Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Rethinking the Regulatory Response to Risk-Taking in Banking, June 1, 1989

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

June 1, 1989

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

Rethinking the Regulatory Response
to Risk-Taking in Banking
by W. Lee Hoskins

he record number of bank and
savings and loan failures in this decade
emphatically illustrates that the current
financial regulatory system is seriously
flawed. Its underlying shortcoming is
that it ignores, and attempts to override,
market forces. As we consider regulatory reform of the financial industry, we
face two avenues: One road leads to
reinvigoration of market principles and
incentives to guide the industry. The
other road leads to further reliance on
the regulatory apparatus.
This Economic Commentary contends
that the first course of action is the correct one and outlines the steps that will
take us down that road. First, banking
regulators must emphasize supervision
rather than regulation. The essential difference between these two approaches
lies in the nature of the limits placed on
the discretion of bank management.
Regulation amounts to placing unconditionallimits on their discretion, implying that the judgment of bank managers
cannot be trusted. Supervision implies
conditional limits on their freedom of
action, activated only when management actions threaten to impose costs
on the insurance fund or on taxpayers.
This approach presumes that management is competent unless they
demonstrate otherwise.

ISSN 0428·1276

Second, the current framework of multiple regulatory agencies offers a number of advantages over streamlined alternatives that have been proposed.
This system should be preserved and
fine-tuned, rather than discarded.
Third, the deposit-insurance system
must be reformed so that the market
plays a larger role in assessing and pricing bank risk. The current method of
deposit-insurance pricing encourages
bank management to take additional
risks and substitute insured deposits for

In considering reforms to promote
the health and efficiency of our financial services industry, the critical
focus should be on revamping the current system of deposit-insurance pricing and coverage. These reforms
should emphasize greater reliance on
market forces and less reliance on the
regulatory apparatus, while retaining
the advantages of a multiple-agency
framework.

uninsured debt and equity. It reduces
the incentives for insured depositors to
care about the riskiness of their banks.
Further, it leaves the tasks of monitoring and restraining bank risk-taking almost entirely in the hands of regulators.

•

Regulation and Its Costs

At present, we are essentially following
the approach adopted nearly 50 years
ago, amid the financial fallout of the
Great Depression: the goal of a safe and
sound financial system has been entrusted largely to a regulatory process, rather
than to private decisionmakers operating in free markets. Regulators have attempted to achieve a strong financial
sector by controlling the activities of
certain classes of financial intermediaries, most notably commercial banks.

Numerous constraints on the discretion
of bank management to undertake risky
competitive actions were imposed mainly through acts of Congress. Controls
on pricing, products, location, and
balance-sheet composition were
designed to prevent the failure of individual banks. Moreover, deposit

liabilities were insured (up to a limit) to

Regulatory barriers to competition may

reduce the incentives for depositholders to withdraw their funds in the
unlikely event that a failure occurred.

have a further subtle effect on the costs
of regulated firms. Protection from com-

For several decades after the Depression, the financial system appeared to
be relatively safe and sound. The supervisory and regulatory apparatus that
was erected seemed to be an effective,

petition reduces the incentives of regulated firms to minimize current costs. It
also reduces their need and desire to
seek out and adopt innovations that
could result in lower costs in the future.
Regulation entails still other costs.

inexpensive, and permanent bulwark
against fears of chronic financial instability. The regulators appeared to be
doing their jobs well, since bank

Regulatory rules limit firms' ability to
take certain actions, but do not
eliminate management's desire to pursue profitable business opportunities.

failures were few in number and not
costly. However, as the 1970s began, a
confluence of forces-most
notably
volatile inflation and high nominal interest rates, along with a substantial
decline in the costs of information
processing and transmission-served
to illuminate the substantial flaws and

The lure of profits, combined with
changes in technology, conducive
economic conditions, and the existence
of domestic and foreign competitors

social costs of the existing system of
bank regulation.

bly, regulated financial institutions will
search for substitute ways to engage in
lucrative, prohibited activities. Such activity is costly, however, and even if

What have we learned from this experience of exclusive reliance on
regulation? It should be obvious that
using government regulation to achieve
economic goals entails both substantial
costs and a number of risks. One risk
is that a regulatory system will not be
as effective as desired, both when initially implemented and over time.
Another risk is that regulation will
have unintended, perverse effects.
The present system of bank regulation,
which includes numerous constraints
on the market mechanism, is inevitably
costly. Some costs are highly visible
and explicit: regulated institutions incur
compliance costs, and regulators bear
monitoring costs. Other costs are not so
visible. For example, costs associated
with restrictions on permissible activities can prevent economies of scale
and scope from being realized, thereby

who are subject to different degrees of
regulation, gives regulated firms the
motive and the opportunity to avoid existing regulatory constraints. Inevita-

successful, results in the inefficient
provision of financial services. Hence,
regulators are continually faced with a
dilemma: acquiesce or add more regulation to plug the loopholes. The latter
restarts the costly cycle.
In addition to the inevitable costs,
regulation can have unintended, perverse effects. For example, regulatory
limitations on the ability of commercial
banks to diversify, both geographically
and into additional lines of business,

• Supervision Rather Than
Regulation
If regulation is costly and cannot be
relied on to produce the desired result,
then what should be done? Certainly, a
political and legal framework is indispensable for assuring individual liberties and property rights, and for setting
the rules of the game within which
markets operate. But detailed regulation should not be used to guard
against the normal risks of a competitive marketplace. Such direct controls
adversely affect long-term decisionmaking and inevitably hurt those they
were intended to help. The examples
are plentiful. Railroads, sheltered by
rate-of-return regulation, eventually
withered into near-complete decay.
The U.S. steel industry, once protected
from the rest of the world by a government-guaranteed price floor, soon became a world leader in inefficiency.
The same seems to be true for the banking industry. Banks have lost market
share to less-regulated competitors in
areas that they had long dominated,
such as commercial lending, consumer
installment credit, and retail deposits.
In addition, the banking industry's
profitability has been falling during the
1980s, reaching levels not seen since
1959.
A safe and sound financial system can
be attained at a substantially lower
cost if we rely less on regulation and
more on supervision. This requires a
sharp reversal in the attitude of government authorities. Rather than imposing

were designed to reduce risk by limiting
competition and preventing bank
involvement in activities where large
losses could be incurred. Astute use of
diversification by banks was presumably viewed as unlikely. The huge
losses realized by banks with undiver-

unconditional limits on the discretion
of bank management, or regulating
their behavior, the authorities should
conditionally cede discretion to bank
management. That is, the authorities

sified loan portfolios in the 1980s il-

should let bank management manage.

regulators do not. The amount of dis-

closure will ensure that the costs of

to promptly close institutions that are in-

cretion extended to management could
vary across banks, depending on a number of factors, such as the supervisory
authority's assessment of the quality of

bank failures are not excessive and are
borne by uninsured creditors and stockholders, not transferred to the insurance funds or to taxpayers. Govern-

solvent, resulting in higher costs for the
insurance funds and taxpayers. The
ability of banks in this system to alter
their regulatory status also allegedly in-

the institution's internal controls and
management, the institution's current
and expected financial strength as
evidenced by its capital and earnings,

ment authorities need to ensure that
depository institutions supply adequate, accurate, and timely information
on their financial condition not only to
the supervisor, but also to the public.

duces "competition in laxity," where
regulators compete for constituents by
relaxing their standards. The implication is that consolidation of regulatory,

and the size of subsidies attributable to
the provision of the federal safety net.
The recent debate about the appropriate
response to bank involvement in leveraged buyouts (LBOs) illustrates the
distinction between these two approaches. Some people are urging that
bank involvement in LBOs be regulated-restricted
or precluded. These
critics presume that bank management
cannot accurately evaluate risk. Others
argue that bank participation in LBOs
can generate a number of benefits for
banks, firms, and the economy. Proponents of a supervisory approach
argue that bank management has substantial expertise in evaluating risks and
should be free to take risks commensurate with expected returns. Happily, we
have refrained from regulating LBO
lending by banks, choosing instead to
supervise.
The appropriate role of banking
authorities in a supervisory function is
to distill the existing body of regulations into a compact, effective set, and
to monitor and supervise the behavior
of firms under their jurisdiction with as

Depositors and creditors will thus have
incentives to choose and monitor more
carefully the condition of financial
institutions. Information provided by
supervisors will be a vital input to
these decisions. In turn, information
generated by markets, such as the rates
that banks need to offer to obtain funds
from depositors and creditors, will complement the information from the supervisory process.
• Should the Regulatory Structure
Be Changed?
The structure of the bank regulatory
system in the United States is unique
in a number of respects. Banks can
choose to be regulated or supervised by
one or more federal and state agencies,
each of whom has different goals and
incentives corresponding to differences
in their authority and responsibilities.
For example, a chartering/regulatory
authority has the incentive to maintain
or increase its constituency. To accomplish this, it might offer broader
powers or prevent the closure of insol-

little intrusion as possible. Ideally, the
arrangement would closely resemble
bond or loan covenants, which are
designed to influence management be-

vent institutions. The failure of institutions could be interpreted by some as
ineffectiveness on the part of the
government authority. A deposit insurer
has an incentive to protect its fund; con-

havior with minimal intervention. The
amount of discretion granted in these

sequently, if able, it may also prevent
or delay costly failures.

arrangements depends on judgments
about the capabilities of management

supervisory, and insurance functions
into fewer, or perhaps even one, agency
is a desirable and necessary change.
I disagree with this view. It is not clear
that regulatory consolidation would
result in improved, less-costly regulation. Given the inevitable incentives of
the insuring agency to protect the insurance fund, it would be particularly
dangerous to concentrate the chartering, regulatory, supervisory, and insuring functions in a single entity.
It has been alleged that closures would
occur more quickly and that costs of
failure resolution would be lower if the
Federal Deposit Insurance Corporation
(FDIC), the insurer, also had
regulatory, supervisory, and closure
powers. This was certainly not the case
for savings and loan institutions where
the federal insurer, the Federal Savings
and Loan Insurance Corporation
(FSLIC), and the regulator, the Federal
Home Loan Bank Board, were combined in a single organization.
The FDIC, like any insurer, has incentives to maintain the value of its insurance fund and therefore might delay
closures that would materially reduce
the value of the fund. Indeed, in the
recent past, both the FSLIC and FDIC
have been strong advocates of forbearance policies. Further, existing and
threatened litigation stemming from
recent closure decisions indicates that
regulators' actions to close troubled in-

and their resources.

location decrease the options available
to consumers and artificially raise

A supervisory approach recognizes that
regulation is costly; it also recognizes
that bank management has the skills, information, and incentive to make op-

Critics have persistently argued that the
multiple-agency system is seriously

Supervisory authorities need timely, accurate information to be able to identify and close troubled institutions as

stitutions more quickly are viewed by
some as violations of individuals'
property rights. I Thus, it is not clear

prices by limiting competition.

timum use of its resources, while bank

flawed and largely to blame for costly
and ineffective bank regulation. In particular, it has been charged that this
structure is primarily responsible for the

they become insolvent. Prudent use of

unwillingness or inability of regulators

resolve failures any faster or at less
cost than it does currently.

raising the costs of regulated firms.
Restrictions on activities, products, and

lustrate the misguided, unintentional impact of regulation.

that the FDIC acting independently can