The Region

Market Discipline as Bank Regulator

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Gary H. Stern - President, 1985-2009

Published June 1, 1998  |  June 1998 issue

Recently announced "mega-mergers" of already large banks and, in one case, a bank and a major diversified financial services firm appropriately have spurred renewed interest in deposit insurance reform and the too-big-to-fail doctrine. These are issues in which we are deeply interested and about which we have written extensively; indeed, we have offered a specific proposal for deposit insurance reform. My purpose on this occasion, however, is principally to comment on the role of market discipline in helping to constrain excessive risk taking by banks, especially large banks.

Before getting to this, let me briefly outline the key ingredients of our reform proposal, so that we have a common base with which to work. The proposal addresses the too-big-to-fail issue through legislation, specifically an amendment to FDICIA (1991) which would provide that uninsured depositors suffer some loss even when FDICIA's too-big-to-fail provisions are invoked. The idea is that these creditors would know in advance that they would have to bear the consequences of their decisions, and therefore before-the-fact market discipline from uninsured depositors would increase. This reform would be coupled in our plan with market-based pricing of deposit insurance premiums and increased disclosure of information about the financial condition of banks.

One of the most frequently voiced objections to our coinsurance proposal is the criticism that enhanced market discipline would prove ineffective, because market participants would systematically fail to understand the risks assumed by large, complex, sophisticated banks. At an abstract level, this is a curious criticism for participants in the U.S. economy to make. After all, we rely on the marketplace to establish prices and thereby allocate resources for the great preponderance of goods and services in the economy, and it generally does so effectively. There is widespread recognition, I think, that the market is largely responsible for the economic progress we have enjoyed, and we are hard-pressed in most circumstances to devise ways to improve upon market outcomes.

But, one might argue, this broad faith in market signals may not apply to banks because of the inherent opacity of their assets and the many complex off-balance sheet positions they take. Undoubtedly, there is truth to this rejoinder — banks are special in several ways, which is fundamentally why we do not advocate eliminating deposit insurance altogether. However, our proposal is relatively modest; it seeks to increase market discipline but not to rely on it exclusively.

More importantly, it is essential to realize that if and as incentives change, so will market practices, as would be expected. Thus, when large depositors recognize that they are in fact at some risk even in large (too-big-to-fail) institutions, they will demand and analyze additional information about such institutions. Furthermore, services that provide the information and prepare the analyses will almost certainly spring up in order to meet this demand. And confronted by new incentives, many banks will find it in their interest to emphasize financial strength and the soundness of their management practices to gain competitive advantage. Right now, of course, there is virtually no incentive to make such a case because of the de facto scope of deposit insurance. But in the new environment, institutions that are not voluntarily forthcoming may well face considerable pressure to supply the information market participants seek.

In short, we would expect market discipline to become increasingly effective as market participants react to new incentives. More and higher quality information about banks will be available, the nature of competition among banks will change, and deposit pricing will vary more appropriately by institution as creditors pay attention to the caliber of the banks with which they do business.

Even if these adjustments to new incentives do not occur quickly and smoothly, uninsured depositors retain the options of diversification and of doing business with banks whose positions and practices they understand. To the extent that the preference for diversification increases, it should become more costly at the margin for large, opaque institutions to assemble funds, and therefore should be risk reducing. To the extent that uninsured depositors gravitate to "plain vanilla" institutions, community and mid-size banks would probably pick up business, at least relative to what otherwise would have been the case.

Assuming our reform proposals are adopted and the market responds as anticipated, where would that leave us? Greater market discipline, accompanied by ongoing bank supervision, should better protect the taxpayer from expensive bailouts and better guard the economy against serious resource misallocation. There is also the possibility that the potential for systemic instability will increase — that is the cost of gaining the benefits of increased market discipline. But our proposal carefully limits the exposure of uninsured depositors, so it is designed to mitigate a significant increase in instability.

Finally, the significance of the deposit insurance reform issue should not be underestimated. The health of a nation's banking infrastructure clearly influences its rate of growth and living standards. Economic growth can be assisted, then, by policies which contribute to a sound banking system—that is, by the introduction of additional market incentives to contain excessive risk taking in banking.

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