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Using market data to manage risk

The potential of financial modernization

March 1, 2000


Gary H. Stern Former President (1985 - 2009)
Using market data to manage risk

This issue of The Region is devoted to financial modernization and, in particular, to the legislation passed and signed into law late last year—the Gramm-Leach-Bliley (GLB) Act. The commentaries included here cover a wide range—from consumer and competitive matters to concerns about the regulatory and supervisory framework, the insurance fund and ultimately the ongoing role of commercial banks in the financial system. As you will see, they represent different perspectives and, in some instances, view GLB in very different lights.

My principal interest is the constraint placed by GLB on excessive risk taking by large banks. This is a subject in which I and others at the Minneapolis Fed have long had an interest, and our interest is heightened since GLB is likely to lead to more large institutions engaged in an increasingly expansive array of financial activities.

Examination of GLB from this perspective—the perspective of risk taking by large banking and financial holding company organizations—yields divergent implications. In particular, it appears that the recent legislation unintentionally could contribute to excessive risk taking by large banks and thus could increase the exposure of taxpayers to prospective losses. Moreover, as detailed in the article by Minneapolis Fed supervision staff, it is not clear that much of the regulatory structure created by the bill to address this risk taking will prove effective. At the same time, GLB creates an incipient framework for enhanced management of risk through increased use of market data in banking regulation. The legislation does not go as far as it could, but policymakers have an opportunity to better contain risk taking by fully exploiting the GLB framework in the future.

Some concerns about GLB

GLB repeals limits on banking organizations' ability to underwrite securities and insurance and on other financial activities. This was a worthy goal given the weak foundation for these restrictions. Policymakers must now be tempted to call a time out, yet the very act of passing modernization legislation makes it even more important that the regulatory and supervisory apparatus governing bank risk taking be enhanced.

Reform is needed because the federal government assumes risks that banks would otherwise have to face. Some of this risk assumption is explicit (for example, federal insurance on deposits under $100,000). Risk assumption also occurs via the practice of too-big-to-fail (TBTF), whereby uninsured creditors of the largest failing banks have from time to time been protected. TBTF is particularly relevant post-GLB. Banking organizations can more readily control large insurance and securities firms, and the failure of these nonbanking firms could jeopardize the health of the entire banking organization. This at least raises the possibility that federal bailouts will protect creditors of nonbanking firms, to say nothing of the possibility that there may be more large banks whose creditors are deemed worthy of support.

Policymakers have understood and warned against the increased exposure that liberalizing financial activities could create. It appears that the primary GLB response to increased exposure focuses on organizational rules. For example, firms exercising the expanded powers allowed under GLB must be legally distinct from insured banks, and GLB restricts transactions between these legal entities. For reasons discussed in detail in the aforementioned article, we think the regulatory and organizational structure created by GLB will face significant challenges.

In contrast to many of the regulatory steps taken in the legislation, we believe effective policy responses must go further and address the underlying risk-taking proclivities of federally protected banking organizations. We believe increased market discipline and greater use of market signals by banking regulators hold considerable promise in addressing effectively excessive risk taking by banks ("A Response to Critics of Market Discipline," The Region, September 1999). GLB certainly did not move as aggressively on this front as we might have liked, legislating what amounts to modest enhancements in the use of market assessments in bank regulation. But these actions set the stage for increased future use of market data and discipline.

Market discipline in GLB

There are two actions in the legislation that could create additional market discipline. First, GLB grants new powers to the subsidiaries of national banks. But these new powers are conditional on several factors, one of which is market-oriented and aimed at the 100 largest national banks. Specifically, these large national bank parents of the subsidiary must have at least one issue of outstanding long-term unsecured debt rated in the top three categories by a credit rating firm (for example, rated at least "A" by a firm like Moody's). The bank would not be able to make new equity investments in its existing subsidiaries nor establish new subsidiaries if the bond rating fell out of the top three categories.

An association representing some of the largest banking organizations has expressed a desire to escape this provision, arguing that banks should not be required to issue a particular kind of debt. While the Comptroller has rejected this suggestion as a matter of law, such evasion should also be stopped as a matter of sound public policy. The requirement that banks must issue some public debt compels them to face market forces, potentially at a time when they would prefer to raise funds via insured and sheltered money. Indeed, the interim decision by the Treasury and the Federal Reserve to allow national banks that fall between the 50th and 100th largest in the country to escape this issuance requirement could be debated on these grounds (although there were certainly other strong reasons for the agencies to take this step).

Second, GLB requires the Board of Governors of the Federal Reserve System and the Treasury to study the "feasibility and appropriateness" of requiring large banks to issue subordinated debt. Holders of this debt are unlikely to receive full and timely payment if the banking organization issuing the debt fails. Thus, these creditors have reason to require higher interest rates when the issuer takes on more risk (that is, apply market discipline). In fact, empirical research suggests that subordinated debt holders already act on this incentive.

Regardless of its necessity, the Treasury and Federal Reserve review of subordinated debt could provide impetus for actually implementing a regime that increases market discipline. To exert a positive influence, the report, and Federal Reserve and Treasury policymakers, would have to recommend a plan for creating credible market prices. This could be accomplished by mandating subordinated debt issuance by large banks and by explicitly putting creditors of large banks at risk of loss. We believe available evidence supports such recommendations. We would encourage such a plan, which could first call for monitoring prices on voluntarily issued subordinated debt, or other bank liabilities such as jumbo CDs, before mandates ensue.

Exploiting the GLB framework

The upside of GLB does not come from the immediate steps it takes. Rather, the benefit is more likely to come in the future when policymakers more fully exploit the framework that the legislation created. In particular, policymakers and regulators have increasingly relied on "regulatory triggers" that require supervisory action against a bank when its condition changes (for example, its capital falls below a prescribed level). Regulators also use triggers to grant banks regulatory relief (for example, banks with strong management assessments and capital receive expedited supervisory review). GLB creates an additional regulatory trigger. A high credit rating allows the exercise of new powers by national bank subsidiaries and a drop in the rating could limit such activity. Should policymakers stop at the use of credit rating or look to other triggers in the future?

It is perhaps faint praise to argue that GLB's reliance on market-based data is an advance over traditional, lagging indicators of a bank's financial condition such as capital. Credit ratings do provide regulators with an assessment of repayment prospects for bond holders, and the new GLB trigger could very well limit risk taking. Only one bond issuer has defaulted since 1937 while holding a Moody's rating of "A" or higher. However, credit ratings are inferior to market prices as a tool for regulators for several reasons. In particular, market prices:

  • incorporate credit ratings plus the host of other factors that market participants find valuable,

  • result from tens of thousands of decisions by a huge array of market participants,

  • have an almost infinite degree of gradation, and change in real time, while ratings are much more likely to be static measures with a limited number of outcomes (for example, "AAA," "AA"), and

  • reflect the views of those with money to lose (although credit rating firms have a profit motive to accurately gauge risk).

Accordingly, we suggest that over time policymakers exploit the trigger system they have developed by substituting market prices for credit ratings. This combination of triggers and market prices would provide the nexus between the credit rating regime established by GLB and its call for a study of subordinated debt plans. Under one possible scenario, the exercise of new powers could occur only if the difference, or spread, between the yield on a bank's subordinated debt and the yields on comparable risk-free Treasury securities was no greater than the average spread for peer banks. Clearly, there are a large number of permutations that this price trigger could take, and the experience gained with the credit rating trigger may help in the calibration process.

In conclusion, despite some of the reservations expressed above, overall we think that with work GLB could set the stage for increased market discipline and, hence, for more effective limitation of excessively risky banking. At the least, it suggests an outline and opportunity for doing so.