Regional President Speech

THE FINANCIAL SAFETY NET: COSTS, BENEFITS, AND IMPLICATIONS FOR REGULATION 37TH ANNUAL CONFERENCE ON BANK STRUCTURE AND COMPETITION Chicago, Illinois May 11, 2001 ..................................................................... A Review of the Conference Good afternoon. While you’re finishing your dessert, I’d like to take a few minutes to summarize some of the discussion we’ve had during this year’s Bank Structure Conference. Yesterday in my opening comments, I stated that we had chosen a timely theme for this year’s conference. I believe the discussion has borne that out. It is issues related to the safety net that are dominating the pub- lic policy debate in financial services. How we choose to address these issues, both in the U.S. and interna- tionally, will have lasting implications for the financial industry and for society. Why are issues related to the safety net so controversial? As with most regulation, there are benefits and costs associated with the safety net which one, are difficult to quantify to capture the net effect, and two, have sub- stantial distributional effects across sectors of the industry and society. The major argument concerning the benefits of the safety net are well known: by enhancing financial stabil- ity, the safety net has induced more macroeconomic stability and has allowed the economy to be stronger and less volatile than it otherwise would have been. The costs of the safety net were succinctly summarized by Chairman Greenspan yesterday. He noted that the costs include distortions in the price signals, induced excessive risk-taking, and greater government super- vision and regulation in order to limit moral hazard. The result of these costs is a “vicious circle” in which the government replaces market oversight, and real resources are misallocated. Perhaps the most frequently cited example of these costs is the role of moral hazard in the financial problems of the 1980s in the U.S. Michael Moskow Speeches 2001 379 So, as in most economic endeavors, there is a trade off. Some would argue that financial markets can best accomplish their basic function of efficiently allocating capital if market forces are given full reign. Yet given ahistory of occasional, but significant, market instability, society has decided that this market process should not be wholly unchecked. As a result, the debate rages over the net benefits of the safety net and how best to reap the benefits without incurring significant costs. I’ll return to alternative means of accomplishing this in a minute. We also said that there were distributional effects resulting from the safety net. Yesterday it was argued that the stakes of safety net reform are quite high. At issue is the very viability of community banks, and the sec- tors of the economy that these banks disproportionately service. It was argued that guarantees for larger banks associated with the safety net most importantly, the implicit and explicit “too-big-to-fail” provisions put community banks at a competitive disadvantage. The competitive playing field needs to be leveled. If the implicit safety net provided to larger banks is not reduced, it is argued, then this leveling can only occur by increasing the safety net benefits to those that are disadvantaged. How best can we adjust the safety net to reap the recognized benefits without imposing undue costs? This is a topic on which there was much discussion, and much disagreement. Yesterday, it was that while more improvement is necessary, a number of key regulatory reforms have already been put in place to limit the undesirable consequences of the safety net. These include aspects the Federal Deposit Insurance Corporation Improvement Act as well as the initial Basel Capital Accord, which increased capital standards for selected higher-risk banks and decreased the value of the put-option embedded in the safety net. Butthereare many other proposed improvements. Last year the FDIC initiated a comprehensive review of the federal deposit insurance system. The conclusions of that evaluation were presented yesterday. Many of the recommendations were the result of concerns about the inflexibility embedded in the current “Hard-Target” approach to funding. This current approach has several undesirable aspects. Banks pay most premiums at the timetheycan least afford it, safer banks subsidize risky banks to a greater extent than is necessary, and new deposits receive insurance without having to pay for the coverage. To increase flexibility, the FDIC made 5 basic recommendations including developing a premium scheme that has all banks paying some premium for coverage on a regular basis, based on risk; relaxing the hard fund- reserve target and using surcharges and rebates to manage the size of the fund; and indexing coverage to allow it to vary through time, with the starting point coverage explicitly decided by Congress. Others would go further than the changes proposed by the FDIC. This morning additional efforts to have the deposit insurance arrangement more closely imitate, or mimic, the private marketplace were proposed. MIMIC, as the proposal has been labeled, advocates two new adjustments to deposit insurance. First, it calls for the FDIC to pay for both the line of credit and re-insurance that the Treasury provides. With responsibil- ity for paying risk-based fees, the FDIC is more likely to more accurately charge them to banks. Second, it was recommended that there be a dilution fee on any new deposits that come under the FDIC umbrella. The fee would preclude growth at any bank from reducing the reserve ratio and imposing extra costs on other banks. At the same time, the FDIC would refund fees to banks that lose insured deposits. Perhaps the most contentious debate concerns the tradeoffs in deciding upon the appropriate extent of the safety net. How do we weigh the benefits of financial stability against the moral hazard implications? Ideally we could adjust the safety net to reap the benefits, but have banks behave as they would if there were no safety net. Proposals attempting to approximate that ideal model have been discussed during this conference and at past 380 Michael Moskow Speeches 2001 Bank Structure Conferences. They include proposals such as co-insurance; increased reliance on subordinat- ed debt; narrow bank proposals; cross-guarantee arrangements; structured-early-intervention; and an array of proposals classified as incentive-compatible regulation. I agree with comments made yesterday that it’s highly unlikely that the debate over bailouts and moral haz- ard will ever be satisfactorily resolved. But improvements can be made and we should be willing to critical- ly evaluate proposed changes to the current structure. I believe this conference has once again served an important role in bringing together the relevant parties from within the industry, the regulatory agencies, and academia to help shape public policy. The evidence on the issues needs to be critiqued and the issues need to be debated. From that standpoint, I think the conference has been a great success and I’d like to thank Doug Evanoff and Curt Hunter of our Research Department for their outstanding work in organizing the conference. And we are not done. A current policy issue that has received significant attention over the past six months is the appropriate role and regulation of Government Sponsored Enterprises. Yesterday we discussed the impact of GSEs on the underlying markets and had a healthy discussion of the impact of these entities on market behavior. It was obvious that the views of the participants were very firmly held. Today we continue our evaluation of this most important topic. In fact, the remainder of the conference is dedicated to the topic of GSEs; which leads me to our luncheon speaker, Armando Falcon Jr., Director of The Office of Federal Housing Enterprise Oversight. The office func- tions as the financial regulator of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Mr. Falcon was not a newcomer to Washington when he was appointed to his current position in January of 1999. For the preceding eight years, he served on the legal staff of the Committee on Banking and Financial Services of the House of Representatives. During his last three years with the committee, he was General Counsel. Previously, Mr. Falcon was an attorney in private practice in San Antonio Texas. He received his undergraduate degree from St. Mary’s University, before attending the John F. Kennedy School of Government at Harvard, where he received his masters, and the University of Texas School of Law. Please welcome, Armando Falcon, Jr. Michael Moskow Speeches 2001 381

Michael Moskow (2001, May 10). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20010511_michael_moskow

@misc{wtfs_regional_speeche_20010511_michael_moskow,
  author = {Michael Moskow},
  title = {Regional President Speech},
  year = {2001},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20010511_michael_moskow},
  note = {Retrieved via When the Fed Speaks corpus}
}