activities expands the costs associated with safety nets that I noted earlier. To the extent that banks do not bear the full social costs of their activities, they may make loans or engage in other activities that might not othe1wise be viable. In addition, this increase in moral hazard makes it necessa1y to extend regulation and prndential supervision to new activities. For example, new activities would have to be regulated under a safety and soundness criterion rather than the less extensive fraud and disclosure requirements for market-based activities. Thus, as activities are expanded within the bank, there is a greater regulat01y burden for banks, greater costs for bank regulators, and perhaps less efficient decisions by banks. The alternative to conducting new activities directly in the bank is to conduct them in affiliates or subsidia1ies that are separated and insulated from the bank with firewalls. The advantage of isolating new activities in this way is that it would limit the exposure of the safety net to new risks, thereby better controlling the costs associated with extending the safety net. In pa1ticular, while some oversight would still be required, the degree of regulation necessa1y to control moral hazard would be substantially less than if the activities were conducted in the bank itself. In general, supervision and regulation could be designed to focus on transactions and other relationships between the bank and the affiliate. More specifically, the role of supervision would be to make sure that affiliates operate as separate entities, do not expose banks to additional risks, and do not gain an advantage over nonbank firmsby exploiting the safety net. The disadvantage of this approach is that although some of the synergies remain, there would be reduced direct benefits of new activities for the bank. In addition, some additional regulation and supervision would be necessa1y, although as I just mentioned, it would be less than if new activities were conducted directly by the bank. 5 Conclusion In conclusion, I am convinced that financial modernization and expanded powers are inevitable, as banks must adapt to a changing financial world. For me, a key issue is the impact of modernization on the safety net. While the safety net serves an impo1tant role in helping to prese1ve financial stability, it also increases moral hazard. As a result, it is necessa1y to regulate banks differently than financial and nonfinancial firmsthat are not protected by a safety net. While I am in favor of safety net refo1m, it will require a sea change in attitude by the public, and this strikes me as unlikely as I view the past and current environment. Thus, as we proceed with financial modernization, we must first be aware of its impact on the safety net. Then, we should proceed only after a careful balancing of the private and social costs and benefits of new activities and, to the extent possible, in a way that limits fu1ther inadvertentextension of the safety net to new activities and firms. 6

Thomas M. Hoenig (1998, January 28). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19980129_thomas_m_hoenig

@misc{wtfs_regional_speeche_19980129_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1998},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19980129_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}