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CONFERENCE ON PREVENTING BANK CRISES: LESSONS FROM RECENT GLOBAL BANK FAILURES CO-SPONSORED BY THE FEDERAL RESERVE BANK OF CHICAGO AND THE WORLD BANK Lake Bluff, Illinois June 11-13, 1997 ..................................................................... I’m pleased to have this opportunity to discuss a v itally important subject—preventing banking crises from a regulator y perspective. This conference is an excellent forum for sharing infor mation on the causes and consequences of past crises and discussing alter natives for resolv ing crises when they occur. How have different countries addressed this challenge? What are the advantages of each approach? Most importantly, this conference prov ides an opportunity to discuss how to design regulator y oversight to prevent future crises. Today I’d like to prov ide a broad over v iew of what constitutes effective regulation and more specifically how super v isors can prevent a crisis situation. First, I’ll rev iew the basic elements that are essential for a healthy banking system and effective super v ision. Then I’d like to briefly discuss a few innovative regulator y approaches that have been proposed in recent years. One of the major points I’d like to stress today is the importance of focusing on preventing bank crises. The prompt resolution of a banking crisis is important, of course. But I believe regulators spend too much time preparing to pick up the pieces in case a crisis occurs. We can spend less time on crisis resolution by spending more time on prevention. What’s the best way to prevent a crisis? That’s the second point I’d like to stress. In my v iew, superv isors have a underutilized tool at their disposal—market forces. It’s essential that super v isors take advantage of market forces and incentive-compatible approaches whenever possible. It’s the most efficient, effective way to accomplish our regulator y goals. The need for supervision First, I’d like to quickly rev iew why we need bank super v ision in market economies. The role of a regulator is ver y different where the state controls a bank’s decisions. In short, credit allocation in Michael Moskow Speeches 1997 197 response to political pressures is much different than allocation in response to market forces. I want to emphasize that my comments will be mainly focused on regulation’s role in private-market economies. Why is regulator y oversight necessar y? It’s difficult to argue for gover nment inter vention in markets that are perfect and efficient. The decisions of indiv idual agents in the economy should promote the general public interest unless there are distorting factors. However, there are times when the costs and benefits to an indiv idual agent may diverge from the costs and benefits to society. That’s when there’s a role for regulation. Banking is generally considered to require such inter vention. One reason is that banks are highly leveraged, with a low ratio of capital to assets compared to other types of fir ms. Banks also have assets that are typically somewhat opaque. Investors don’t have as much infor mation on a bank’s condition as bank management does. This asymmetric infor mation between banks and investors makes it difficult to deter mine whether banks are healthy during times of stress. The potential for spillover from one institution to another is higher in banking than in other industries because banks are typically closely intertwined through interbank borrowings and through balances and payments clearing arrangements. This potential for systemic risk—the possibility that the whole process could multiply until there’s a full-fledged banking panic—is one of the major reasons that central bankers are paid to worr y. I should note that the purpose of regulation is not to avoid all bank failures. As Federal Reser ve Chair man Alan Greenspan has pointed out, the optimal number of hank failures is not zero. Banks need to incur risk if they are to play a useful role in the economy. Regulations are developed with the best of intentions, of course. But the law of unintended consequences comes into play. Sometimes regulations meant to address market failure are the root cause of banking industr y problems. You’re all familiar with the list of usual suspects…moral hazard, regulator y forbearance, and distorted incentives resulting from the mispricing of the safety net. Such regulator y problems have been the underlying cause of industr y problems in several countries. In the U.S. we’re paying dearly for hav ing poorly structured regulations and inadequate super v ision of our sav ing and loan associations. It’s estimated that the failure of hundreds of S&L’s will ultimately cost American taxpayers anywhere from $175 billion to $225 billion. The causes of financial crises What causes a financial crisis, such as the problems in the S&L industr y? There’s generally one of two reasons: macroeconomic instability or microeconomic problems. The major cause by far of financial crisis is an unstable economy. The U.S. banking system, for example, has been extremely stable in the absence of severe macroeconomic shocks. An unstable economy leads to deteriorating asset quality, price bubbles, and wide swings in asset prices and exchange rates. This obv iously imposes strains on the fundamental business of banking and can lead to system-wide problems. 198 Michael Moskow Speeches 1997 Economic instability may also increase problems because there’s a natural tendency to forget about the bad times. Banks sometimes exacerbate the business cycle during an economic upswing by weakening credit standards and driv ing up asset prices. A banking crisis is generally triggered by macroeconomic shocks, but it can be made significantly worse by microeconomic structural problems. These include inadequate corporate gover nance; distorted incentives generated by flawed regulator y arrangements; illegal activ ities such as insider lending and fraud; and poor management practices. These shortcomings can allow a relatively minor problem to grow into a major one. Preventing bank crises That brings me to the question of the day—how do we prevent banking crises? The solutions fall into three interdependent categories: • One—developing sound macroeconomic policy; • Two—building an appropriate infrastructure; and • Three—following guiding regulator y principles. First, the need for sound economic policy is self ev ident. Some would argue that creating the env ironment for stable growth is the single most important solution. It’s also typically the major responsibility of central banks around the world. Nevertheless, economic instability continues to be the major cause of financial crises. The second category is building an appropriate infrastructure. I’m referring to fundamental infrastructure requirements, which are necessary for a stable banking industry. Among the key components are: • One, a system of laws and rules for corporate gover nance and property rights. This includes laws covering bankruptcy and the rights of creditors in seizing or disposing of assets; • Two, a unifor m set of transparent accounting standards, statements, and supporting schedules and reports; • Three, a facility prov iding for exter nal bank auditors and examiners; and • Four—rules for public disclosure of nonproprietar y financial infor mation. Most of these elements are outside the direct control of banks and bank super v isors. But they’re v ital to the work of regulators and to the ability of the market to evaluate the perfor mance of banks. For developing and transitioning economies, these elements should be in place before the banking system is privatized. For developed countries, it’s important to realize that hav ing only some, but not all, of these elements is a recipe for trouble. Michael Moskow Speeches 1997 199 The accounting system is perhaps the most basic to the efficiency of the financial markets. The rules for preparing financial statements must be clearly specified. These statements communicate v ital infor mation to creditors, investors, commercial counterparts, and regulators. The need for public disclosure is closely related to the standardization of accounting principles. The question is not whether financial statements should be available to the public. The question is how often they should be prov ided and the appropriate amount of infor mation they should include. There’s a limited need role for regulation if markets have both the relevant infor mation and the capability to adequately discipline banks. If markets have the ability to discipline, but lack complete infor mation, regulators should focus on ensuring adequate disclosure. The general level of public disclosure has increased as financial markets have demanded more and better infor mation from all fir ms. This is particularly true in banking where there is a need for better infor mation on hidden reser ves, loan loss prov isions, and non-perfor ming loans. The benefit of disclosure is one of the lessons we’ve lear ned from the derivatives debacles of the last few years. Regulations requiring fir ms to disclose both their ex ante rationale as well as the ex post perfor mance would have meant a much quicker unwinding of many derivative positions. This would have prevented the large losses that occurred. I’m not arguing that disclosure is a cure-all. Not ever yone agrees that depositors are able to interpret disclosures. And the conventional notion that ’more disclosure is better’ ignores the fact that some of this infor mation might be useless to the market. A much higher level of disclosure might make it more difficult for market participants to extract useful infor mation. And forcing the disclosure of strategic and proprietar y infor mation might hamper the efficient operation of fir ms. We shouldn’t forget these potential drawbacks. But it’s my opinion that more disclosure is generally preferred to less. Disclosure and the market discipline it fosters are an important part of the regulator’s arsenal. The BIS recently noted that disclosure is an effective compliment to regulation in its Core Principles for Effective Banking Super v ision. The committee has also set up a sub-group to study disclosure issues and prov ide guidance to the banking industr y. In the U.S., the SEC and FASB have developed proposals on the disclosure and accounting for derivatives. Efforts such as these are steps in the right direction. Principles driving bank regulation So far I’ve discussed two of the three key factors for preventing bank crises. Now I’d like to tur n to the last one—following guiding regulator y principles. I’d like to suggest three fundamental principles that should guide regulator y policy: 200 Michael Moskow Speeches 1997 • Regulation should be goal-oriented; • Regulation should not discourage appropriate changes in technology and market structure; and • Regulation should be efficient at accomplishing its stated goals. First, regulation should be goal-oriented, not process-oriented. We should start by asking the question, “Do our regulations help us accomplish our fundamental public-policy objectives?” It’s important to avoid being wedded to past approaches. They’re simply a means for achiev ing a goal, not the goal itself. This may seem obv ious, but it’s remarkable how often this basic principle is ignored. I’ve obser ved the regulator y process, both from the inside and the outside, for more than twenty-five years. I’d say that most super v isors take the current regulator y framework as a given. Regulator y “innovation” usually takes the for m of looking for better ways of applying the current framework. In some cases, regulators arc constrained by laws they are required to carr y out. But in my experience, regulators can do more to focus on their fundamental goals. The second principle is that regulation should not discourage appropriate changes in technology and market structure. Again, this principle seems obv ious, but it’s rarely applied. Instead, we often see regulator y approaches still being used long after they’ve been rendered obsolete by technological change. Regulation should be constructed to be self-evolv ing, if possible. Regulator y change that’s dependent on the actions of cumbersome political bodies—either national or inter national—are generally difficult to implement. It’s better to have a structure that’s designed to evolve with the industr y. This is easier said than done, of course. But it’s an important principle to keep in mind. The third principle is that regulator y goals should be accomplished in the most efficient way possible. I would say that a regulator y approach is efficient if it accomplishes the desired goal with the least amount of “collateral damage” to the industr y’s activ ity. In other words, super v isors should use the least intrusive approach that achieves the goals. One of the keys to efficient regulation is taking advantage of market mechanisms or using incentive-compatible approaches. I should note, though, that it’s essential to have the appropriate infrastructure in place before relying on market-driven mechanisms. The first questions for a regulator should be, “Is gover nment regulation necessar y? Is it possible to use market forces to regulate?” The main roadblock to market regulation may be the existence of barriers to free entr y. If that’s the case, regulators should focus on remov ing these barriers, if possible. Ironically, these barriers are often created by the gover nment in the first place. Another means for achiev ing regulator y efficiency is taking advantage of incentives. Under “incentivecompatibility,” the regulator seeks to align the incentives of fir ms with societal goals. In other words, this approach makes it in the fir ms’ own self-interest to efficiently achieve the regulator y objectives. Michael Moskow Speeches 1997 201 I should mention that it’s somewhat misleading to use the word “deregulation” to describe the process of developing more efficient regulator y approaches. Our regulator y goals haven’t changed. In that sense, we’re not “deregulating” at all. You might say we’re “smart-regulating”-achiev ing the same regulator y goals in a better way. Reform proposals Now I’d like to quickly rev iew three refor m proposals, keeping in mind the regulator y principles I’ve just mentioned. I want to emphasize the incentive-compatible nature of these proposals. As you know, the moral hazard problems created by a mispriced safety net has generated much debate as well as a number of proposals aimed at resolv ing these problems. In particular, there is support for implementing deposit insurance refor m in the U.S., now that banking conditions are relatively good. I’d like to briefly discuss three refor m proposals: • first, the narrow bank; • second, significantly decreasing the safety net and increasing the role of disclosure; and • third, altering the capital structure to emphasize the role of subordinated debt. The narrow bank proposal would limit insurance coverage to a “narrow” class of deposits, which would be “covered” by extremely safe and liquid assets. Activ ities outside this narrow class of deposits wouldn’t be covered by the insurance fund. The market would discipline all other activ ities. This proposal satisfies the regulator y principles laid out above, but depends on the completeness of the infrastructure, and the credibility of the gover nment to keep the safety net within the stated limits. No countr y has implemented this proposal to my knowledge. The second proposal is to decrease the safety net and increase the role of disclosure and market discipline. This approach is grounded in the contention that the systemic implications of banking failures are relatively limited. Proponents contend that the private sector can adequately oversee the activ ities of the banking industr y if it’s given adequate infor mation. This approach is being tried in New Zealand. Banks in New Zealand have been required to make detailed disclosure statements since the middle of 1996—including infor mation about credit ratings, guarantees, impaired assets, material exposure, and capital adequacy. A number of regulator y structures were removed in retur n, including deposit insurance. A two-page summar y of these disclosures is displayed in ever y branch to help depositors decide the creditworthiness of the institution. The central bank of New Zealand is not responsible for bailing out depositors. The presumption is that depositors no longer need gover nment protection with full disclosure. This approach obv iously requires a well-developed infrastructure with a free flow of infor mation. The third proposal is increasing the role of subordinated debt in the capital structure of banks. This proposal is designed to decrease the moral hazard problem, increase market discipline, and prov ide for an improved process of resolv ing failures. A command regulation approach to moral hazard would 202 Michael Moskow Speeches 1997 have regulators mandate a maximum level of risk for any insured bank. This approach has the typical problems associated with command regulation. First, it’s difficult for regulators to accurately measure the risk associated with a bank’s loan portfolio. Second, any credible effort to accurately measure this risk is likely to be extremely intrusive. And finally, a one-size-fits-all restriction may actually prevent capital from flowing to valuable investment projects. Utilizing subordinated debt may resolve these problems. Proponents of this approach argue that debt holders are a superior buffer against income variations for both depositors and the insurance fund. The reasoning is that debt holders have an incentive to avoid banks with riskier portfolios, unlike equity holders. Additionally, debt-holders can help maintain an orderly failure resolution process. Uninsured depositors may trigger a bank run when asset quality is questioned. Debt holders can only “walk” away from the bank as their issues come due. This proposal is consistent w ith the regulator y pr inciples I discussed. It requires an adequate infrastr ucture, including mature capital markets, to allow for the required market discipline. We’ve recently seen this concept implemented in Argentina. It has also been proposed in the U.S. as an extension to a refor m proposal emphasi zing market discipline recently released by the Bankers Roundtable. I believe each of these proposal are in keeping w ith the pr inciples I’ve outlined and war rant additional consideration. It’s encouraging to me that they are being considered by countr ies represented in this audience. Let me conclude by noting that it’s clear that financial and economic liberalization combined with globalization have changed the contours of the world financial system. Interest rate and exchange rate volatility have increased, competition among financial institutions has intensified, and new financial products are being developed continuously. In the face of these changes, banks around the world have had to develop new markets and ser v ices to maintain profits and meet the growing needs of customers. The changing financial env ironment has presented important new challenges for regulators. Most notably, super v isors need to adapt regulations to changing market realities, improve the infrastructure undergirding the financial system, and coordinate super v isor y and regulator y efforts inter nationally. As we undertake these difficult tasks, I hope we will focus on preventing bank crises and work to take advantage of market forces and incentive-compatible approaches whenever possible. Thank you. Michael Moskow Speeches 1997 203
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