Reform of the financial services industry is currently at the forefront
of America's domestic agenda. The administration, members of Congress,
banking associations and regulatory agencies have all advanced ideas
that, they believe, are essential to the industry's future.
While they differ in details, most of these reform proposals generally
address three issues: supervisory and regulatory reform, including
capital-based supervision and changes in deposit insurance coverage;
geographic and activities expansion for banks, including nationwide
interstate banking and broader securities powers; and regulatory
agency restructuring and consolidation.
Conceptually, there is little to object to in these ideas, but
in practice these measures are inadequate on two distinct levels.
First, the proposed reforms of the deposit insurance system do not
address the fundamental flaw in the system, namely the moral hazard
problem. As matters now stand, risk taking in banking is underpriced
and, as a consequence of this mispricing, depository institutions
whose liabilities are insured take on more risk than they should,
especially since insurance coverage is virtually without limit.
In fact, as matters now stand, it is possible for even insolvent
institutions to increase their coverage and the size of their operations.
The results of current deposit insurance policy are evident (in
the extreme) in the savings and loan industry and in the string
of earnings "disappointments" at many large commercial banks over
The second level on which many of the supervisory and regulatory
reform proposals are inadequate is in their practical implementation.
We may agree on the desirability of higher capital standards but,
so far as I know, no one is seriously proposing a return to the
capital levels prevailing before federal deposit insurance, although
presumably those are roughly the levels required to contain moral
hazard. As it is, some institutions have difficulty meeting the
modest tangible leverage ratio now in effect.
Moreover, how do you rigorously maintain capital standards and
impose prompt supervisory discipline without market value accounting?
It seems that much, perhaps too much, is left to the discretion
of the bank supervisors, a problem also encountered by suggestions
for risk-based deposit insurance premia administered by supervisors.
As the problems of the industry suggest, we may already be asking
the supervisors to do too much.
Another example of excessive reliance on supervisors may be found
in the so-called "credit crunch" controversy. Personally, I think
this is one of the more exaggerated issues of the day. But to the
extent that there is a credit crunch, it has resulted in part from
the inherent difficulties bank examiners have in distinguishing
between "good" and "bad" real estate loans. Do we really want to
introduce more supervisory discretion in banking?
In thinking about the banking and financial system of the future,
and the principles which, from a public policy perspective, might
guide its evolution, several considerations come to the fore.
- Financial reform should not be concerned per se with the profitability
of a particular class of institution nor with returns for the
industry as a whole. Rather, reform should emphasize the interests
of the customers of financial services firmshouseholds,
big business, small business, municipalities, and so onand
assure that customers are well served.
- Similarly, reform should be directed to shape a financial system
that protects the interests of taxpayers.
- To the extent that the United States has an international comparative
advantage in the provision of financial services, reform should
permit this advantage to be exploited.
- Within the regulatory limits that follow from the three preceding
principles, decisions about which activities to engage in, which
services to provide, pricing and where to operate should be left
to the management of banks and other financial services firms.
How do we implement these principles? I doubt that government
officials can or should provide a detailed road map. Preferably,
we call on the market or, more precisely, make it possible for market
forces to play an increasing role in determining the future shape
and scope of the banking and financial services industry.
To accomplish this, we must start by correcting the incentives
and redressing the misallocation of resources resulting from the
current deposit insurance system and the "too big to fail" doctrine.
As matters now stand, we have a system that relies on extensive
regulation and supervision to offset the moral hazard inherent in
deposit insurance. When this fails, as in the savings and loan industry,
the taxpayer is at risk.
To help straighten out incentives and increase market discipline
on insured depository institutions, we at the Federal Reserve Bank
of Minneapolis have previously proposed a form of coinsurance. The
basic elements are as follows. Over and above the nominal $100,000
insurance limit (and only one insured account, in the system, per
customer), depositors would explicitly be at risk for, say, 10 percent
of their deposit, so that insurance coverage over $100,000 would
be 90 percent, in contrast to the de facto 100 percent coverage
prevailing today. This 10 percent exposure, we believe, would give
(large) depositors ample incentive to pay attention to the calibre
of the institutions with which they do business, again in contrast
to current practice where such incentive is largely lacking.
Other changes would follow from this one. For example, increased
disclosure of banks' financial condition is likely, especially as
strong institutions find it in their interest to make their virtues
known. A much more fully developed market for information about
the condition of banks would emerge over time. Depositors might
also become more interested in diversifying the list of institutions
with which they do business.
Several caveats about this proposal are, of course, in order.
Such a change in deposit insurance coverage cannot be introduced
overnight. A period of preparation and phase-in should be allowed,
so that both banks and depositors can adjust. Moreover, coinsurance
is not, in my view, a substitute for supervision. Rather, it is
a complement to it that relies on market discipline to a greater
extent than is the case today.
Further, coinsurance is likely to increase the frequency of bank
runs. Before recoiling at the thought, we should recognize that
this is not all bad. On the one hand, runs that occur at open but
insolvent institutions represent a market version of prompt intervention
and are desirable, especially if one believes there is excess capacity
in banking. On the other hand, runs that occur at solvent institutions
or threaten to become systemic are problematic, but there is the
Federal Reserve discount window to provide liquidity. That is why
the window was established in the first place. I recognize, in contemplating
a higher incidence of bank runs, that there may be an understandable
reluctance to embrace coinsurance. But it is not as if the current
system has worked all that well; witness the cost of resolving the
savings and loan problem borne by the taxpayer. Think about the
current debate about how to "recapitalize" the Bank Insurance Fund.
There are at least two other significant advantages of coinsurance
beyond the market discipline it directly imposes. First, it is the
only reform proposal of which I am aware that, at least potentially,
provides a vehicle for eliminating the pernicious doctrine of too
big to fail. While many, perhaps most, analysts, policy-makers and
bankers agree that too big to fail must be discarded as a policy,
such agreement in itself is insufficient. A mechanism, a method
for terminating the policy must be identified.
The reason that coinsurance provides a vehicle for dealing with
too big to fail is that it caps the size of depositor exposure and,
if desired, the exposure of other creditors as well when a bank
fails. Remember that under the coinsurance proposal a depositor
is at risk for only 10 percent of his balance over $100,000. Thus,
spillovers are held to modest proportions, potentially allowing
supervisors to treat institutions of any size identically. In the
Continental Illinois case, perhaps the precedent setter for the
too big to fail policy, concern for the large number of small banks
which had correspondent relations with, and considerable exposure
to, Continental was a major impediment to closing and liquidating
Coinsurance could also quickly end the debate about the advisability
of imposing market value accounting on banks. Assuming that coinsurance
would contribute to effective depositor discipline on insured institutions,
insisting on marking a bank's balance sheet to market would be unnecessary.
Depositors would use all available tools and make whatever calculations
they felt necessary to assess the safety and soundness of the institutions
with which they conduct business.
With increased market discipline, regulators should be far less
concerned than they are today about the range of activities in which
insured institutions engage, whether such activities are in the
bank or in the holding company, or the geographic scope and size
of the operation. So long as large depositors understand they are
truly at risk and act accordingly, risk taking will be more accurately
priced than it is today and bank management will have an incentive
to act more prudently. With the proper incentives in place, we can
leave it to bank management to pursue profit opportunities by determining
the services they want to provide and where they want to provide
In leaving these decisions to bank management, I suspect we will
end up with a financial services industry at least as diverse as,
and more competitive, domestically and internationally, than the
one we have today. Some firms will operate internationally, some
will confine themselves to a local market. Some large firms will
carve out profitable niches and stick to them; other large firms
will aggressively expand both service lines and geographically.
There will be mergers and there will be consolidation, and over
time there will probably be fewer firms doing a traditional banking
business than there are today. But this hardly need concern us,
given the large number of firms in the business.
In my view, the essential elements of reform of the banking system
are clear. We should increase market discipline on banks by introducing
coinsurance, a step that could also facilitate termination of the
policy of too big to fail. Once coinsurance is in place, banks should
be permitted to move ahead as they see fit with geographic and activities
expansion. Legislation will of course be required, so none of this
is simple. Nevertheless, I am convinced it is the best of the alternatives.