Society relies on bank supervision and regulation to assess the
risks that banks take and to ensure that such risks do not get "too
large." Over the last several years I have argued that we would benefit
from more market discipline and, in particular, from incorporating
market information into the supervisory process. We have proposed
a plan to achieve that goal. (See Summary of the
work of the Minneapolis Fed in this area.) Other policymakers have
also advocated more market discipline.
However, any change to increase the role of markets in bank regulation,
no matter how modest, raises strong opinions and concerns. Indeed,
new questions arise and the intensity of older criticisms increases
as discussion turns to implementation. Thus, it seems like a good
time to respond to some of the questions that I have received while
advocating a larger role for market discipline. What follows are
my responses to questions that have recently been posed to me.
It seems a little out of character to hear a bank regulator
advocating market discipline, since we already have supervision
and regulation to monitor banks' behavior. What does market discipline
add to the mix?
I have to explain what I mean by market discipline. What you want
to do is put some group of creditorslarge depositors or holders
of other bank obligationsunequivocally at risk of losing some
of their money if their bank fails. These creditors will then have
more incentive than at present to pay attention to the caliber of
banking institutions with which they do business. Given that incentive,
you will start to get pricing of risk in the market. What does that
mean? That means that those providing large sums of money to a bank-by
buying the bank's debt, for example-will demand a higher return
from a bank perceived as riskier. In practice, this risk of loss
could mean that a holder of bank subordinated debt does not receive
full repayment or that we allow uninsured depositors to lose some
amount, say 10 percent of their funds, when their large bank fails.
The point here isn't to argue the specifics of the method for putting
funds at risk, but to reiterate the case for its necessity.
This type of market discipline would add several favorable attributes
to the current regulatory mix. Most importantly, it would give regulators
the market's take on how much risk a bank is taking. We rely on
market signalsprices and so forthfor resource allocation
all the time in our economy. And much to our advantage, I might
add. In this sense, it seems almost irresponsible not to rely on
information available from the market. Not only do market signals
provide a good sense for which bank is taking more risk than another,
the use of these signals could lead regulators to act more quickly
than they might otherwise. Market signals also provide regulators
with a sense of how much risk taking is efficient. I'm not sure
how regulators can determine the right amount of risk without the
help of markets, which probably helps to explain why regulators
go from worrying about being "too lax" to fearing creation of a
I should note that occasionally other types of reform fall under
the heading of increased market discipline. Some confuse market
discipline with a mandate that regulators look at the results of
the models that banks use to measure their risk and incorporate
those model results in their exams. This may be a positive step,
but it does not tell regulators what outside creditors think of
the bank's risk taking. Others claim that having banks disclose
more information will produce the favorable results I mentioned.
While more disclosure also may be helpful, we first need to give
creditors a reason to care about the financial condition of a bank.
This last point raises an issue to emphasize about market discipline:
Once you change the incentives you are going to change the way participants
behave. I think that's true not just of bank creditors, who clearly
would have more incentive to pay attention, but banks will find
it worthwhile to provide more information and, indeed, to market
the safety and soundness of their institution. After all, banks
that hold assets that are difficult to analyze would have to pay
a higher cost to raise money. It follows, then, that these banks
would either provide more information, charge borrowers more money
when the bank holds their opaque loans, shift to more transparent
assets, such as Treasuries, or some combination. Contrast this situation
with what we have currently. It's really interesting, if you stop
to think about it, no bank today says, "Leave your money with us
because we only make low-risk loans or hold low-risk securities."
What makes you think we can really get the kind of information
that will allow for better assessment and management of bank risk
If you don't follow the economics of banking too closely, this
question may seem somewhat odd. As I said, our economy routinely
relies on markets to judge risk and allocate resources, and worldwide
trends over the last 15 years suggest that this market-based system
has grown in popularity But, in fact, this question actually cuts
to the heart of the debate. Banks are a little different from other
firms because the loans they hold are not easy for an outsider to
assess. This fact, in part, helps justify the current regulatory
regime. Even with this difficulty, however, we have plenty of evidence
indicating that you would expect to see pricing distinctions between
banks based on their riskiness.
It is worth repeating that I am not relying on some abstract theory,
but instead can point to a number of studies showing that markets
can be effective in assessing risk. Given the existing body of research,
I'm not sure what additional evidence could be provided to policymakers
without actually moving to a pilot project of some type where we
try to incrementally increase the amount of market discipline in
the banking system and in banking regulation. I guess I would like
to hear what specific facts we need to acquire before we have enough
evidence to move to a system of more market discipline. Unfortunately,
and while I'm sure they are a minority, I think there are some people
who oppose the various plans to increase market discipline and information
because they don't trust that markets can work. I'm not sure that
they would ever support a change in the current system, no matter
what evidence others or I could provide.
You've convinced me that market discipline is important, so
why only go part way? Why not introduce even more market discipline
and get out of the business of regulating banks?
First of all, I view market discipline as a complement, or supplement,
to what we're already doing in terms of safety and soundness examinations.
We have a decent amount of evidence that regulators are able to
serve a useful role in obtaining information about certain attributes
of banks, such as asset quality. So I have never claimed that market
discipline is a substitute for supervision, but that doesn't mean
regulators couldn't use a little help. As I've said before, there's
no excuse for not taking advantage of market information. Indeed,
critics of market-based reforms are really saying that such information
has little or nothing to add. This strikes me as a difficult case
But you can go too far. There are legitimate concerns that if
you relied exclusively on market discipline you would introduce
more instability in the financial sectorand particularly in
the banking sectorthan is desirable. So, what you're trying
to do is strike a balance and incorporate both supervision and market
discipline. And our plan and others like it try to achieve this
balance by limiting who would suffer losses and how much they could
suffer. As a result, I find the concern that increasing market discipline
will create a system besieged by banking panics to be a straw man.
Credible proposals will only put the largest creditors at risk and
take steps, such as capping their losses, to address the potential
for instability. In fact, it is the current system that lacks a
balance between government protection and banking system stability.
So, while I think it's fair to say that there are some things that
may limit your enthusiasm for relying exclusively on market discipline,
we're nowhere near that extreme right now, nor are we advocating
going to that extreme.
I'm a community banker, and every time I hear the words "market
discipline" I get nervous because it usually means that my large
competitors get an advantage. I don't fear the market, but I do
fear rules that favor big banks. How can I be sure that your proposal
won't give big banks an advantage?
One way to be sure is to think about the current system where
big banks, under the too-big-to-fail practices, actually do have
an advantage. Nobody pretends that small community banks are covered
by any too-big-to-fail doctrine. So small banks, from a number of
perspectives, are subject to a reasonable amount of market discipline.
In fact, just look at the record following the passage of FDICIA.
One of the things that we're certain did work about FDICIA is that
small banks now do not always have their uninsured depositors protected.
If you have over $100,000 at a small bank in Minnesota, for example,
you need to know that the failure of your bank could expose you
to risk of loss (the FDIC did not protect uninsured deposits at
about 60 percent of failures between 1992 and 1997). The same depositor
at a large institution has little reason to believe right now, under
the current regime, that they're going to lose money. So what we're
talking about and what most reforms try to achieve is leveling the
playing field. Small banks should favor these plans.
I should also add that I don't find concerns about a slippery
slope to be very compelling. In particular, I don't see how putting
the largest depositors at risk at the largest banks creates an environment
where the smallest depositors at the smallest banks will lose government
protection. Our proposal does not advocate any change in the $100,000
Whenever we make more rules we add more costs. In an era where
we are trying to reduce regulatory burden, why would you support
plans that could lead to these higher costs?
I think we need to be careful in thinking about the costs of the
current system and a future one under a plan like ours. The current
system results in too much risk taking on the part of banks, which
has a cost in terms of a misallocation of resources. And, as we
saw in the late 1980s and early 1990s, cleaning up those problems
can be very expensive to the taxpayer.
Why do those problems occur? Well, they occur in large measure
because we've decided to shield banks, particularly the largest
ones, through government programs like deposit insurance so that
they do not have to pay the true costs for funds that markets would
We're only suggesting that they pay costs closer to what the market
would otherwise charge. This seems much more fair than imposing
the costs of large bank risk taking on society as a whole, as occurs
through the current system. And even under our plan, banks control
the funding costs they face by determining how much risk they want
to bear. This suggests that the cost of market discipline proposals
has very little in common with the costs of command and control
type banking regulations.
The good health of the banking system means that we have not
tested FDICIA, which was passed in 1991 to address, in part, the
concerns you have expressed; why not see if this bill will work?
FDICIA did a lot things that should prove helpful over time. But
it did not do much, from my perspective, to increase market discipline
for the largest banks, and it clearly did not require regulators
to make use of market information, even though the evidence suggests
that market signals can help determine whether Bank A is riskier
than Bank B. So, as I've suggested before, a supporter of FDICIA
is really saying that market signals don't have anything to add,
that such market information is not helpful. Otherwise, why should
we wait? Moreover, we're not talking about gutting the law and starting
from scratch, but simply adding to FDICIA by taking advantage of
market information. The spirit of our proposal goes hand in hand
with the intent of FDICIA and should only serve to further its resolve.
Finally, we should undertake significant reform when the system
is healthy and stable. You can't do this kind of thing when you're
in the midst of a banking crisis, because that's not the time to
change the rules of the game and the incentives; you would only
add to the concerns and to the crisis atmosphere.
If some form of the financial modernization bill passes and
banks continue to evolve into an all-purpose financial service firm,
will your reforms still apply?
I think from a broad perspective the more that large banks become more
like nonbank providers of financial services-like Merrill Lynch or Goldman
Sachs-the more compelling the argument for reining in government protection
becomes. After all, we don't provide this kind of safety net for these
large nonbank firms. Rather, we have a system where these firms bear the
cost of their actions. If we're not careful we will find ourselves in
the rather strange situation of protecting a broader range of activities
at the same time that larger banks lose those attributes that led to the
protection in the first place.
The Minneapolis Fed on Increased Market Discipline
The Minneapolis Fed has argued for an increased role for market
participants and information in deposit insurance and banking
regulation over the last 15 years. In 1996, we renewed our calls
for reform, arguing that changes to banking regulation should
occur when the economy and banks are healthy and before banks
are granted expanded business powers ("An
Opportune Time for Deposit Insurance Reform," The
Region, December 1996).
We were particularly concerned about the influence of the
current regulatory regime on the risk taking of the largest
banks. Mergers are creating more and larger banks that could
fall under the so-called too-big-to-fail designation. The
problem is that uninsured depositors and other legally unprotected
creditors believe the government will bail them out if the
large bank falters. As a result, these creditors do not incorporate
the full riskiness of the banks' activities into the interest
rate they charge. Banks get the wrong signal from the market
and end up taking on more risk than they would otherwise.
This policy ultimately leaves the taxpayer on the hook.
Congress tried to fix the TBTF problem in the Federal Deposit
Insurance Corp. Improvement Act of 1991, but we believe it
simply codified existing, flawed practices. Bank risk taking
would be better addressed by putting uninsured creditors at
risk of loss. As such, we proposed that Congress amend FDICIA
to prohibit the full protection of uninsured depositors and
other creditors in TBTF cases ("Fixing
FDICIA: A Plan to Address the Too-Big-to-Fail Problem",
1997 Annual Report essay, The Region, March 1998).
Once creditors of these large banks have been credibly put
at risk, the market will generate assessments of risk that
will prove useful for regulators. We therefore believe these
market signals should be incorporated into the deposit insurance
and supervisory system. Banks that markets judged to pose
higher risks would pay higher deposit insurance premiums or
face more regulatory scrutiny, for example ("Managing
Moral Hazard with Market Signals: How Regulation Should Change
With Banking," The Region, June 1999).