Gary H. Stern - President, 1985-2009
Published June 1, 2003 | June 2003 issue
Editor's note: This article is based on remarks made at a symposium sponsored by the Federal Deposit Insurance Corp. on "The Future of Financial Regulation: Structural Reform or Status Quo?" March 13, 2003, Washington, D.C.
Observers have long been troubled by the "excessive number" of government agencies that supervise and regulate banking organizations. Analysts have also expressed concern about an "artificial division" between the supervision and regulation of banking organizations and other financial intermediaries such as insurance and securities firms. Plans to reduce the number of bank supervisors (or all the agencies that govern financial intermediation) through consolidation go under the rubric of regulatory restructuring. Discussions of restructuring were reenergized in 2002 with some senior officials at the Treasury Department and the Federal Deposit Insurance Corp. offering their observations on and suggestions for regulatory restructuring.1
As these officials recognize, the numerous restructuring proposals put forward over the years have failed to pick up momentum despite extensive study and discussion. Given this lack of momentum, I think it productive to consider methods of achieving the objectives of regulatory restructuring without going through the process itself. Specifically, I will suggest several potentially significant improvements to regulation and supervision that do not require regulatory restructuring, but stay true to the purposes behind proposed reforms. (Of course, these are my views and not the views of the Federal Reserve System.)
In these comments, I first suggest why regulatory restructuring has failed in the past, then briefly discuss what I see as the underlying objectives of regulatory reform and finally describe some options for achieving these objectives without venturing into the morass of regulatory restructuring.
Justifications to restructure the supervision and regulation of financial institutions almost always include a flow chart depicting the multiple government bureaucracies that interact with firms engaged, at the broadest level, in the same types of activities. Such pictures purport to demonstrate duplication of effort on the one hand and inefficient division of responsibilities on the other. Whatever the optimal organization of supervisors and regulators should be, one would be hard-pressed to argue that the current systemwith its apparent cost inefficienciesis one that we would build from scratch.
Given this negative assessment of the current arrangement, why do efforts at restructuringincluding those reforms aimed directly at cost reductionfail to achieve appreciable momentum? I see three possible explanations:
First, some observers see nonpecuniary benefits in the current system. They argue that creating multiple agencies to supervise banks creates competition among those agencies and encourages them to innovate and adapt. Proponents of this view believe the benefits of this innovation exceed the costs of potentially inefficient operations.
Second, any proposal to alter bureaucratic responsibilities naturally raises concerns about "turf." The many agencies potentially affected by restructuring create a natural opposition to reform. In contrast, the public is indifferent to the current structure and changes to it. The political calculus is therefore not favorably disposed toward restructuring.
Third, the benefits of regulatory reform could be significantly smaller in practice than in theory. Moreover, these benefits could also seem small relative to other reforms that could be pursued without encountering the hassle of restructuring. The premise that restructuring would clearly pass a benefit/cost test is perhaps weaker than "Rube Goldberg" diagrams of banking supervision suggest.
Intuition, along with a process of elimination, leads me to believe that this last explanation does the best job of explaining why serious regulatory reform stalls. Supervisors have tried to innovate, but it is far from clear that such attempts have kept up with the industry. I also seriously doubt that the existence of multiple supervisors explains the innovation that has occurred. From what I can see, supervisory agenciesindividually and collectivelyinnovate when their practices fall sufficiently behind the industry. And while turf certainly matters, there are many counterexamplessuch as military base closings and the dismantling of much economic regulationwhere such resistance has been overcome.
In contrast, the behavior of the supervisors themselves suggests that the benefits of restructuring might be overstated. When needed, the agencies turn inward to achieve cost savings through traditional means such as job reductions and regional office closings. When the agencies do work collectively, they tend to do so on major policy issues (for example, Basel II) rather than on reductions in back-office costs. Such cost reductions presumably could be achieved simply by contracting out with each other.
If the cost reduction benefits of restructuring or consolidation per se are not high, one might still find objectives associated with the effort that are worthwhile. In fact, such worthy objectives exist and we now turn to them.
As I see it, there are two underlying objectives of regulatory reform beyond the cost-saving rationale just discussed. The first is to improve the performance of banking supervision and regulation. More specifically, supporters of restructuring hope to make supervisors more sensitive and responsive to bank risk taking. They hope restructuring allows supervisors to identify risk more accurately and respond to it more proactively.
The second underlying objective of restructuring is to improve economic efficiency. Restructuring could improve the allocation of society's resources such that net benefits are maximized. Of course, careful attention to duplication (and other) issues that may raise costs unnecessarily is part of this objective, but the goal is much broader in scope than simple cost efficiency.
If this is a reasonable characterization of the underlying objectives of regulatory restructuring, are there meaningful steps to achieve them short of consolidation? I would suggest there are, and they include:
Focus on systemic risk;
Enhance use of market data;
Move to accrual budgeting; and
Review the benefits and costs of regulation.
The reforms discussed below explicitly do not require a consolidation of bank supervisory agencies. Nonetheless, I think their focus and potential results capture the reasons why restructuring remains a topic of enduring interest.
Leverage expertise. Some insured depositories have concentrated their activities in what a decade or two ago would have been seen as "nontraditional" businesses. These activities include securities underwriting and trading, processing of payments and securities transactions, lending to consumers and especially to borrowers with blemished credit histories. Not only might the concentration of activity increase the riskiness of these banks, but also these activities could be particularly risky in their own right. Some might view these institutions as posing an outsized risk to the deposit insurance fund. The number of banks with such high-risk specialties is small, but the potential for imposing loss is high, and it may also be that such specialties make effective supervision of these entities more challenging than that of "plain vanilla" organizations.
There are many regulatory approaches to this issue, including higher capital standards and limits on growth and, clearly, the supervisory approach to these institutions will also be important. A lynchpin of supervisory strategy, in my view, should be to charge examiners with appropriate specialized skills to review these potentially high-risk banks. Having each supervisory agency develop this human capital separately could be ineffective. A cross-agency team of examiners focused on these specialized institutions should lead to staff with the desired backgrounds, significant experience and adequate resources.
To be sure, there are recent examples of effective sharing of resources in examination of specialized entities and in examination of and supervisory action against large banking organizations. But we are proposing going further, and having supervisory agencies rely on pooled expertise rather than building their own human capital whenever the situation demands. This approach also has the potential to help the supervisory agencies react more swiftly to new risks at specialized institutions and provide a more consistent response to them.
Focus on systemic risk. The discussion of specialized institutions makes the obvious point that risk is not evenly distributed across banks. In the same vein, the risk that the failure of one bank will lead to the failure of other institutions or otherwise lead to reductions in real economic output is not relevant for most institutions. The largest banks, or banks focused on payments system processing, in general pose systemic risks while other banks do not. Given that the prevention of systemic risk is one of the primary justifications for bank regulation and supervision, policymakers should ensure that resources are allocated disproportionately to those banks that raise this threat.
Despite some shifting of resources to more systemically important banks, it is my impression that supervisory resources are still largely allocated according to the distribution of banks rather than banking assets. Because there are many more small than large banks, supervisors end up using the bulk of their resources to supervise banks that no one could claim pose a systemic threat. The failure of a small bankwhile potentially costly to employees, some creditors and certain borrowersis unlikely to have ramifications for large economic units like states or countries. This consideration suggests that supervisory resources could be reallocated to better match the threat to the real economy.
The Federal Reserve System provides an example of potential misallocation of resources. We devote about 75 percent of our total domestic institution supervision hours to institutions with under $10 billion in assets. Yet these banks hold only 30 percent of aggregate banking assets, and it seems unlikely that such relatively small institutions pose any great risk to the system as a whole.
While supervisors might not know precisely which banks are systemically important, they have a pretty good idea and can allocate resources accordingly. But identifying the systemically important banks is only one step. Presumably, supervisors should want to focus resources on those important banks which are in trouble, or likely to become so. This is not an easy task, but it leads me to some additional steps that supervisors can take to better assess bank risk taking.
Enhance use of market data. We believe that market data can be a valuable and low-cost complement or adjunct to standard bank examination data in the assessment of bank risk taking. We have detailed this position elsewhere, so I will only touch on the major issues here.2 Market data can be valuable in assessing and responding to bank risk taking because they have many traits that the financial data traditionally used by bank examiners do not. Specifically, market data are available on a timely basis, are forward looking, can serve to confirm (or alternatively to raise cautions) about supervisory judgments and can be used effectively to communicate examiner findings to bank management and to boards of directors.
To be sure, incorporation of market data into supervisory assessments is no panacea. For several reasons, including explicit and implicit government support for bank creditors, market signals are not all they could be. Moreover, there will certainly be a learning curve in determining the best ways to use market data in the supervisory process. Nevertheless, the scholarship suggests that market data add value even for examiners who have access to private, internal information about banks.
Obviously, increased utilization of market data does not require regulatory reform. But if one bank regulatory agency pushes ahead with it, I would expect that competition would bring others along as well. There has already been a bit of interagency work on this topic with staff at the Federal Deposit Insurance Corp. and the Federal Reserve producing some of the scholarship to which I've just referred.
Accrual budgeting. Another constructive proposal that does not require regulatory reform but could improve supervisory effectiveness pertains to the federal budget and the signals and incentives it provides. Currently, the budget records the cash flows associated with deposit insurance in order to measure the exposure of taxpayers to bank failures. When current cash flows into the deposit insurance fund (premiums and investment income) exceed the cash outflows (funds used to resolve bank failures), policymakers receive a financial signal from the budget that everything is okay.
However, these cash flows might well have little connection to the current or future financial condition of the banking industry. Instead, they largely reflect previous bank actions. Thus, at precisely the time that premiums exceed resolution costs, banks could be taking on significant risk that will result in future losses to taxpayers. Under current practices, when policymakers and supervisors should in fact be taking steps to restrict bank risk taking, the financial signal they'll be seeingbased on cash flowswill be pointing in the wrong direction.
An accrual budgeting system, in contrast, would rely on estimates of the long-run exposure of the government (taxpayer) to bank failures. These estimates would form the basis for current budgetary charges. When it appears that future costs are increasing, policymakers would have to add charges to their budgets today. Supervisory agencies and lawmakers would thereby gain a heightened sense of the need to respond to risk taking in the current period by enacting changes in law, policy or supervisory strategy. To the degree that such changes reduce expected future costs, agencies and officials would avoid additional current charges.
While this proposal might appear arcane, it is worth noting that Federal Reserve Board Chairman Greenspan has recently made identical points with regard to other federal programs.3 Officials at the Office of Management and Budget engaged in federal budgeting on a full-time basis have called for similar budgeting practices in the past.4 While such a system poses technical and accounting issues, they seem surmountable with existing technology, posing no more of a challenge than that which exists in the current system and offering a more accurate assessment of current and future conditions. Again, one should note that these benefits occur across supervisory agencies and do not require changes to structure.
The rules, not the rulemakers. Another commonly voiced concern about the current regulatory structure, with its multiplicity of regulators, is its potential to limit competition in banking and in financial services more broadly. Each regulator might issue rules that increase the safety and soundness of the firms it governs but which, for example, make entry of new service providers more costly. If this actually occurs, it means the financial system is less efficient than it could be, and hence customers are not as well served as they should be.
An alternative, although not mutually exclusive, view is that such inefficiencies are minor relative to the costs of rules that have little if any effect on the ability of firms to effectively compete. Moreover, these costly rules could very well find support whatever the regulatory structure. I find this alternative view compelling, and I would guess that the source of inefficiency is likely in the number and details of the rules already in place and not in the number of rulemakers. And while I admit my argument relies on assertion rather than on empirical evidence, relatively rigorous evaluation suggests the costs of regulation are high. Analysis by Board of Governors staff puts the cost of activities undertaken by banks solely because of regulation at about 6.5 percent of aggregate noninterest expense (which amounted to $7.5 billion for the year  studied and would amount to around $13 billion today).5
We already have a forum to take on excessively costly regulation, namely, the Federal Financial Institutions Examination Council (FFIEC). Among other duties, the FFIEC coordinates the release of new regulations. Instead of looking to the FFIEC to issue new regulations, perhaps it should be charged with sponsoring research to assess the benefits and costs of existing regulations. The results of such research could then be provided to appropriate officials.
This commentary discussed some suggestions, and their associated rationales, to accomplish the objectives of regulatory reform while avoiding at least some of the aggravation associated with wholesale restructuring. Essentially, there are two objectives: Improve the effectiveness of supervision and reduce the economic inefficiency resulting from the current bank regulatory system. In this vein, I have made five proposals:
Focus on systemic issues;
Utilize market data;
Introduce accrual budgeting; and
Assess costs and benefits of regulations.
The first three recommendations could help address both objectives, namely, effectiveness and efficiency, at least to some degree. The fourth recommendation, the introduction of accrual budgeting, should also improve supervisory effectiveness to the extent that it heightens decision-maker sensitivity to the potential costs of bank failures. My final recommendation, on benefit/cost analysis, clearly goes to the issue of economic efficiency, and it may also increase effectiveness if it leads to improved resource deployment and better supervision.
Of course, this list of recommendations is selective, and partial. Others might choose a different set of tools to achieve the two objectives I laid out. Thus, I would encourage interested parties who do not find the reforms suggested here attractive to focus on the underlying objectives of restructuring. In this light, the contribution of this list is not the specific items I supportalthough, of course, I hope others rally to thembut rather the impetus it might give to other policymakers to consider and assemble their own recommendations. We then would have an alternative path if restructuring falters once again.
1 See Donald E. Powell, Chairman of the Federal Deposit Insurance Corp., "Why Regulatory Restructuring? Why Now?" Comments before the Exchequer Club, Washington, D.C., Oct. 16, 2002; and Peter R. Fisher, Undersecretary for Domestic Finance, U.S. Department of the Treasury, "The Need to Reduce Regulatory Arbitrage." Comments before the Brooklyn Law School, Center for the Study of International Business Law, Sept. 20, 2002.
3 See Testimony of Chairman Alan Greenspan, Federal Reserve Board's semiannual monetary policy report to the Congress before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Feb. 11, 2003.
4 Office of Management and Budget. 1992. The Budget of the United States Government, Fiscal Year 1993.
5 Gregory Elliehausen, "The Cost of Banking Regulation: A Review of the Evidence," Federal Reserve Board of Governors Staff Study, Number 171 (April 1998).