We cannot count on addressing moral hazard by jawboning or having
creditors spontaneously changing their minds and pricing risk accurately.
Financial modernization has the real potential to expand the
safety net, especially for the largest banks that take on new
powers, and exacerbate the moral hazard problem. As such, we have
extra incentive after the passage of the Gramm-Leach-Bliley Act
of 1999 (GLBA) to increase our consideration of plans to address
excessive risk taking by too big to fail (TBTF) banks and affiliated
Plans to limit safety net expansion and moral hazard will prove effective only if they are credible or
time consistent. That is, these policies must contain features
or commitments such that creditors believe they will suffer at
least some loss upon the failure of their financial institution.
We categorize methods for achieving credibility into four groups
based on the manner in which they address the incentives that
policymakers face when deciding to bail out creditors.
Congress prohibits bailouts or passes other simple legal restrictions.
This strategy essentially requires regulators to ignore incentives
to bail out creditors.
- Congress enacts procedures that penalize or otherwise raise the cost
to regulators for providing bailouts. This strategy seeks to raise
the explicit disincentives to bailouts such that they exceed the incentives
Regulators take steps that reduce the incentives that have led them
to bail out creditors in the past. This strategy relies on changing
the dynamics that create the time-consistency problem in the first
Congress focuses on policymakers themselves and appoints regulators
who have a predilection to resist bailouts. This strategy focuses
on the incentives internal to the policymaker.
We believe the first two methods are the least likely to be credible
because they do not address the underlying factors that give policymakers
incentives to bail out creditors at TBTF institutions. As a result, policymakers
have significant cause to evade these reforms, making these strategies
deficient. The latter two strategies have more potential because they
try to alter underlying incentives, although they also raise implementation
concerns. (The table summarizes this review.)
Certainly, these initial thoughts do not constitute a very rigorous
evaluation of the commitment technologies available to policymakers. Nonetheless,
we hope our attempts at categorizing and discussing these plans will encourage
more detailed evaluations of them and prompt new suggestions for establishing
credibility. Without such efforts we may end up by default with a potentially
costly policy of "constructive ambiguity."
Financial modernization and moral hazard
The connection between financial modernization, moral hazard and too-big-to-fail
may not be intuitive to all. Thankfully, Chairman Greenspan has spent
considerable time explaining the problem of moral hazard and its connection
to recently passed financial modernization legislation that expands the
powers available to banking organizations.
The chairman described the basic problem of moral hazard in banking
"... As a society we have made the choice to create a safety
net for depository institutions, not only to protect the public's
deposits, but also to minimize the impact of adverse developments
in financial markets on our economy. Although we have clearly been
successful in doing so, the safety net has predictably created a moral
hazard: The banks determine the level of risk taking and receive the
gains therefrom, but do not bear the full cost of that risk; the remainder
is borne by the government. Since the sovereign credit of the United
States ultimately guarantees the stability of the banking system and
the claims of insured depositors, bank creditors do not apply the
same self-interest monitoring of banks to protect their own position
as they would without discount window access and deposit insurance.
... Put another way, the safety net requires that the government replace
with law, regulation and supervision much of the disciplinary role
that the market plays for other businesses."1
While some of the safety net the chairman describes is explicit,
a major source of moral hazard arises from implicit or discretionary
federal coverage. Indeed, it is this form of moral hazard that
has received the greatest amount of attention over the last several
years. Implied coverage exists for the nominally uninsured bank
creditors of too-big-to-fail banking institutions as well the
creditors of nonbanking firms. Simply put, despite the fact that
these creditors are not entitled to protection from loss when
their financial institution fails, they believe and act as if
they have such protection. This belief is based both on the historical
coverage of such creditors as well as the incentives of policymakers,
discussed in more detail below, that could lead them to conduct
Why discuss the problem of moral hazard resulting from explicit
and implicit coverage in conjunction with financial modernization? The
chairman's concern was that legislation allowing banking organizations
to carry out insurance, securities and other financial activities would
lead creditors of the insurance firms, securities firms, etc., that
were affiliated with banks to believe they were covered by the bank
safety net. This belief leads to the mispricing of risk by these creditors,
thereby encouraging excessive risk taking by bank affiliates. This outcome
was clearly troubling to the chairman, who noted that, "The last
thing we should want, therefore, is to widen or spread this unintended,
but nevertheless corrosive dimension of the safety net to other financial
and business entities and markets. It is clear that to do so would not
only spread a subsidy to new forms of risk taking, but ultimately require
the expansion of banklike supervision as well."2
The chairman did not see the potential pitfalls of expanded powers
for banking organizations as insurmountable. Indeed, he argued that
careful organizational design would address concerns about safety net
expansion while allowing increased powers for banks. Specifically, the
chairman supported the exercise of new powers in subsidiaries of holding
companies that own banks but opposed their location in the bank itself
or in a subsidiary of the bank. The chairman noted that "... the
subsidy that the government provides to banks as a byproduct of the
safety net would be directly transferable to their operating subsidiaries
to finance powers not currently permissible to the bank or its subsidiaries."3 In contrast, "... the holding company structure is the most appropriate
and effective one for limiting transfer of the federal subsidy to new
activities and fostering a level playing field both for financial firms
affiliated with banks and independent firms. It will also, in our judgment,
foster the protection of the safety and soundness of our insured banking
system and the taxpayers."4
The version of financial modernization that did pass, the Gramm-Leach-Bliley
Act of 1999, contained a compromise between the U.S. Treasury
and the Board of Governors rather than a pure version of the chairman's
plan. The compromise legislation allowed banks to exercise some
new powers in subsidiaries of banks while simultaneously taking
steps to limit or discourage the use of this option (for example,
the legislation forbids certain activities from being carried
out in bank subsidiaries and caps the size of these subsidiaries).
Despite differences, both the chairman's original proposal and
the compromise position are premised on the notion that organizational
design is an effective tool for addressing a potential increase
in moral hazard. But will organizational strategies prove effective?
We cannot begin to answer this question without first determining
which factors policymakers should consider when judging the likelihood
that a proposal will be an appropriate response to moral hazard.
This determination should be paramount in our minds for exactly
the reasons the chairman has argued. Financial modernization has
opened the door for a potentially significant increase in the
moral hazard problem.
Let me state from the beginning that I believe the credibility,
or time consistency, of efforts to contain moral hazard is the
key to determining their effectiveness. This was true before GLBA,
is even more true after its passage, and will be the focus of
the rest of this column.
Credibility and the moral hazard problem
Addressing moral hazard appears deceptively simple. Just make creditors
at TBTF banks believe they are at risk of loss. Thus, the prices charged
by uninsured creditors will reflect the risk taking of the financial institution.
These price signals, directly and through appropriate links to regulatory
discipline, can alter the behavior of the financial institution, leading
to less moral hazard and less risk taking. These results are the benefits
to society from a strategy of putting creditors at risk of loss.
However, putting creditors at risk is not as trivial as it sounds
because of the so-called time-consistency problem. The problem
arises because at the time policymakers must force creditors to
bear losses, they will face at least two significant incentives
to renege on the commitment to do so. These incentives to bail
out creditors include the potential wrath of those who lose money
or their political supporters and the prevention of spillover
failures or at least serious disruptions at other banks.5 These spillovers can also occur between banks and other financial
participants (for example, securities firms) to which they have
exposure. Policymakers may fear that this kind of contagion will
prevent the efficient operation of the financial sector. Weaknesses
in the financial sector could produce a diminution of output and
employment in the real economy. By providing full protection against
loss to uninsured creditors, policymakers may believe they have
potentially saved society from a costly financial shutdown.
Just saying that regulators will not bail out creditors is therefore
not time consistent. Creditors will recognize policymakers' incentives
to go back on their word and bail them out and behave as if they
have nothing to lose. This suggests why a credible commitment
to putting creditors at risk of loss is so important. Without
this commitment, significant moral hazard is inevitable.
One might question why policymakers don't follow through on
their promise, given that their decision to bail out creditors
produces moral hazard. In other words, isn't the potential for
moral hazard a sufficiently large disincentive to outweigh the
incentives to bail out creditors? One answer is that policymakers
might think they will act differently in the future, the next
time decisions on bailouts must be made. Moral hazard will not
occur, policymakers might think, because creditors will recognize
the current bailout is a one-time event. However, creditors will
actually recognize that each time the decision must be made, the
policymaker will face the same incentive that led to the decision
to bail out creditors the first time. Alternatively, the policymaker
might consider the disincentive of moral hazard to be of less
importance than the incentives to bail out because moral hazard
costs will be evident in the future while the benefits of bailouts
are received today.
A second challenge to our concern about time-consistent behavior
comes from research suggesting that the threat of contagion is
overblown. Some economists have argued that creditors' losses
from bank failures in the past were not so large as to produce
significant spillovers. Others have argued that bank creditors
exhibit rational behavior even during panics (for example, depositors
differentiate between financially sound and unsound banks during
having seen this evidence, the reasoning goes, will have little
reason to bail out creditors of large banks in the current period.
However, we do not believe that policymakers will change their
decision-making based on this research because of the uncertainty
they will continue to face. At a minimum, there is disagreement
as to the conclusions one should draw from research on banking
policymakers may not find the conclusions relevant to the particular
bank failure that they will face in the future. Policymakers are
likely to believe that there is some chance that basing decisions
in the current period on past experience will be wrong. The costs
of an inappropriate decision (that is, not providing government
support in the rare case when it may be needed) will likely appear
so high to policymakers as to swamp the rationale for not taking
It is clear to us, therefore, that credibility will have to
be explicitly and deliberately established through commitment
plans that put creditors at risk of loss. We cannot count on addressing
moral hazard by jawboning or having creditors spontaneously changing
their minds and pricing risk accurately. Consequently, I think
it useful to (1) review and categorize strategies conceivably
used to establish credibility in addressing moral hazard and (2)
provide some general discussion as to which of these strategies
are likely to be effective in establishing credibility. We conclude
with thoughts about a policy of constructive ambiguity.
Identifying and assessing methods for achieving credibility
To be somewhat systematic about our discussion, we will group strategies
by how they affect the incentives to bail out creditors. Strategies include
(1) rules or laws that prohibit bailouts of uninsured creditors and thus
require policymakers to ignore incentives to provide bailouts, (2) policies
that penalize policymakers for bailouts or otherwise increase the explicit
disincentives to provide protection, (3) reforms that try to eliminate
potential spillovers from the failure of large financial institutions
or otherwise mitigate against the very incentives policymakers have for
bailing out creditors and (4) appointment of policymakers with a natural
disinclination to bail out creditors. (While listed separately, many reform
plans use multiple commitment strategies.)
After describing the types of proposals that fall under each
category, we will provide some initial thoughts on the likelihood
that these proposals will be time consistent. That is, will they
be credible and alter incentives enough to make creditors believe
they are at risk of loss? These comments are aimed at generating
additional discussion and suggestions rather than at presenting
a rigorous review. The table summarizes
our categories and thoughts.
Bailout prohibitions and other rules that force
policymakers to ignore incentives
A direct response to the time-consistency problem is to forbid policymakers
from acting on their incentives at the time the decision to bail out creditors
must be made. This would be most simply accomplished by forbidding in
law the coverage of all creditors of a certain type (for example, coverage
only allowed for those with bank deposits under $100,000). Despite its
benign appearance, this approach is often associated with more radical
plans to address moral hazard. For example, plans that eliminate public
deposit insurance and replace it with a private insurance system or with
nothing at all essentially foreclose government protection.8 Likewise, the collateralized deposit system created by narrow banking
plans creates a group of "wide banks" beyond legal coverage. A more recent
version of this genre was the system of uninsured wholesale financial
institutions that almost made it into the financial modernization legislation.
Creditors of these institutions were not covered by deposit insurance.
Chairman Greenspan's organizational approach is also based on legal
constructions and rules. He suggests that policymakers will be less likely
to bail out creditors, and creditors will be less likely to expect a bailout,
because they have a financial relationship with an entity legally distinct
from the bank. In other words, these creditors are simply not entitled
under any legal regime to ex post protection. As part of that organizational
approach, the financial modernization legislation also calls for functional
regulation, where bank regulators do not have primary responsibility for
monitoring insurance or securities affiliates of the banking organization.
Instead, that task falls to securities and insurance regulators. This
arrangement also appears to rely on the appearance and legal status of
the nonbanking creditors. If bank regulators do not have legal responsibility
for the firm, the thinking goes, they will have less legal rationale and
ability to effectuate bailouts.
The rule-based approach is quite easy to implement, and it offers a
simple and direct way to convey the sentiments of policymakers to creditors.
But, is it credible? That is, will it change the decision that policymakers
face when a TBTF bank is failing? While these rules might be better than
doing nothing at all, I don't think they have a high degree of credibility.
To be credible, policymakers must have little desire to evade the rule
and such evasion must be difficult. I think both of these tests fail in
First, these legal regimes do not change any of the incentives to provide
bailouts. Policymakers will still fear the economic and political costs
associated with large bank failure and will have a strong rationale for
evading the rule. Second, there are a fair number of options available
to policymakers for circumventing prohibitions, including emergency legislation,
lending from the Federal Reserve's discount window and resolution techniques
that accomplish the economic substance of a bailout without violating
the legal restriction.9 We don't think a complete contract that addresses all the methods that
policymakers can use to effectuate bailouts can be written. As such, we
think it unreasonable to believe that policymakers will shackle themselves
when the incentive benefits of extending the safety net arise, as they
surely will some day.
Penalties and other disincentives to providing bailouts
A variety of commitment strategies attempt to raise the costs to policymakers
of engaging in bailouts without relying on prohibitions per se. The Federal
Deposit Insurance Corp. Improvement Act of 1991 (FDICIA) contains reforms
of this nature. In particular, FDICIA requires policymakers to take a
series of votes that will be reported to the public before bailouts occur.
FDICIA raises costs via the extra publicity and formality that would accompany
an attempt to bail out creditors. FDICIA combines this approach with a
legal rule that requires resolution of a failed institution on a least-cost
basis. This explicitly requires the FDIC to quantify the cost of protecting
uninsured creditors (as well as creating an explicit ex post levy
on banks to pay for bailouts). Resolutions are then subject to review
by the General Accounting Office.
Are such disincentives examples of commitment strategies that produce
credibility? It does appear that the voting mechanism along with the least-cost
test is materially reducing implicit coverage at smaller institutions.
However, in previous comments we have noted that the explicit process
that FDICIA created for approving bailouts and escaping the least-cost
test appears quite similar to the informal process that regulators took
prior to FDICIA when they acted in the Continental Illinois case.10 While FDICIA may have raised the disincentives of bailouts, we are not
convinced that the disincentives currently exceed the incentives of providing
Another commitment strategy that relies on disincentives and has received
attention in the literature on credible monetary policy involves explicit
contracts. For example, a contract could penalize policymakers monetarily
for actions that make implicit coverage more likely or for the coverage
itself (as Professor Carl Walsh has suggested for central bankers when
they fail to meet inflation targets).12 A second approach would require issuance of debt which pays holders a
lump sum if a bailout occurs and nothing otherwise.13 This option raises the explicit costs of bailouts and puts the burden
on the taxpayer. Not only could the costs associated with these bonds
discourage such bailouts, but also the pricing of these debt instruments
would give policymakers the market's assessment of the likelihood of bailouts.
Again, these explicit means of establishing commitment are better than
doing nothing. Moreover, these strategies are not as extreme as general
prohibitions and thus cannot be dismissed as easily. But, even ignoring
their lack of political viability, these contracts may not prove a useful
means to alter future decisions of policymakers. The problem here is one
of implementation. It appears difficult to write the contracts such that
all contingencies and actions by policymakers are covered. Thus, the same
types of evasion that are possible under the rules-based reforms could
occur here as well. While we don't think the rationale for evasion remains
as strong as it was for prohibition, it is still of concern.
Reducing the incentives to provide bailouts
Whereas the previous section reviewed more moderate plans that focused
on penalties, this section discusses commitment strategies that try to
achieve credibility by reducing the incentives to bail out creditors.
Methods to diminish these incentives include reducing the likelihood of
spillovers and altering who is at risk of loss.
Spillovers. A major incentive to policymakers to provide coverage
is the management of systemic risk and the prevention of spillover failures
and contagion. If a plan could eliminate these events, then policymakers
would have less incentive to offer such coverage. A few reform efforts
of this type focus on the payments system (proponents of this type of
plan include Tom Hoenig, president of the Federal Reserve Bank of Kansas
City, and Professor Mark Flannery).14 Proponents argue that spillovers from the failure of a large financial
institution are transmitted via the payments system. The plans contain
methods for limiting or better managing the amount of risk transferred
via the payments system, making it less likely, in theory at least, that
the failure of one institution will lead to failures or problems at other
A second type of spillover reduction plan focuses on the amount of loss
that uninsured creditors bear. This type of plan does not try to prohibit
bailouts, viewing that option as inherently not credible and potentially
not desirable. Instead, the goal is to limit the loss that uninsured creditors
bear to an amount that motivates them to monitor financial institutions
with which they have relationships but which does not lead to their own
insolvency. As a result, the failure of one bank would not lead to the
failure of other creditor banks. We have proposed a plan which implements
this notion through the application of co-insurance for uninsured creditors
at TBTF banks.
FDICIA also contains reforms to reduce potential contagion. In particular,
the prompt corrective actions (PCA) rules created by FDICIA should limit
the number of fixed-income creditors who suffer losses, as equity holders
should bear the bulk of those costs.
Finally, a novel suggestion by Professor Frederic Mishkin could address
policymakers' concerns about spillovers through a rule.15 Specifically, creditors of the first large institution that fails cannot
be bailed out, but creditors of institutions that subsequently fail could
receive bailouts. This proposal would allow policymakers to address their
fear of spillover failures. At the same time, the plan increases creditors'
incentives to price risk correctly so they are compensated for the chance
that their bank is the first to fail and they suffer losses.
Risk of loss. A different commitment approach relies on policymakers'
disinclination to assist certain types of creditors. Subordinated debt
plans exemplify this approach. Holders of this debt are sophisticated
and have had ample warning that their low priority in bankruptcy means
they should not expect significant proceeds after a bank fails. There
is some evidence that holders of banking organizations' subordinated debt
already believe they are at some risk of loss.16 Some subordinated debt plans have taken this notion one step further,
explicitly requiring particular groups to hold the debt. One plan would
have restricted subordinated debt holders to foreign banks. Others fear
that these factors may not be enough to prevent the bailout of subordinated
debt holders. As such, they also call for something akin to the co-insurance
plan described above. For example, the subordinated debt contract could
require that the holder of the debt suffer at least some loss if the government
provides funds to protect creditors of the failed bank.17
In total, these plans cover a wide range and it is difficult
to evaluate their credibility concisely. A few of them seem unlikely
to alter incentives and put creditors at risk of loss. For example,
PCA as implemented by bank regulators is triggered by book measures
of capital, leading to deeply insolvent banks that still report
positive capital. And while I am sure distributional matters play
some role, I don't think bailouts are largely driven by these
issues. Instead, I think policymakers genuinely fear, rightly
or wrongly, systemic risk.
The rest of these plans to reduce the underlying incentives
to provide bailouts often present quite complex and difficult
issues to evaluate. Some have questioned, for example, the ability
of policymakers to devise the co-insurance loss rate that would
prevent spillovers. Perhaps the focus on payments systems would
not adequately limit exposures between financial institutions.
I certainly don't intend to review all of these questions, and
I'm not sure that all of them are amenable to clear answers, given
available evidence. But valid reservations notwithstanding, I
would argue that several of these proposals move us in the direction
of credibility; that is, they alter the underlying incentives
that policymakers face. I think it will be extremely difficult
to reduce the likelihood of bailouts without reducing the incentives
that policymakers have to take those actions. Reforms that focus
on prohibitions and disincentives, in contrast, seem likely to
fail precisely because they do not reduce the incentives that
lead to bailouts in the first place.
Appoint policymakers with a disinclination
to provide bailouts
So far we have discussed commitment strategies that create new rules
or procedures. Another method for addressing the underlying incentives
to provide bailouts is to appoint policymakers with significant concerns
about moral hazard. These policymakers could be said to have a low discount
rate, which means that they will place a high value in the current period
on future moral hazard costs. When these policymakers come to decide on
bailouts, they will find that the disincentives, namely the future costs
of their actions in terms of moral hazard, could very well outweigh the
incentives to provide bailouts. As such, their commitment to avoid bailouts
will be relatively credible.
This suggestion is a derivation of Professor Kenneth Rogoff's work showing
that appointment of a central banker who is more "conservative" than the
general population could lead to a credible commitment by the central
bank not to inflate.18 This idea has both theoretical and practical appeal, and the reasons that
make the Rogoff suggestion welcome for monetary policy would seem to apply
here as well.
An interesting question is if the appointment of conservative policymakers
is sufficient. Indeed, some may arguebased on insight gained as
a policymaker or from close contact with themthat we have overstated
the desire of policymakers to provide protection. That is, we could already
have fairly conservative policymakers. Even if this were the case, I would
argue that society would be better off if steps were taken to establish
a credible no-bailout regime.19 Creditors base current decisions on expectations of the future. Ambiguity
about future actions by regulators will lead to mispricing that will only
be corrected after the regulator allows creditors to absorb losses. Regulators
can address this costly learning process by getting creditors to believe
in the real potential for future losses and the need to more accurately
price risk. Better pricing should lead to a reduction in excessive risk
taking. This process could result in fewer potential bank failures, obviating
the need for regulators to impose losses in the first place. This reasoning
suggests that the appointment of conservative policymakers be accompanied
by other commitment strategies.
Concluding thoughts about ambiguity
So far I have discussed plans that take action to establish credibility,
even if it were nothing more than one line in legislation that forbade
bailouts. This discussion clearly leaves out a policy of constructive
ambiguity, where policymakers remain silent as to their policies. As previously
suggested, the policy of constructive ambiguity is unnecessarily costly
if policymakers oppose bailouts. The lack of an overt strategy to communicate
the no-bailout position to creditors creates more doubt than is justified,
given the likely actions of the regulator. In contrast, one could argue
that ambiguity is better than an explicit extension of the safety net,
in that it will produce more market discipline, at least initially.20 But this honeymoon period will come to an end, or at least be greatly
attenuated, after a bailout occurs.
Indeed, it is fair to say that we are in such an interim period now.
Routinely, those opposed to plans to address moral hazard argue that the
FDICIA regime, which includes this type of ambiguity, should be tested
before it is changed. Only after we have a period of failures, they argue,
should we consider making reforms to the current system.21 I think this policy unnecessarily increases the ultimate cost that society
will bear for excessive risk taking by financial institutions. The recent
passage of financial modernization legislation only reinforces my conviction
that we need to act before losses pile up. Remarks by Chairman Greenspan
suggest similar concerns and desire to address perceptions of TBTF.
"There are many that hold the misperception that some American financial
institutions are too-big-to- fail. I can certainly envision that in
times of crisis the financial implosion of a large intermediary could
exacerbate the situation. Accordingly, the monetary and supervisory
authorities would doubtlessly endeavor to manage an orderly liquidation
of the failed entity, including the unwinding of its positions. But
shareholders would not be protected, and I would anticipate appropriate
discounts or "haircuts" for other than federally guaranteed liabilities."22
But it is not adequate to only voice these sentiments. Rather than waiting
passively to tally costs, I suggest we continue to evaluate reforms in
terms of their credibility, as well as other dimensions that will determine
their effectiveness. The goal is implementation of steps to increase credibility
as soon as feasible.
This column is adapted from a speech Stern presented in April at
"The Future of Finance: Globalization, the Internet and Regulatory Reform"
conference, sponsored by the University of Chicago's George J. Stigler
Center for the Study of the Economy and the State.
1 Testimony of Chairman Alan Greenspan before the Committee on Banking, Housing
and Urban Affairs, U.S. Senate, June 17, 1998, p 3.
2 Ibid, 3.
3 Testimony of Chairman Alan Greenspan before the Subcommittee on Finance
and Hazardous Materials, Committee on Commerce, U.S. House of
Representatives, April 28, 1999.
4 Ibid, 6.
5 Of course, there could be political fallout from providing support
as well, but we assume this will play a smaller role in decision
6 For a summary of this work see George Benston and George Kaufman,
"Is the Banking and Payments System Fragile?" Journal of
Financial Services Research 9 (3-4) 1995, pp. 15-46.
Greenbaum, Comment, same issue, pp. 105-108.
examples see: Bank Administration Institute (1996), Building
Better Banks: The Case for Performance-Based Regulation, (Chicago,
IL: Bank Administration Institute), pp. 63-70; Richard Kovacevich
(April 1996), "Deposit Insurance:
It's Time to Cage the Monster," Federal Reserve Bank of Minneapolis fedgazette, pp. 14-15; Bankers Roundtable (1997), Deposit
Insurance Reform in the Public Interest (Washington, D.C.: Bankers
Alfred Broaddus of the Federal Reserve Bank of Richmond recently
expressed concern that discount window lending could offer a way
to support failing institutions. See Remarks by J. Alfred Broaddus
Discipline and Fed Lending" for the Federal Reserve Bank of
Chicago's Bank Structure Conference, May 5, 2000.
10 Ron Feldman and Arthur Rolnick, "Fixing
FDICIA: A Plan to Address the Too-Big-To-Fail Problem," Federal
Reserve Bank of Minneapolis Annual Report, March 1998.
have recently made the point that FDICIA did not eliminate TBTF. For
example, see Anthony Santomero and David Eckles, "The
Determinants of Success in the New Financial Services Environment,"
Federal Reserve Bank of New York, Economic Policy Review,
October 2000, p. 8. [PDF Format]
12 Carl E. Walsh, "Optimal Contracts for Central Bankers," American
Economic Review 85 (March 1995), pp. 150-167.
13 Wall has suggested a similar type of instrument called capital
notes that would measure the health of the deposit insurance system.
Larry Wall, "Taking Note of the Deposit Insurance Fund: A Plan
for the FDIC to Issue Capital Notes," Economic Review,
82, 1997, pp. 14-31. Insurance firms have issued so-called catastrophic
bonds that make payouts if a disaster occurs but pay nothing if
it does not. In addition, several financial institutions issued
so-called goodwill certificates that paid investors some portion
of payments the firms would receive if they won a series of legal
decisions from the federal governments.
14 Thomas Hoenig (1996), "Rethinking Financial Regulation," Economic
Review, 81 (2), pp. 5-13, and Mark Flannery. "Modernizing
Financial Regulation: The Relation Between Interbank Transactions
and Supervisory Reform," forthcoming in Journal of Financial
15 Frederic Mishkin, "Moral Hazard and Reform of the Government Safety
Net," paper presented at "Lessons from Recent Global Financial
Crises" sponsored by the Federal Reserve Bank of Chicago, October
1, 1999; and Frederic Mishkin and Philip Strahan, "What Will Technology
Do to Financial Structure," Brookings-Wharton Papers on Financial
16 Mark Flannery and Sorin Sorescu, 1996, "Evidence of Bank Market
Discipline in Subordinated Debenture Yields: 1983-1991," Journal
of Finance LI (4), pp. 1347-1377.
17 William Lang and Douglas Robertson, "Analysis of Proposals for
a Minimum Subordinated Debt Requirement," Office of the Comptroller
of the Currency Economic and Policy Analysis Working Paper 2000-4,
18 Kenneth Rogoff, "The Optimal Degree of Commitment to an Intermediate
Monetary Target," Quarterly Journal of Economics 100 (November 1985), pp. 1169-1190.
19 Richard Clarida, Jordi Gali, and Mark Gertler, "The Science of
Monetary Policy: A New Keynesian Perspective," Journal of
Economic Literature, Vol. XXXVII (December 1999), p. 1680.
20 Douglas Cook and Lewis Spellman,"Taxpayer Resistance, Guarantee
Uncertainty, and Housing Finance Subsidies," Journal of
Real Estate Finance and Economics, 5, pp. 181-195.
21 This is the implicit theme of recent summary of deposit insurance
reforms by the FDIC. See George Hanc, "Deposit Insurance Reform:
State of the Debate," FDIC Banking Review (December
1999), pp. 1-26.
22 Remarks of Chairman Alan Greenspan, "Banking
Evolution," at the 36th Annual Conference on Bank Structure
and Competition of the Federal Reserve Bank of Chicago, Chicago,
Ill., May 4, 2000, p. 3.