The Region

Harnessing Market Discipline

Alan Greenspan - Federal Reserve Chairman

Published September 1, 2001  |  September 2001 issue

Using market data logo In recent years, market participants, analysts and policymakers have come to realize, or perhaps I should say rediscover, the importance of market discipline in banking. Market discipline—private counterparty supervision—is, and always has been, the first line of regulatory defense in protecting the safety and soundness of the banking system.

Before examining the challenges facing supervisors in our own era, when rapid technological advances are dramatically changing the nature of both banking and banking supervision, it may prove interesting to note some parallels to a much earlier period, the so-called free-banking era before the Civil War. Then as now, technology—particularly the telegraph and the railroad—was profoundly altering the financial landscape by increasing the effectiveness of market discipline. In that time, before the existence of the federal safety net (deposit insurance and the discount window, and access to settlement of payments on the books of the Federal Reserve), banks were, in effect, supervised by the market. They competed for a reputation for safe and sound banking. In such an environment, bank capital/asset ratios were substantially higher than today. Banks issued their own currency and when the market exhibited a lack of confidence in a bank, its notes tended to exchange at a discount to par. Private money brokers purchased notes at a discount and transported them to the issuing bank, where they demanded par redemption. This had the effect of constraining the supply of notes from individual banks to prudential levels. The railroad, by facilitating the rapid transport of notes, and the telegraph, by facilitating the rapid transmission of information, made monitoring banks by money brokers and counterparties much more effective.

As we move into the 21st century, advances in computer and telecommunications technologies underlie an analogous evolutionary, if not revolutionary, transformation. By promoting the still faster and freer flow of accurate and relevant real-time information throughout the financial system, these advances are making greater reliance on market discipline both possible and necessary. They enhance market discipline by increasing bankers' ability to unbundle risks and by facilitating increasingly sophisticated methods of modeling, monitoring and managing risks. This is especially the case for large, complex institutions but also, to a considerable degree, for community banks, which are employing such techniques as credit-scoring and securitization to manage risk. For supervisors, the technological advances I mentioned, by rendering obsolete much of the bank examination regime of the past, also necessitate greater reliance on market discipline. The growing complexities of financial instruments, and the potential for rapid change in their value, have required supervisors to focus more on risk-management procedures and market signals than on point-in-time examinations. This is especially so for the expanding bank options and swaps markets and for other derivative transactions.

Our challenge as policymakers is to find ways of fostering effective emphasis on safety and soundness by, for instance, encouraging appropriate disclosure by banks. Furthermore, policymakers are seeking to find ways of harnessing market discipline and data as a complement to supervision. In pursuit of the first goal, the Board of Governors, with the support of the Office of the Comptroller of the Currency (OCC) and the Securities and Exchange Commission (SEC), established the private-sector Working Group on Public Disclosure. The working group, chaired by retired Chase Manhattan Bank Chairman Walter V. Shipley, early this year recommended enhanced disclosures by large banking and securities organizations, including quarterly disclosure of some market-risk information that is now disclosed annually and improved disclosures about credit concentrations and credit quality of portfolios. In March, the Federal Reserve Board's Division of Supervision and Regulation wrote to the chief executives of large banking organizations, encouraging them to use the recommendations. Later this year, it plans to issue additional guidance addressing the role of the supervisory process in promoting sound disclosure practices. The OCC and SEC have joined in issuing letters to encourage the use of the working group's recommendations.

In January, the Basel Committee proposed a number of disclosure enhancements for banks as part of the new Capital Accord. These proposals include more disclosures about an institution's risk profile and risk management, capital instruments and capital adequacy. The proposed disclosures are an integral part of the new accord and reflect the committee's belief that market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems.

But, more important than the impact of such regulatory initiatives is that financial institution managers, with little prodding from supervisors, are moving toward greater disclosure of their own volition. Increasingly and inevitably, they are realizing that endeavoring to preserve old ways of doing business, by keeping information, especially adverse information, from their funding sources, is unwise. They are realizing that if their institution is less than transparent, if the information coming out of their institution is somehow questionable, markets will impose an uncertainty premium on their liabilities, perhaps a costly one. Moreover, sound, well-managed firms are recognizing that they can benefit if better disclosure enables them to obtain funds at risk premiums that better reflect their comparatively lower risk profiles.

On the second goal, using market information in supervision, the Federal Reserve and other regulatory agencies already monitor subordinated debt yields and issuance patterns in evaluating the condition of large banking organizations, virtually all of whom voluntarily issue such debt. And, early this year, the Board and the Treasury Department, in a report to Congress required by the Gramm-Leach-Bliley Act, found evidence supporting the value of monitoring subordinated debt. Significant changes in a banking organization's debt spreads, in absolute terms or compared with peer banks, can prompt more intensive monitoring of the institution. The report indicates the Federal Reserve and Treasury's Office of the Comptroller of the Currency and Office of Thrift Supervision will consider ways to enhance their use of subordinated debt in supervisory monitoring. This use of subordinated debt is one example of the effort supervisors should undertake to employ data from a variety of markets.

So it is that I take great pleasure in wishing you success in your deliberations today and tomorrow. They are part of an ongoing and crucial conversation that, I am confident, will move our banking and supervisory systems toward increased reliance on market discipline and use of market data in supervision. The alternative, I fear, would be the expansion of invasive and burdensome-and less effective-supervision and regulation.

Chairman Greenspan's remarks were presented by videotape at the Minneapolis Fed conference.

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