Regional President Speech

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Stern | President, 1985-2009 Economic Policy Papers Why I Dissented Economic Education Winter Institute Messages St. Cloud State University Exchange Rate Policies at the Zero Lower Bound February 26, 1999 Working Paper Independent Reviews TWEET SHARE EMAIL PRINT Banking in the Ninth The rapid evolution of the banking industry should concern policymakers and regulators. To be sure, the source of the Connect concern is not the evolution itself. That the banking industry has MinneapolisFed on Twitter Minneapolis Fed on Facebook become more consolidated, more complex and more competitive RSS Feeds may well be an appropriate and efficient response to changing market conditions and technological innovations. The trouble arises from the interaction of these developments with our policies to safeguard the banking system and bank depositors. Specifically, I am concerned that the fundamental changes taking place in the banking industry exacerbate the tendency of government safeguards to encourage banks to take on too much risk—the so-called moral hazard problem. This excessive risk taking arises when the government agrees, through means such as deposit insurance, to bear losses that firms and their creditors normally bear. Earlier this year, an official of the Bundesbank put it well. He said, “... the special role of banks must not be interpreted to mean that bank boards can count on government support in emergencies. If they could, the risk of a precarious situation in the banking sector would increase even more. This would create a moral hazard, which would result in banks taking excessive risk in order to obtain higher returns, in the confidence that they could rely on government support in the event of a failure.” Indeed, many have argued persuasively that this distortion to the risk/reward tradeoff was an important factor behind the savings and loan and banking crises of the 1980s and perhaps the recent financial turmoil in Asia as well. Given this experience, there is a compelling need to adopt policies that dampen the incentive to take on too much risk. In fact, the need for regulatory reform is no longer controversial, but deciding which reform to choose and implement is. Proposals that rely on unfettered markets or that rely exclusively on supervision and regulation are either not credible or are unlikely to effectively address the underlying moral hazard problem. Nevertheless, all is not lost. The many years spent analyzing moral hazard have also yielded promising reform proposals that make use of market signals. Moreover, regulators have made progress in shifting supervisory resources to areas of banking believed to pose the most serious threats to the deposit insurance fund. Drawing on these plans and reforms, I propose combining market signals of 1 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... risk with the best aspects of current regulation to discipline effectively bank behavior. I. Developments in the Banking Industry Will Increase Excessive Risk Taking. Several trends characterize the banking industry over the last two decades, including heightened competition, increasing asset concentration and a growing degree of complexity in bank operations. All three trends make it more likely than formerly that banks will respond to the existing safety net by taking on excessive risk. Such a response raises the specter of future economic losses, and gives policymakers and regulators impetus to reform the safety net. Increasing Competition and Increasing Risk Increased competition among banks and between banks and other providers of financial services over the last two decades has stemmed from at least two sources. First, legal reforms such as approval of inter- and intra-state banking and the phase-out of interest rate restrictions on deposits reduced banks' market power. Second, technological advances have allowed nonbank financial intermediaries to offer products that either match or improve upon the previously unique features of bank liabilities and assets. Examples of these trends on the liability side of the balance sheet are well known and include the shift in household assets away from insured deposits toward money market mutual funds and many other instruments. Other innovations, such as extensive use of commercial paper funding and securitization, have increased competition for banks on the asset side of the balance sheet. In total, these shifts unmistakably suggest a reduction in the value the market places on the unique aspects of bank products and attributes, including federal deposit insurance, and this development brings with it increased risk taking by banks. Some point to the new technology not as an incentive for increased bank risk taking but rather as evidence that banks are innovating. Banks are themselves in the mutual fund business, securitize loans and carry out valued risk management techniques through new, off-balance sheet tools. But replacement of traditional lending and funding sources with products and services offered by a wide variety of financial firms does not alter the conclusion about the decline in the economic advantages of being a bank. In fact, when the “special features” of banks no longer merit that designation, the value of being a bank falls. And when the benefit of being a bank falls, managers have less to lose and more incentive to take on risk. Increasing Asset Concentration and Increasing Risk Banking assets are increasingly controlled by the largest firms. In 1980, there were more than 12,000 banks in the country, with institutions with assets greater than $10 billion controlling 37 percent of total bank assets. These figures had barely changed by 1990 but, by 1998, there were far fewer banks (8,910), with the 64 over $10 billion in assets controlling a large share of total banks assets (63 percent). The accepted wisdom, buttressed by econometric models, forecasts a continuation of this trend toward consolidation. This rising concentration has almost certainly led to more Too-Big- To-Fail (TBTF) institutions. This matters, because policymakers and regulators have long made clear that they will rescue the 2 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... liability holders of the largest banks because of their fear of contagion and systemic instability. Because of the TBTF guarantee, liability holders do not have adequate incentive to charge large banks higher rates when they take on more risk, and thus TBTF banks face significantly less than optimal market discipline; in other words, they have the incentive to take on too much risk. Increasing Complexity and Increasing Risk Bank operations are also more complex, and therefore banks are both more difficult to manage effectively and to supervise effectively. There are several reasons for this, including: Increased bank size and geographic reach. Increased scope of product offerings (e.g., insurance sales, underwriting of securities, etc.) Increased skills needed to offer some new products (e.g., derivative structuring) and implement new risk management systems that may differ radically from previous practices. Bank supervisors have expressed concern about their ability to effectively monitor and respond to the risk taking of the largest and most complex banks. The calls to redraft the Basle Capital Accord exemplify the issue. The current accord fixes a capital charge on bank loans based on the general purpose of the loan (e.g. mortgage loans vs. commercial and industrial loans). But the capital charge does not vary with the probability that the specific loan will default. Regulators believe, however, that large banks using economic capital models have begun to arbitrage between the amount of capital they should hold given the financial risk of their credit positions and the fixed regulatory capital requirements. In practice, banks engaging in this arbitrage sell off credit positions where regulatory capital requirements exceed economic capital and retain positions where regulatory capital requirements are less than the quantity of economic capital they should hold based on risk. As a result, the banks are in full compliance with regulatory capital standards even though the expected losses of their portfolio exceed the capital that regulations require they hold. Several Federal Reserve policymakers and senior staff have argued that a capital regime based on a bank's internal models or loan ratings is necessary to end this kind of arbitrage. Implicitly then, they argue that examiners cannot quickly and adequately identify capital arbitrage and end it. In other words, regulators face a difficult time in responding to the new techniques by which large banks assume risk. II. Conventional Reforms Fall Short of the Mark Analysts have devised a variety of responses to the trends just described and their implications for moral hazard and excessive risk taking. Some well-known reform proposals take a laissez faire approach and advocate privatizing deposit insurance or moving to a system of so-called “narrow banks.” Another approach focuses attention on regulatory and supervisory initiatives. In my judgment, these responses will not adequately address the moral hazard problem because they are either not sufficiently credible or not sufficiently effective. Why Laissez Faire Responses to Moral Hazard Fall Short 3 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... Several reform proposals look to unfettered markets to manage the risk-taking incentives created by the safety net. One option, privatization, would simply eliminate the federal safety net and with it the need for regulators to monitor banks. Instead, private insurers would assume that role. Several large commercial banks are the proponents of these schemes, which vary from plan to plan but which often call for stripping deposit insurance of its federal features, such as the full faith guarantee of the U.S. government. Narrow banking plans, whose features are well known, essentially take a similar approach. The uninsured, unregulated “wide banks” under the scheme are the same as banks under a privatized system and have the same economic justification for their creation. The difference is that the narrow bank would meet the residual demand for insured deposits. The safe, transparent assets of the narrow bank eliminate the need for existing safety and soundness examinations and, presumably, for federal insurance, although it could be retained if desired. A third alternative would also rely on market forces alone to reduce exposure under the safety net by further diminishing the value of being a bank; this proposal might be viewed as “accepting (or accelerating) the inevitable.” To achieve this outcome, policymakers could, for example, provide nonbank financial intermediaries access to services previously reserved for banks. For example, the government could grant mutual fund organizations direct access to the small dollar retail payment system. In a more extreme case, the government could auction deposit insurance coverage to nonbank intermediaries. Competitors presumably would use new powers to increase market share and profitability vis a vis banks and further reduce the distinction between bank and nonbank financial intermediation. In response, banks could give up their charters or more likely move assets to nonbanking firms they control. Excessive risk taking in the banking sector would become relatively inconsequential as the portion of the banking industry under the safety net shrinks. A serious problem with these laissez faire approaches is that they do not credibly address the potential for instability in the banking system nor the related TBTF problem. The complete absence of a federal safety net creates the potential for banking panics which could have substantial financial and real costs, but one need not hold this view to conclude that laissez faire reforms will fail to reduce risk taking incentives. This is because policymakers and regulators have long made clear that they will rescue liability holders of the largest banks, and perhaps even smaller institutions, because of their fear of contagion and systemic instability. These policies raise doubts about the credibility of the "no government support" pledge central to privatization and narrow banking plans. As such, narrow banking and privatization are not likely to reduce materially market expectations of bailouts and hence the accompanying under pricing of risk. And as the discussion suggests, the problem is particularly acute for large institutions. The suggestion to encourage further decline in the value of the banking charter also lacks credibility, as it could easily produce the very outcome it purports to eliminate. As noted above, the decline in the value of being a bank leads, other things equal, to more risk taking. Hence, excessive risk taking may well occur as 4 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... further diminution in the value of the bank charter takes place. At the same time, the proposal may magnify the exposure of the taxpayer by potentially extending the safety net to nonbank intermediaries. Why Regulatory and Supervisory Approaches to Moral Hazard Fall Short The primary response to the pernicious incentives created by the safety net is to regulate bank risk taking. Policymakers and bank supervisors have both taken, and proposed, several legal, regulatory and supervisory responses to the new trends in banking. In total, these reforms have focused resources on banks in poor financial condition. For example, banks in relatively poor financial shape pay a higher deposit insurance premium. Likewise, banks in weak financial condition face restrictions on their activities and more frequent examinations than financially sound institutions. And for all banks, supervisors have implemented examination procedures which shift staff resources to review of higher risk activities and of the banks' policies for controlling their risk exposure. Finally, regulators have hired more “rocket scientists,” staff with the specialized human capital necessary to evaluate new forms of bank risk taking and management. All of these steps appear beneficial. But even with them, we cannot rely solely on regulatory and supervisory reforms to adequately contain moral hazard incentives. There are several reasons for this conclusion, including: Moral hazard results when economic agents do not bear the marginal costs of their actions. Regulatory reforms would not directly alter marginal costs. The strength of legal and bureaucratic norms, along with the ability of banks to alter their risk profiles quickly, makes restricting bank activities in a timely fashion difficult. Moreover, regulatory forbearance has occurred at times when rapid bank closure would have been the appropriate policy. Unfortunately, current rules meant to close banks while they are still solvent may be incapable of achieving that outcome. Regulators have access to “inside information” that helps them judge the riskiness of bank activities. But government agents do not have a sound basis for determining how much risk taking in the banking industry is “too much” or “too little.” Banking supervision and regulation, in other words, should not be expected to lead to something like an efficient amount of risk taking. The asymmetry of information between banks and regulators limits the effective use of internal bank practices to supervise banks. For example, regulators cannot reasonably verify the accuracy of bank capital models and comfortably use those results in the regulatory process with precision. It is unlikely that society will allocate enough resources to regulators so that they can hire and retain quantitative staff on a par with the firms the regulators must examine. These observations do not argue against any of the changes to regulation that have been made or that have been proposed. Indeed, it is a positive step that policymakers and supervisors have moved from a traditional command and control regime to a 5 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... system where supervisory intensity and rules depend on the financial condition and management of the bank. However, regulatory steps alone are unlikely to adequately address distortions created by the safety net. Rather, and let me emphasize this, market signals, in conjunction with regulation and supervision, constitute the “required discipline” that will lead to improved management of the moral hazard problem. Note, also, that application of internal bank capital models in supervision, an adoption of a market practice, is not a step toward market discipline. Market discipline requires market pricing of bank liabilities under circumstances where participants know they bear at least some risk of loss. III. Incorporating Market Signals in the Regulatory Process. Increased market discipline is then an essential step in addressing moral hazard. However, incorporating market signals from creditors put-at-risk into the regulatory process requires a credible policy framework, one which accounts for TBTF and potential systemic instability, and which supervisors and legislators will embrace. Further, market discipline alone has limitations, and therefore it should be incorporated with existing regulation. The idea, then, is to require, by law, that depositors and other creditors at all banks, even those considered TBTF, bear some risk of loss in the event of the failure of the institution, and to incorporate the market signals that this policy generates into the current regulatory regime. What Market Signals Offer A wide body of empirical research suggests that bank creditors, credibly put at risk, do assess and act upon the risk taking of banks. That is, these investors alter their pricing to reflect changes in the riskiness of the bank. The incorporation of new information by creditors means that market prices for bank funding will directly affect the bank's marginal cost of taking risks. In particular, this means that greater reliance on market signals is potentially capable of reducing the mispricing of risk taking which occurs today. Moreover, market participants have proven reliable in analyzing and incorporating new means of production in their assessment of risk, so further financial innovation can be expected to be accommodated within this approach. A Policy Framework With Market Signals and Regulation Development of a policy framework for the use of market signals requires two steps. First, policymakers must credibly put creditors and others capable of providing market discipline at risk of loss, so that market signals are generated. To accomplish this successfully, the reform must address TBTF and instability. Second, bank regulators must explicitly and systematically incorporate market signals into the supervisory process. Creating Credible Market Signals Analysts have suggested several credible methods for developing market signals. The Federal Reserve Bank of Minneapolis has called for amending FDICIA so that uninsured depositors and other creditors at TBTF institutions would lose a modest but meaningful percentage (e.g. 20 percent) of funds if their bank fails. This plan takes advantage of the vast experience of private insurers who have long used coinsurance to address moral hazard. In the banking context, such coinsurance is credible because the limitation on loss size 6 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... should preclude substantial financial spillovers, and thus the issue of contagion should not arise. As a result, Congress and bank supervisors would have less incentive to bailout TBTF institutions or worry excessively about the threat of panics. Once at risk, these uninsured creditors would demand additional information about their banks to the degree that current disclosures do not allow for a clear assessment of risk taking, and so we recommend mandating additional disclosure requirements only after assessing the data provided voluntarily under this new regime. With increased incentive for large depositors to monitor the quality of banks, the risk premia found in the rates charged by such depositors and other creditors put at risk should provide good evidence of bank risk. A similar type of plan would, alternatively, require large banks to issue subordinated debt equal to some small percent of the bank's assets. Subordinated debt holders come only before equity holders in making a claim on failed bank assets. Thus, they could lose a significant investment if their bank becomes insolvent. This gives subordinated debt holders incentives that regulators should desire. The debt holders want banks to take enough risk to generate profits, but they should demand bank closure before the institution becomes more than minimally insolvent. The Federal Reserve Banks of Chicago and Atlanta have been leaders in developing these plans and, more recently, Federal Reserve Board Governor Meyer has actively reintroduced such a proposal. Although subordinated debt plans vary by author, their general structure has generated more support than proposals that rely on depositor discipline. In particular, holders of subordinated debt cannot demand immediate repayment as can some depositors, and therefore such plans are seen as potentially less destabilizing. Moreover, the subordination of debt could reduce the likelihood that holders would receive coverage during a bank bailout. However, there are no free lunches; the market discipline/instability tradeoff is inescapable. The secondary market for subordinated debt has the potential to be illiquid, in part due to mandating the issuance of such securities in greater amounts than currently demanded or supplied. Moreover, some subordinated debt plans require relatively infrequent issuance of the debt. These two traits could limit the usefulness of the market signals provided by subordinated debt. In addition, some subordinated debt plans are vague as to how they would address TBTF. Private insurance offers a third source for generating market signals. Congress could require large banks or the FDIC to purchase a small amount of private deposit insurance, covering 5 percent of deposits, for example. In fact, in 1991 Congress mandated that the FDIC study the establishment of a private reinsurance system. Financial engineers could also design instruments to allow private investors to bear the cost of covering insured depositors. Such instruments already exist for natural disasters. Either of these proposals would require market participants to price the likelihood of a bank's failure. The effect of these arrangements on stability depends on the confidence of the insured creditors. If they do not believe private insurance capable of honoring their claims, insured creditors will run banks, although 7 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... the limited amount of risk they would bear should limit that problem. Moreover, these insurance arrangements do not address TBTF per se. But they could be structured such that the bailout by the government of the liability holders of a large bank with private insurance does not eliminate the insurer's requirement to make a payout. As such, pricing should still reflect the risk of a claim against the private insurer. All of these proposals to put bank creditors at risk have the virtue of gradual implementation, if needed. The coinsurance rate, for example, need not rise to 20 percent at once (or ever), nor does the required amount of subordinated debt have to meet its maximum level at once. This should reduce concerns about instability. Incorporation of Market Signals Putting bank creditors at risk, however, is not a replacement for supervision. Some portion of large bank assets, for example, will remain opaque, leading to incomplete information for market participants and, presumably, to imperfect market signals. The supervisory process can generate and act on valuable information for such assets and therefore may contribute to restriction of bank risk taking. More generally, the market discipline provided by creditors may not be enough on its own to address excessive bank risk taking. If creditors bear only a small amount of loss when banks take on extreme levels of risk—perhaps because they are well diversified and receive high compensating interest rates—then the perverse incentives of the safety net would to some extent remain. More practically, policymakers and regulators do not appear willing at this time to create bank supervisory regimes dominated by the market signals creditors create. Thus, the supervisory process will continue to play an important role going forward. In this environment, to rein in moral hazard effectively, the signals created by the market must be incorporated in two general areas of regulation: deposit insurance assessments and the supervisory process. Assessments: Under any credible reform to the safety net, the government will continue to provide a base level of deposit insurance. To limit moral hazard, then, the government must charge deposit insurance assessments that vary with the riskiness of the bank (as signaled by the market). The means of incorporating market signals into the assessment depends on the source. Private insurance premiums would offer the most straightforward source for incorporation, but other market signals would work as well. The risk premia evident from the prices charged by depositors or other creditors put at risk of loss suggests a way to differentiate deposit insurance pricing. In order to reduce administrative costs, the deposit insurer would most likely group institutions with fairly similar risk premia into assessment categories. And the insurer would surely use market premia as only one factor in the assessment setting process, along with supervisory and other information that add predictive value. Supervisory Process: The existing regulatory system relies in part on “triggers” which require risky institutions, as evaluated by bank supervisors, to face more supervisory scrutiny, higher insurance costs and more restrictions on activities than do sound institutions. Under Prompt Correction Action (PCA), for example, banks with declining capital ratios face increasing restrictions on 8 of 9 3/22/2017 3:38 PM From Command and Control to Market Discipline: How Regulation Shou... https://minneapolisfed.org/news-and-events/presidents-speeches/from-... activities until the point that regulators close them. The frequency of bank examinations is also linked to capital ratios and supervisory ratings of management (for smaller banks). Incorporating market signals into these supervisory triggers would enhance the ability of supervisors to address moral hazard. In a fairly simple approach, supervisors could make use of the new, risk-based deposit insurance premium groupings to sort banks into various trigger categories. Alternatively, supervisors could put banks into regulatory categories based on their funding costs relative to some benchmark rate (e.g. the average rate on a particular quality bond or the average for bank debt). IV. Thoughts on the Future The reforms suggested here are modest in many ways. They maintain deposit insurance, the existing supervisory structure, and phase in change gradually. At the same time, the reforms create the infrastructure for future efforts. They do so by starting to address directly the fundamental problems of moral hazard and banking instability and by taking the first steps toward explicit incorporation of market signals into the regulatory process. They also give regulators and policymakers time to learn and gain experience, thereby likely enhancing the quality of additional, future reforms. Why bring up future reforms on the heels of this proposal? One answer is that the justification for regulation and the safety net declines, and could eventually disappear, if banks continue to become more like other financial services firms. These reforms provide a framework for transitioning from existing regulation, to regulation and market signals, to a system even more reliant on the market. Top TWEET SHARE EMAIL PRINT Minneapolis Fed Other Federal Reserve System Sites About the Fed Privacy and Terms Board of Governors Kansas City Banking Supervision Disclaimer Atlanta New York Economic Research Accessibility Boston Philadelphia Regional Economy Glossary Chicago Richmond Community Careers Cleveland San Francisco News & Events Contact Us Dallas St. Louis Publications loading 9 of 9 3/22/2017 3:38 PM

E. Gerald Corrigan (1999, February 25). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19990226_e_gerald_corrigan

@misc{wtfs_regional_speeche_19990226_e_gerald_corrigan,
  author = {E. Gerald Corrigan},
  title = {Regional President Speech},
  year = {1999},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19990226_e_gerald_corrigan},
  note = {Retrieved via When the Fed Speaks corpus}
}