The rapid evolution of the banking industry should concern policymakers
and regulators. To be sure, the source of the concern is not the evolution
itself. That the banking industry has become more consolidated, more
complex and more competitive may well be an appropriate and efficient
response to changing market conditions and technological innovations.
The trouble arises from the interaction of these developments with our
policies to safeguard the banking system and bank depositors.
Specifically, I am concerned that the fundamental changes taking place
in the banking industry exacerbate the tendency of government safeguards
to encourage banks to take on too much riskthe so-called moral hazard
problem. This excessive risk taking arises when the government agrees,
through means such as deposit insurance, to bear losses that firms and
their creditors normally bear. Earlier this year, an official of the Bundesbank
put it well. He said, ... the special role of banks must not be
interpreted to mean that bank boards can count on government support in
emergencies. If they could, the risk of a precarious situation in the
banking sector would increase even more. This would create a moral hazard,
which would result in banks taking excessive risk in order to obtain higher
returns, in the confidence that they could rely on government support
in the event of a failure. Indeed, many have argued persuasively
that this distortion to the risk/reward tradeoff was an important factor
behind the savings and loan and banking crises of the 1980s and perhaps
the recent financial turmoil in Asia as well.
Given this experience, there is a compelling need to adopt policies
that dampen the incentive to take on too much risk. In fact, the need
for regulatory reform is no longer controversial, but deciding which reform
to choose and implement is. Proposals that rely on unfettered markets
or that rely exclusively on supervision and regulation are either not
credible or are unlikely to effectively address the underlying moral hazard
problem. Nevertheless, all is not lost. The many years spent analyzing
moral hazard have also yielded promising reform proposals that make use
of market signals. Moreover, regulators have made progress in shifting
supervisory resources to areas of banking believed to pose the most serious
threats to the deposit insurance fund. Drawing on these plans and reforms,
I propose combining market signals of risk with the best aspects of current
regulation to discipline effectively bank behavior.
I. Developments in the Banking Industry Will Increase Excessive Risk
Several trends characterize the banking industry over the last two decades,
including heightened competition, increasing asset concentration and a
growing degree of complexity in bank operations. All three trends make
it more likely than formerly that banks will respond to the existing safety
net by taking on excessive risk. Such a response raises the specter of
future economic losses, and gives policymakers and regulators impetus
to reform the safety net.
Increasing Competition and Increasing Risk
Increased competition among banks and between banks and other providers
of financial services over the last two decades has stemmed from at least
two sources. First, legal reforms such as approval of inter- and intra-state
banking and the phase-out of interest rate restrictions on deposits reduced
banks' market power. Second, technological advances have allowed nonbank
financial intermediaries to offer products that either match or improve
upon the previously unique features of bank liabilities and assets. Examples
of these trends on the liability side of the balance sheet are well known
and include the shift in household assets away from insured deposits toward
money market mutual funds and many other instruments. Other innovations,
such as extensive use of commercial paper funding and securitization,
have increased competition for banks on the asset side of the balance
sheet. In total, these shifts unmistakably suggest a reduction in the
value the market places on the unique aspects of bank products and attributes,
including federal deposit insurance, and this development brings with
it increased risk taking by banks.
Some point to the new technology not as an incentive for increased bank
risk taking but rather as evidence that banks are innovating. Banks are
themselves in the mutual fund business, securitize loans and carry out
valued risk management techniques through new, off-balance sheet tools.
But replacement of traditional lending and funding sources with products
and services offered by a wide variety of financial firms does not alter
the conclusion about the decline in the economic advantages of being a
bank. In fact, when the special features of banks no longer
merit that designation, the value of being a bank falls. And when the
benefit of being a bank falls, managers have less to lose and more incentive
to take on risk.
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 banks 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 Too-Big-To-Fail
(TBTF) institutions. This matters, because policymakers and regulators
have long made clear that they will rescue the liability holders of the
largest banks because of their fear of contagion and systemic instability.
Because of the TBTF guarantee, liability holders do not have adequate
incentive to charge large banks higher rates when they take on more risk,
and thus TBTF banks face significantly less than optimal market discipline;
in other words, they have the incentive to take on too much risk.
Increasing Complexity and Increasing Risk
Bank operations are also more complex, and therefore banks are both more
difficult to manage effectively and to supervise effectively. 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.
Bank supervisors have expressed concern about their ability to effectively
monitor and respond to the risk taking of the largest and most complex
banks. The calls to redraft the Basle Capital Accord exemplify the issue.
The current accord fixes a capital charge on bank loans based on the
general purpose of the loan (e.g. mortgage loans vs. commercial and
industrial loans). But the capital charge does not vary with the probability
that the specific loan will default.
Regulators believe, however, that large banks using economic capital
models have begun to arbitrage between the amount of capital they should
hold given the financial risk of their credit positions and the fixed
regulatory capital requirements. In practice, banks engaging in this arbitrage
sell off credit positions where regulatory capital requirements exceed
economic capital and retain positions where regulatory capital requirements
are less than the quantity of economic capital they should hold based
on risk. As a result, the banks are in full compliance with regulatory
capital standards even though the expected losses of their portfolio exceed
the capital that regulations require they hold.
Several Federal Reserve policymakers and senior staff have argued that
a capital regime based on a bank's internal models or loan ratings is
necessary to end this kind of arbitrage. Implicitly then, they argue that
examiners cannot quickly and adequately identify capital arbitrage and
end it. In other words, regulators face a difficult time in responding
to the new techniques by which large banks assume risk.
II. Conventional Reforms Fall Short of the Mark
Analysts have devised a variety of responses to the trends just described
and their implications for moral hazard and excessive risk taking. Some
well-known reform proposals take a laissez faire approach and advocate
privatizing deposit insurance or moving to a system of so-called narrow
banks. Another approach focuses attention on regulatory and supervisory
initiatives. In my judgment, these responses will not adequately address
the moral hazard problem because they are either not sufficiently credible
or not sufficiently effective.
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
simply 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.
Narrow banking plans, whose features are well known, essentially take
a similar approach. The uninsured, unregulated wide banks
under the 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 bank 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 if desired.
A third alternative would also rely on market forces alone to reduce
exposure under the safety net by further diminishing the value of being
a bank; this proposal might be viewed as accepting (or accelerating)
the inevitable. To achieve this outcome, policymakers could, for
example, provide nonbank financial intermediaries access to services previously
reserved for banks. For example, the government could grant mutual fund
organizations direct access to the small dollar retail payment system.
In a more extreme case, the government could auction deposit insurance
coverage to nonbank intermediaries. Competitors presumably would use new
powers to increase market share and profitability vis a vis banks and
further reduce the distinction between bank and nonbank financial intermediation.
In response, banks could give up their charters or more likely move assets
to nonbanking firms they control. Excessive risk taking in the banking
sector would become relatively inconsequential as the portion of the banking
industry under the safety net shrinks.
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 risk taking incentives.
This is because policymakers and regulators have long made clear that
they will rescue liability holders of the largest banks, and perhaps even
smaller institutions, because of their fear of contagion and systemic
instability. These policies 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 bailouts and hence the accompanying
under pricing of risk. And as the discussion suggests, the problem is
particularly acute for large institutions.
The suggestion to encourage further decline in the value of the banking
charter also lacks credibility, as it could easily produce the very outcome
it purports to eliminate. As noted above, the decline in the value of
being a bank leads, other things equal, to more risk taking. Hence, excessive
risk taking may well occur as further diminution in the value of the bank
charter takes place. At the same time, the proposal may magnify the exposure
of the taxpayer by potentially extending the safety net to nonbank intermediaries.
Why Regulatory and Supervisory Approaches to Moral Hazard Fall Short
The primary response to the pernicious incentives created by the safety
net is to regulate bank risk taking. Policymakers and bank supervisors
have both taken, and proposed, several legal, regulatory and supervisory
responses to the new trends in banking. In total, these reforms have focused
resources on banks in poor financial condition. For example, banks in
relatively poor financial shape pay a higher deposit insurance premium.
Likewise, banks in weak financial condition face restrictions on their
activities and more frequent examinations 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
All of these steps appear beneficial. But even with them, we cannot
rely solely on regulatory and supervisory reforms to adequately contain
moral hazard incentives. There are several reasons for this conclusion,
- Moral hazard results when economic agents do not bear the marginal
costs of their actions. Regulatory reforms would not directly alter
- The strength of legal and bureaucratic norms, along with the ability
of banks to alter their risk profiles quickly, makes restricting bank
activities in a timely fashion difficult. Moreover, regulatory forbearance
has occurred at times when rapid bank closure would have been the appropriate
policy. Unfortunately, current rules meant to close banks while they
are still solvent may be incapable of achieving that outcome.
- Regulators have access to inside information that helps
them judge the riskiness of bank activities. But government agents do
not have a sound basis for determining how much risk taking in the banking
industry 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.
- The asymmetry of information between banks and regulators limits the
effective use of internal bank practices to supervise banks. For example,
regulators cannot reasonably verify the accuracy of bank capital models
and comfortably use those results in the regulatory process with precision.
- It is unlikely that society will allocate enough resources to regulators
so that they can hire and retain quantitative staff on a par with the
firms the regulators must examine.
These observations do not argue against any of the changes to regulation
that have been made or that have been proposed. Indeed, it is a positive
step 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. However, regulatory
steps alone are unlikely to adequately address distortions created by
the safety net. Rather, and let me emphasize this, market signals, in
conjunction with regulation and supervision, constitute the required
discipline that will lead to improved management of the moral hazard
problem. Note, also, that application of internal bank capital models
in supervision, an adoption of a market practice, is not a step toward
market discipline. Market discipline requires market pricing of bank liabilities
under circumstances where participants know they bear at least some risk
III. Incorporating Market Signals in the Regulatory Process.
Increased market discipline is then an essential step in addressing
moral hazard. However, incorporating market signals from creditors put-at-risk
into the regulatory process requires a credible policy framework, one
which accounts for TBTF and potential systemic instability, and which
supervisors and legislators will embrace. Further, market discipline alone
has limitations, and therefore it should be incorporated with existing
regulation. The idea, then, is to require, by law, that depositors and
other creditors at all banks, 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
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. 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 analyzing and incorporating new means of production in their
assessment of risk, so further financial innovation can be expected to
be accommodated within this approach.
A Policy Framework With Market Signals and Regulation
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 the issue of contagion should not arise.
As a result, Congress and bank supervisors would have less incentive to
bailout TBTF institutions or worry excessively about the threat of panics.
Once at risk, these 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 this 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 good
evidence of bank risk.
A similar type of plan would, alternatively, require large banks to
issue subordinated debt equal to some small percent 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. 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, Federal Reserve Board Governor Meyer has actively
reintroduced 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.
However, there are no free lunches; the market discipline/instability
tradeoff is inescapable. The secondary market for subordinated debt has
the potential to be illiquid, in part due to mandating the issuance of
such securities in greater amounts than currently demanded or supplied.
Moreover, some subordinated debt plans require relatively infrequent issuance
of the debt. These two traits could limit the usefulness of the market
signals provided by subordinated debt. In addition, some subordinated
debt plans are vague as to how they would address TBTF.
Private insurance offers a third source for generating market signals.
Congress could require large banks or the FDIC to purchase a small amount
of private deposit insurance, covering 5 percent of deposits, for example.
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 the cost of covering insured
depositors. Such instruments already exist for natural disasters.
Either of these proposals would require market participants to price
the likelihood of a bank's failure. 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 risk they would
bear should limit that problem. Moreover, these 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 insurer's 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 meet its maximum level at once. This should
reduce concerns about instability.
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 for
such assets and therefore may 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. If creditors
bear only a small amount of loss when banks take on extreme levels of
riskperhaps because they are well diversified and receive high compensating
interest ratesthen the perverse incentives of the safety net would
to some extent remain. More practically, policymakers and regulators do
not appear willing at this time to create bank supervisory regimes dominated
by the market signals creditors create.
Thus, the supervisory process will continue to play an important role
going forward. In this environment, to rein in moral hazard effectively,
the signals created by the market must be incorporated in two general
areas of regulation: deposit insurance assessments and the supervisory
Assessments: Under any credible reform to 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 for 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 suggests 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. The frequency of bank examinations is also
linked to capital ratios and supervisory ratings of management (for smaller
Incorporating market signals into these supervisory triggers would enhance
the ability of supervisors to address moral hazard. 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 average rate on
a particular quality bond or the average for bank debt).
IV. Thoughts on the Future
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 starting to address directly the fundamental problems of
moral hazard and banking instability and by taking the first steps toward
explicit incorporation of market signals into 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 the justification for regulation and the safety net declines,
and could eventually disappear, if banks continue to become more like
other financial services firms. These reforms provide a framework for
transitioning from existing regulation, to regulation and market signals,
to a system even more reliant on the market.