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
systemthat is, by the introduction of additional market incentives
to contain excessive risk taking in banking.