The process of reforming banking regulation and safety net policies
has tested the endurance of many an analyst. Those at this conference
know of, and in some cases authored, the continuous, 20-year flow
of proposals on the subject of reform. This work has left few policy
stones unturned, making it nearly impossible to advance new proposals.
Yet, the actual regulatory and legal changes introduced over the
periodalthough positive stepsare inadequate to address
the safety net's perversion of the risk/return trade-off.
In fact, trends that have accelerated over the last decade, such
as banking consolidation and increasing complexity of bank operations,
make the reforms adopted appear even less equal to the task of addressing
the major concernthe moral hazard problem that is inherent
in providing a financial safety net. Because the government protects
depositors and other bank creditors from losses, interest rates
paid on bank deposits and other forms of bank debt do not fully
incorporate the riskiness of the banks' activities. Banks then receive
a price signal that is too low and end up financing higher-risk
projects than they would otherwise. This behavior is not venal,
despite its "moral hazard" designation; one need not conjure up
images of bankers meeting to rip off taxpayers to understand how
a firm would rationally react to the incentives created by mispricing.
But it now appears that a growing number of regulators and policymakers
recognize the power of these price distortions (and Asia provided
a powerful reminder). This shift in view has reduced but not eliminated
the controversy over the need for regulatory reform, especially
with respect to our largest banks. A growing consensus in favor
of reform notwithstanding, there is no agreement about the appropriate
measures to implement.
In my view, proposals that rely exclusively on unfettered markets
to eliminate moral hazard are not credible, and those that rely
exclusively on supervision and regulation are unlikely to effectively
address the moral hazard problem. In contrast, the many years spent
analyzing moral hazard have yielded promising reform proposals that
make use of market signals to enhance discipline. Drawing on these
plans, I propose combining market signals of risk with the best
aspects of current regulation to help mitigate the moral hazard
problem that is most acute with our largest banks. Let me make this
last point clear: The reforms discussed would apply only to our
largest banks, especially those that are considered too-big-to-fail
The Case for Reform
Anyone suggesting regulatory reforms for the largest banks must
first confront the Federal Deposit Insurance Corp. Improvement Act
of 1991 (FDICIA) and follow-up steps that regulators have taken.
We find these steps to be positive and, in fact, they provide the
framework for future reforms. Yet, by definition, our call for further
reforms suggests that FDICIA and regulatory steps are incomplete
in an important way. Moreover, we believe that problems with the
regulatory approach have been exacerbated by increasing consolidation
and complexity in the banking industry, which, by the way, may well
be an appropriate and efficient response to changing market conditions
and technological innovations.
What FDICIA and the New Regulatory Regime Did
and Did Not Fix
The primary response, as exemplified by FDICIA and subsequent reforms,
to the pernicious incentives created by the safety net is to regulate
bank activities so as to limit risk taking. FDICIA was an important
step forward in that it focuses supervisory resources on banks in
poor financial condition. FDICIA, in theory, requires banks in relatively
poor financial shape to pay higher deposit insurance premiums. Likewise,
FDICIA creates a system wherein banks in deteriorating financial
condition face restrictions on their activities and more frequent
review than financially sound institutions. And for all banks, supervisors
have implemented examination procedures which shift staff resources
to review of higher-risk activities and of the banks' policies for
controlling their risk exposure. Finally, regulators have hired
more "rocket scientists," staff with the specialized human capital
necessary to evaluate new forms of bank risk taking and management.
All of these steps appear beneficial. But even with them, we cannot
rely solely on supervision and regulation to adequately contain
moral hazard incentives. There are several factors underpinning
this conclusion, including:
- The ability of regulators to contain moral hazard directly is
limited. Moral hazard results when economic agents do not bear
the marginal costs of their actions. Regulatory reforms can alter
marginal costs but they accomplish this task through very crude
and often exploitable tactics.
- There should be limited confidence that regulation and supervision
will lead to bank closures before institutions become insolvent.
In particular, reliance on lagging regulatory measures, restrictive
regulatory and legal norms, and the ability of banks to quickly
alter their risk profile have often resulted in costly failures.
The existing literature suggests that the rules FDICIA established
to ensure prompt closure of banks are unlikely to effectively
reduce losses during a banking crisis, precisely because of the
weaknesses identified above.
- The ability of regulators to assess bank risk is limited. While
regulators have access to inside information, there are still
areas of profound informational asymmetry between regulators and
banks. Moreover, the ability of regulators to directly rely on
the output of internal bank models to overcome this asymmetry
is currently limited. Problems include inaccuracies of the models
as well as the difficulty regulators face in verifying the bona
fide status and use of their output (i.e., does output represented
as the one in 100 loss event really have that meaning).
- Finally, even if regulators had the ability to accurately assess
bank risk, they do not have a sound basis for determining how
much risk in banking is too much or too little. Banking supervision
and regulation, in other words, should not be expected to lead
to something like an efficient amount of risk taking.
We also have strong doubts that FDICIA adequately addresses the
problem of too-big-to-fail. As you know, policymakers and regulators
indicated prior to FDICIA that they would rescue the liability holders
of the largest banks because of their fear of contagion and systemic
instability. Because of the TBTF assurance, liability holders did
not have adequate incentive to charge large banks higher rates for
higher risk, and thus large banks took on more risk than they would
FDICIA establishes a process that subjects the bank-rescue decision
to more sunlight, formal vote taking and consensus. However, it
is not clear that these changes significantly altered the rescue
process that was in place prior to FDICIA. Indeed the process codified
by FDICIA in 1991 looks very much like the one leading to the rescue
of Continental Illinois in 1984. Consider the following description
of that process by the Comptroller of the Currency, Todd Conover:
"We debated at some length how to handle the Continental situation.
... Participating in those debates were the directors of the FDIC,
the Chairman of the Federal Reserve Board and the Secretary of the
Treasury. In our collective judgment, had Continental failed and
been treated in a way in which depositors and creditors were not
made whole, we could very well have seen a national, if not an international,
financial crisis the dimensions of which were difficult to imagine.
None of us wanted to find out." [Hearings Before the Subcommittee
on Financial Institutions, Supervision, Regulation and Insurance,
Sept. 18, 19 and Oct. 4, 1984, pp. 287-288.]
These observations do not argue against any of the changes to
regulation that have been made or that have been proposed. Indeed,
that policymakers and supervisors have moved from a traditional
command and control regime to a system where supervisory intensity
and rules depend on the financial condition and management of the
bank is a positive step. However, regulatory steps alone are unlikely
to adequately address distortions created by the safety net and,
especially, by the presumption of TBTF. Moreover, two trends that
have accelerated since passage of FDICIA suggest that regulatory
approaches may well have become even more unequal to the task of
containing excessive risk taking by large banks than formerly.
Increasing Asset Concentration and Increasing Risk
Banking assets are increasingly controlled by the largest firms.
In 1980, there were more than 12,000 banks in the country, with
institutions with assets greater than $10 billion controlling 37
percent of total bank assets. These figures had barely changed by
1990 but, by 1998, there were far fewer banks (8,910), with the
64 over $10 billion in assets controlling a large share of total
bank assets (63 percent). The accepted wisdom, buttressed by econometric
models, forecasts a continuation of this trend. This rising concentration
has almost certainly led to more TBTF banks.
Increasing Complexity and Increasing Risk
Bank operations have become more complex. There are several reasons
for this, including:
- Increased bank size and geographic reach.
- Increased scope of product offerings (e.g., insurance sales,
underwriting of securities, etc.).
- Increased skills needed to offer some new products (e.g., derivative
structuring) and implement new risk management systems that may
differ radically from previous practices.
Such trends make it more difficult for bank supervisors to effectively
monitor and respond to the risk taking of the largest and most complex
banks for the general reasons enumerated above. How can regulators,
for example, effectively alter the marginal costs of banks across
so many activities? More generally, the increasing complexity of
banks could raise the level of information asymmetry between the
banks' managers and the regulator.
Implicit in this critique of policies that rely solely on regulation
to address moral hazard is the view that market forces can bring
benefits that are not otherwise available. I am not, however, arguing
for the other extreme. In my judgment, a policy of complete reliance
on the market is not the answer either because such a policy is
not crediblethe government will and should intervene when
there is a negative shock to the entire system. Consequently, a
policy that gives the pretense of relying solely on the market still
creates moral hazard.
Why Laissez Faire Responses to Moral Hazard Fall Short
Several reform proposals look to unfettered markets to manage the
risk taking incentives created by the safety net. One option, privatization,
would eliminate the federal safety net and with it the need for
regulators to monitor banks. Instead, private insurers would assume
that role. Several large commercial banks are the proponents of
these schemes, which vary from plan to plan but which often call
for stripping deposit insurance of its federal features, such as
the full faith guarantee of the U.S. government.
Narrow banking plans, whose features are well known, essentially
take a similar approach. The uninsured, unregulated "wide banks"
under this scheme are the same as banks under a privatized system
and have the same economic justification for their creation. The
difference is that the narrow banks would meet the residual demand
for insured deposits. The safe, transparent assets of the narrow
bank eliminate the need for existing safety and soundness examinations
and, presumably, for federal insurance, although it could be retained
A serious problem with these laissez faire approaches is that
they do not credibly address the potential for instability in the
banking system nor the related TBTF problem. The complete absence
of a federal safety net creates the potential for banking panics
which could have substantial financial and real costs, but one need
not hold this view to conclude that laissez faire reforms will fail
to reduce mispricing of risk. This is because policymakers and regulators
have often indicated through deed and word that they will rescue
liability holders of the largest banks because of their fear of
contagion and systemic instability. These practices raise doubts
about the credibility of the "no government support" pledge central
to privatization and narrow banking plans. As such, narrow banking
and privatization are not likely to reduce materially market expectations
of rescues and hence the accompanying underpricing of risk. And
as the discussion suggests, the problem is particularly acute for
Incorporating Market Signals into the Regulatory Process
In our view, incorporating market signals into the regulatory process
is an essential step in addressing moral hazard. However, incorporating
market signals from creditors who are put at risk requires a credible
policy framework, one which accounts for TBTF and potential systemic
instability, and which supervisors and legislators will embrace.
The idea is to require, by law, that depositors and other creditors
at all banks, not just small institutions but even those considered
TBTF, bear some risk of loss in the event of the failure of the
institution, and to incorporate the market signals that this policy
generates into the current regulatory regime.
What Market Signals Offer
A wide body of empirical research suggests that bank creditors,
credibly put at risk, do assess and act upon the risk taking of
banks. That is, these investors alter their pricing to reflect changes
in the riskiness of the bank. The incorporation of new information
by creditors means that market prices for bank funding will directly
affect the bank's marginal cost of taking risks with a precision
that regulation cannot achieve. In particular, this means that greater
reliance on market signals is potentially capable of reducing the
mispricing of risk taking which occurs today.
Moreover, market participants have proven reliable in incorporating
the implications of new bank products and services in their risk
assessments, so further financial innovation can be expected to
be accommodated within this approach. Finally, market participants
have an option for addressing information asymmetry not available
to regulators. If market participants do not understand a bank's
strategy or operations, they can charge a risk premium to account
for that weakness, thereby providing banks with a signal to provide
A Policy Framework With Market Signals
Development of a policy framework for the use of market signals
requires two steps. First, policymakers must credibly put creditors
and others capable of providing market discipline at risk of loss,
so that market signals are generated. To accomplish this successfully,
the reform must address TBTF and instability. Second, bank regulators
must explicitly and systematically incorporate market signals into
the supervisory process.
Creating Credible Market Signals Analysts have suggested
several credible methods for developing market signals. The Federal
Reserve Bank of Minneapolis has called for amending FDICIA so that
uninsured depositors and other creditors at TBTF institutions would
lose a modest but meaningful percentage (e.g., 20 percent) of funds
if their bank fails. This plan takes advantage of the vast experience
of private insurers who have long used coinsurance to address moral
hazard. In the banking context, such coinsurance is credible because
the limitation on loss size should preclude substantial financial
spillovers and thus should reduce the likelihood of contagion. As
a result, Congress and bank supervisors would have less incentive
to bailout TBTF institutions or worry excessively about the threat
of panics. Certainly, though, there is a trade-off between market
discipline and banking stability. This reform would make banking
panics a possibility, something that is highly unlikely today. We
assert, however, that no effective reform can avoid this trade-off.
Once at risk, uninsured creditors would demand additional information
about their banks to the degree that current disclosures do not
allow for a clear assessment of risk taking, and so we recommend
mandating additional disclosure requirements only after assessing
the data provided voluntarily under the new regime. With increased
incentive for large depositors to monitor the quality of banks,
the risk premia found in the rates charged by such depositors and
other creditors put at risk should provide a more accurate reading
on bank risk than currently exists.
A similar type of plan would, alternatively, require large banks
to issue subordinated debt equal to some (small) percentage of the
bank's assets. Subordinated debt holders come only before equity
holders in making a claim on failed bank assets. Thus, they could
lose a significant investment if their bank becomes insolvent. Most
of the time, this gives subordinated debt holders incentives that
regulators should desire. The debt holders want banks to take enough
risk to generate profits, but they should demand bank closure before
the institution becomes more than minimally insolvent. The Federal
Reserve Banks of Chicago and Atlanta have been leaders in developing
these plans and, more recently, members of the Board of Governors
have expressed strong interest in such a proposal.
Although subordinated debt plans vary by author, their general
structure has generated more support than proposals that rely on
depositor discipline. In particular, holders of subordinated debt
cannot demand immediate repayment as can some depositors, and therefore
such plans are seen as potentially less destabilizing. Moreover,
the subordination of debt could reduce the likelihood that holders
would receive coverage during a bank bailout.
Subordinated debt plans, however, are not the proverbial free
lunch. On the one hand, if issuance of long-term subordinated debt
is mandated such plans may at best provide low-quality pricing data
to regulators. In this case, information from the primary market
may be limited because issuance is infrequent, and the secondary
market for long-term subordinated debt may well be illiquid, especially
if regulators require the issuance of such securities in greater
amounts than currently demanded or supplied. On the other hand,
if banks are required to issue short-term subordinated debt, they
could be subject to paniclike drop-offs in funding. Some subordinated
debt plans try to address this concern by requiring a mix of short-term
and long-term maturities but there is no clear basis on which to
divine the right combination.
Private insurance offers a third source for generating market
signals. For example, Congress could require large banks to purchase
a small amount of private deposit insurance, covering, say, 5 percent
of deposits. In fact, in 1991 Congress mandated that the FDIC study
the establishment of a private reinsurance system. Financial engineers
could also design instruments to allow private investors to bear
some of the cost of covering insured depositors. Such instruments
already exist for natural disasters.
Private insurance proposals would require market participants
to assess and segment banks by their riskiness. The effect of these
arrangements on stability depends on the confidence of the insured
creditors. If they do not believe private insurance capable of honoring
their claims, insured creditors will run banks, although the limited
amount of exposure they bear should limit the problem. In addition,
private insurance arrangements do not address TBTF per se. But they
could be structured such that the bailout by the government of the
liability holders of a large bank with private insurance does not
eliminate the insurers' requirement to make a payout. As such, pricing
should still reflect the risk of a claim against the private insurer.
All of these proposals to put bank creditors at risk have the
virtue of gradual implementation, if needed. The coinsurance rate,
for example, need not rise to 20 percent at once (or ever), nor
does the required amount of subordinated debt have to quickly meet
its maximum level. This flexibility should reduce concerns about
Incorporation of Market Signals Putting bank creditors
at risk, however, is not a replacement for supervision. Some portion
of large bank assets, for example, will remain opaque, leading to
incomplete information for market participants and, presumably,
to imperfect market signals. The supervisory process can generate
and act on valuable information about such assets and therefore
contribute to restriction of bank risk taking.
More generally, the market discipline provided by creditors may
not be enough on its own to address excessive bank risk taking.
As long as some bank creditors receive 100 percent protection, the
prices that banks face for raising money will be distorted. And
none of the options for increasing market discipline would alter
our current full protection for deposits under $100,000. Moreover,
market discipline may be avoided, at least to some extent, if banks
rely increasingly on insured funds in times of stress.
Thus, the supervisory process will continue to play an important
role. In this environment, to rein in moral hazard effectively,
the signals created by the market need to be incorporated in two
general areas of regulation: deposit insurance assessments and the
Assessments: Under any credible reform of the safety net, the
government will continue to provide a base level of deposit insurance.
To limit moral hazard then, the government must charge deposit insurance
assessments that vary with the riskiness of the bank (as signaled
by the market). The means of incorporating market signals into the
assessment depends on the source. Private insurance premiums would
offer the most straightforward source of incorporation, but other
market signals would work as well. The risk premia evident from
the prices charged by depositors or other creditors put at risk
of loss suggest a way to differentiate deposit insurance pricing.
In order to reduce administrative costs, the deposit insurer would
most likely group institutions with fairly similar risk premia into
assessment categories. And the insurer would surely use market premia
as only one factor in the assessment setting process, along with
supervisory and other information that add predictive value.
Supervisory Process: The existing regulatory system relies in
part on "triggers" which require risky institutions, as evaluated
by bank supervisors, to face more supervisory scrutiny, higher insurance
costs and more restrictions on activities than do sound institutions.
Under Prompt Correction Action (PCA), for example, banks with declining
capital ratios face increasing restrictions on activities until
the point that regulators close them. There are also links between
the frequency of bank examinations and capital ratios and supervisory
ratings of management.
The point here is not to endorse the particular triggers used
currently. (In fact, some have argued persuasively that PCA would
be more effective if it were based on market measures of capital
rather than book measures.) Rather, I want to emphasize the importance
of incorporating market signals into supervisory triggers more generally,
in order to enhance the ability of supervisors to address moral
How might this incorporation actually work? In a fairly simple
approach, supervisors could make use of the new, risk-based deposit
insurance premium groupings to sort banks into various trigger categories.
Alternatively, supervisors could put banks into regulatory categories
based on their funding costs relative to some benchmark rate (e.g.,
the difference of a particular institution's debt yield over the
relevant Treasury rate or the average for bank debt). Under the
combined regime, regulatory action would be triggered when banks
moved from one market signal group to another and/or when they move
from one regulatory category to another.
Of course, these comments gloss over many hard to resolve details.
Indeed, it must be acknowledged that distinguishing between the
noise inherent in rates on bank liabilities and meaningful measures
of bank risk taking is a challenge. With this difficulty in mind,
consider the pristine performance of a system incorporating market
signals during a period of intense instability in fixed-income debt
markets, as occurred in the latter part of 1998. For example, should
large banks face restrictions on their activities because yields
on their liabilities suddenly spike up sharply only to return to
average levels? To the degree that the rise in yields reflects an
overall increase in spreads between a risky rate and the risk-free
rate, a system incorporating market signals need not trigger supervisory
action. Supervisors could also filter out shocks in rates by using
some sort of averaging procedure, but averaging has the serious
disadvantage of masking price signals.
But focusing the difficulty of using market signals in banking
regulation, especially during extreme circumstances, obscures the
relevant comparison. Would the current regulatory-based system achieve
more desirable outcomes than a system which incorporates regulation
and market signals? Do we think that regulation alone would react
with greater efficacy to periods of instability in credit markets
and in the banking system more generally? For all of the systematic
differences between regulation and market signals described above,
I believe the burden of evidence rests on those who would argue
that the current system is affirmatively superior to one making
use of market signals.
Despite the call for change, the reforms suggested here are modest
in many ways. They maintain deposit insurance, the existing supervisory
structure, and phase in change gradually. At the same time, the
reforms create the infrastructure for future efforts. They do so
by explicitly recognizing and starting to address directly the fundamental
and interrelated problems of moral hazard and banking instability
and by taking steps toward explicit incorporation of market signals
in the regulatory process. They also give regulators and policymakers
time to learn and gain experience, thereby likely enhancing the
quality of additional, future reforms.
Why bring up future reforms on the heels of this proposal? One
answer is that if banks continue to become more like other financial
services firmsa trend that seems firmly in placethen
the justification for regulation and the safety net changes. These
reforms provide a framework for transitioning from existing regulation,
to regulation and market signals, to a system even more reliant
on the market.
For more on this topic, see the Minneapolis Fed's 1997 Annual Report,
"Fixing FDICIA: A Plan to Address the
Stern presented these remarks at the 35th Annual Conference
on Bank Structure and Competition at the Federal Reserve Bank of Chicago,
May 6, 1999.