The Region

Addressing the Trade-offs: Market Discipline, Stability and Communication

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Gary H. Stern - President, 1985-2009

Published December 1, 2007  |  December 2007 issue

The near collapse and likely sale of Northern Rock—a major mortgage lender in the United Kingdom—highlights once again the fragility of banks. Banks do not often survive when depositors, exercising market discipline, run. In this case, market discipline came at the expense of financial stability.

Northern Rock also illustrates the potential downside of central bank communication around stability issues. Policymakers hoped the announcement of central bank support for Northern Rock would quash depositors' inclination to pull funding. It had the opposite effect; government support reinforced concerns about Northern Rock's solvency and depositors' access to their funds.

Observers might conclude from the Northern Rock experience that an immutable trade-off exists between financial stability and market discipline for banks; that is, an increase in market discipline inevitably begets a reduction in stability. Observers may fear a similar trade-off between financial stability and central bank communication. Certainly policymakers cannot altogether eliminate these trade-offs and must give them serious respect and attention, particularly after a financial crisis erupts. But inadequate market discipline and communication also come with a heavy cost. Both could encourage excessive risk-taking by banks, and such risk-taking could make financial crises more likely.

Ideally, then, central banks would encourage market discipline and communicate about stability-related issues without materially heightening the risk of financial crises. In fact, policymakers can make significant progress toward this goal, recognizing that such gains will prove challenging. The key step is to limit the potential for spillovers or contagion effects (that is, the case where losses from one financial firm or market spread to other firms or markets and then to the broader economy) and communicate about such efforts. To be effective, these actions must come before instability breaks out.

Addressing moral hazard and instability through management of spillovers

In this context, market discipline refers to the price and quantity restrictions that creditors impose on banks. Such creditor actions signal banks about their risk-taking. A bank taking too much risk may find its actions constrained by the price it has to pay to raise funds or, in the extreme, by its inability to raise or retain funds.

In the U.S. economy, we typically expect creditors to provide proper discipline and do not need policies to encourage it. But banking faces the so-called "moral hazard" problem that may lead to insufficient discipline. In the banking context, moral hazard typically refers to the case where bank creditors expect to be protected from loss should their bank fail.

As a consequence of this expectation, creditors charge a lower price for their funds and/or provide more funding than they otherwise would. Such mispricing leads banks to take more risk than otherwise. And the consequence of such risk-taking can be quite costly, resulting in a significant misallocation of resources. Outside the United States, in particular, such misallocation has contributed, in some cases, to massive declines in standards of living in recent decades.

Why do creditors expect bailouts? In some cases, the government provides explicit guarantees that shield depositors from losses (for example, deposit insurance). Among other things, deposit insurance systems reflect policymakers' desire to have a strong bulwark against financial panics and bank runs.

In other cases, creditors believe that they benefit from an implicit government guarantee. In many of these situations, creditors may in fact believe that they have more protection than policymakers intend to provide. Federal Reserve Chairman Ben Bernanke recently argued that implied guarantees have the anticipated reaction of policymakers to spillovers at their root. He noted that "market discipline may erode further if market participants believe that, to avoid the risk of a financial crisis, the government will step in to prevent the failure of any very large institution—the 'too big to fail' problem."1  Put another way, governments provide protection to creditors to limit the costs of spillovers.

Reducing the threat of spillovers, or responding to them without bailouts, should dampen creditors' expectations of receiving full protection and should, therefore, increase market discipline. And, of course, reducing the threat of spillovers directly increases financial stability. Better management of contagion effects can therefore mitigate the trade-off between market discipline and stability.

As usual, the devil is in the details. Policymakers must have confidence that the reforms proposed can really diminish spillovers. I have discussed reform possibilities in other venues. Suffice it to say that proposals range from limiting losses to banks and others in the first place to reducing the degree to which payment systems are the conduit for spillovers.2  The main point is that many actions limiting spillovers reduce the chances of instability and simultaneously make more market discipline possible.

Addressing moral hazard and instability through communication 3

What role can communication play in this set of proposals? My premise is simple: We cannot expect creditors to read minds. Creditors who might otherwise expect bailouts, given past policy and history, must be informed of central bank plans to put them at risk of loss—that is, their expectations of being rescued must be diminished. Otherwise, market discipline will not increase as much as it should. Communication about stability-related initiatives can therefore increase market discipline through its effects on creditor expectations without increasing systemic concerns, provided that spillovers are limited effectively.

Note that the communication effort needs to occur prior to a crisis. The goal is to communicate early on about actions of the central bank and other agencies that reduce the probability of spillovers. Once a crisis breaks out, it is exceedingly difficult to control instability and ensure that communication has the intended consequences.

Before discussing what communication should look like, let me rule out some alternatives. For example, "jaw-boning," constructive ambiguity and general statements announcing that creditors are at risk of loss are not likely to be helpful in establishing credible commitments. Sophisticated creditors will see through such protestations. Indeed, after years of such claims, one of the major credit rating agencies argued this year that creditors of the nation's largest banks-including some not heavily involved in complex activities-will almost surely benefit from bailouts.4

What would constitute improvement?

More regular and predictable communication.

Monetary policy provides a useful model here. A number of regular events, most notably Federal Open Market Committee meetings and the semi-annual Humphrey-Hawkins testimony, provide opportunities for focused communication about monetary policy. Such focus helps to cut through the noise that the intended audience—households, firms and elected officials—must battle and helps to set expectations. To quote Chairman Bernanke again: "Central bank communications is a key component of monetary policy; in a world of uncertainty, informing the public about the central bank's objectives, plans, and outlook can affect behavior."5

Communication about stability policy currently has no such focal point for creditors and other parties potentially interested in such issues. An annual or biannual report on efforts to bolster financial stability might provide a useful focus. Output from other central banks on stability offers samples the Federal Reserve may or may not want to adopt.6

Earlier and greater disclosure.

The Federal Reserve and other agencies routinely have initiatives under way that contribute to understanding of the risk of financial instability. Indeed, the central bank, supervisors and the deposit insurer have made progress over the past several years in identifying potential sources of systemic risk and taking steps to address them. The deposit insurer, for example, has proposed reforms that would allow it to better identify which depositors it must protect, given deposit insurance limits, should a large bank fail and which it can impose losses upon. Supervisors have, in another example, encouraged the shoring up of key parts of the payments infrastructure.  These examples, of course, provide only a sense of the efforts to increase stability that supervisors have taken.7

The Federal Reserve should consider disclosing more information about these efforts, perhaps even as works in progress. Surely sufficient detail can be conveyed to convince creditors that the effort is fire, not smoke, without divulging confidential supervisory information or inadvertently prompting instability. We could, for example, communicate tasks undertaken as part of a failing bank exercise without identifying the depository institutions of interest. Again, timing is important. Disclosing such activity outside of a crisis should decrease the chance of unintended consequences.

Linking stability actions and market discipline.

Limiting moral hazard is not and should not be the primary driver of efforts to manage spillovers and systemic risk. But central banks should take advantage of this secondary benefit, given that it comes at virtually no cost; central banks will already be communicating about stability-related work.

Addressing moral hazard requires one important change in communication. To curb moral hazard, policymakers should explicitly link stability-related initiatives to increased potential for creditor loss. While one might expect creditors to draw such connections on their own and understand the central bank's commitments, the Federal Reserve should ensure that these links are transparent.

Conclusion

Observers have long pointed to a trade-off between increases in market discipline and reductions in financial stability. They have also typically feared that clear central bank communication about stability may, inadvertently, lead to greater instability. While such trade-offs certainly exist, policymakers should not respond to them by giving up on either market discipline or communication. In fact, by enacting reforms and policies to better manage the problem of spillovers, and communicating about such reforms, policymakers can actually help to limit excessive risk-taking by banks.

Here I have offered several options for enhancing such communication; these options include more regular statements, additional detail on stability-related activities, and explicit links between stability-related work and the objective of increasing the market discipline of large financial institutions. Policymakers should certainly consider other enhancements as well. But they should not wait. If nothing else, the Northern Rock case suggests that the problem of financial instability will not resolve itself with the passage of time. Instead, policymakers must renew efforts to get spillovers under control, and such efforts should also seek to improve related communications.


Endnotes

1 See Ben S. Bernanke, "Financial Regulation and the Invisible Hand," remarks at the New York University Law School, April 11, 2007.

2 For a discussion of the full range of options, see Gary H. Stern and Ron J. Feldman, Too Big To Fail: The Hazards of Bank Bailouts (Brookings Institution Press, Washington, D.C., 2004).

3 For an earlier discussion of related issues, see Gary H. Stern and Ron J. Feldman, "Constructive Commitment: Communicating Plans to Impose Losses on Large Bank Creditors," in Douglas D. Evanoff and George G. Kaufman (eds.), Systemic Financial Crises: Resolving Large Bank Insolvencies (World Scientific Publishing, Hackensack, N.J., 2005).

4 See Moody's Investors Service, "Bank Ratings Systemic Support, JDA Implementation," March 2, 2007. Moody's assessments were reported in the trade press. See also "Big-Bank Safety Net," American Banker, March 6, 2007.

5 See Ben S. Bernanke, "Monetary Policy under Uncertainty," remarks at the 32nd Annual Economic Policy Conference, Federal Reserve Bank of St. Louis, Oct. 19, 2007.

6 For a list of several central banks producing stability reports, see John Kambhu, Til Schuermann and Kevin J. Stiroh, "Hedge Funds, Financial Intermediation, and Systemic Risk," FRBNY Economic Policy Review, forthcoming.

7 For an earlier discussion of this progress, see Gary H. Stern and Ron J. Feldman, "Managing Too Big To Fail by Reducing Systemic Risk: Some Recent Developments," The Region, Federal Reserve Bank of Minneapolis, June 2006. See also Donald L. Kohn, "Financial Stability: Preventing and Managing Crises," remarks at the Exchequer Club Luncheon, Washington, D.C., Feb. 21, 2007.

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