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R3: CLEVH,AND. . II4, ADDRESSES . HOSKINS Ci) C¿ ts-i \c, !': ÍJ (-, . ¡\-ì Ct Fi nancial Reform at a Crossroad l,l. Lee Hoskins, President Federal Reserve Bank of Cleveland DePaul University Illinois April 5, .l988 Chicago, Financial Reform at a Crossroad of the Federal Reserve System and 55 bank holiday of 1933, financial regulation is once Ioday,75 years after the founding years after the nationwide again at a crossroad. The confìict between market forces and regulation created serious problems that can't be avoided much longer. At issue ìs very baslc question. Should we go forward with deregulation, or should turn back? The answer will have a very important has a we bearing on the future structure of the financial services industry. Shouìd we make market forces exert a rnore powerful influence in the financial sector or should we reinforce the blanket protections of the regulatory process? I think the choice should be clear: we should rely on market forces. Relying rnore heavily on market forces requires sweeping away both mental institutional cobwebs and making approach, responding us very to The principles are little different a clean break with the past. A piecemeal immediate probìems and pressures, far unless we establish vle must dust economic principles to guide deregulation. My message of sector at work in other industries. Applying these principles to the financial industry will require a lot broadening the poYrers is not likely to get off to guide dereguìation of the financial from those and more than simply banks. this evening is this: In debating and deciding on the steps to take in deregulating the fìnancfal industry, the fundamental goal should be to reinvigorate market incentives and tests financiaì markets. The challenge of performance in banking and other is to eliminate reguìations where possible to strengthen regulations where necessary, building rather than overriding or suppressing them. and on market forces The Backoround For Requlation Government has ìegal framework is a vital role in a i ndi spensabl capi tal i st economy. A pol i ti cal e for assuring individual liberties and and -2property rights, and setting the rules of the game for markets to operate. l'li thi n that f ramework, owners of capi tal and I abor wi I I direct their resources toward uses where opportunities seem greatest. General ìy speaking, private decisions made with full comprehension of possibilities for gain and risks of loss will produce the best results. Regulating some gain and the risk of loss and affects choices with In a static setting is activities and precìuding others aìters the possibility of where respect to resource use. entry into cìosely competing endeavors is expensive, of regulation may seem smalì or sìow to appear, perhaps because they are hidden in public subsidies. In such circumstances, the intrusion of government regulation in technology unchanging, and innovation sìuggish, the costs the marketplace may be able to achieve politicaììy determined results that otherwise would be missed. In a more dynamic setting, such as the markets for financial services, where competition has been strong, firms has been relatively easy and technology has can be quite different, as tre are direct costs to consumers, notr entry by non-reguìated been dynamic, the outcome seeing. Aìthough competition holds down inefficiencies are evident, and through the federal deposit insurance mechanism, risk may well be shifted from private decision makers to the federal deposit insurance system. The special attention banking has received over the years suggests that banking has always been a special case where regulation vas necessary. Certainly as the word "bank" was used in history, there was something unique about the bìend commerciaì of payment services attached to bank liabilities and lending. Almost from the beginning, banks required special charters from governments. Those charters carried with them restrictions the way banks could conduct their business. Nhether these regulations initially intended to prevent fraud or to generate government on were revenues from a -3is a matter of debate, but by the time of the founding Reserve in 1913, regulation of banks was the accepted practice. state-created monopoly of the Federal The legitimacy of the case for banking being considered speciaì stems Iargely from bank run probìems. tlhen depositors in Iarge numbers simultaneousìy demanded cash repayment from perfectly sound banks, there not a enough ready cash available in the nation to meet the demand, was resulting in crisis. Aìl banks, however well-run, could not convert illiquid assets into cash and had to suspend payments, in vioìation of the terms of their charter, or seìl assets at firesale prices, thereby impairing capital, perhaps leading to failure. The prevention of such financiaì crises vlas one of the driving of the Federal Reserve -- a centraì bank lender of last resort. The Federal Reserve can prevent the failure of sound banks in a liquidity crisis by suppìying whatever amount of new cash is required to allay the fears of frightened bank customers. As recently as October of last year forces behind the creation the Federal Reserve performed th'is function following the stock market crash. Bankinq Requlations Many bank reguìations have been justified as a tray to assure sound banking practices and reduce risk called for minimum Since the 1930s, activities typÍcally banks have been precluded from certain kinds of to be risky, including general insurance Subsequent one-bank holding company restricions by permitting a hoìding products than Bank charters capital holdings and broad restrictions on portfolios. of course, deemed underwriting. of loss from unsound banks. its bank subsidiary company could and securities ìegislation loosened some to offer a slightìy broader set of offer dÍrectly. In addition, of course, banks ìn this country have been almost universaììy excluded from -4offering products in, or being affiìÌated in commerce and firms involved in, industry. Banks were forbidden or to any way with to pay interest on reguìar pay more than a cei'ling about whether the prohibition convenient device for banks checking account deposits rate on other deposits. There is of interest to stiìl debate on regular checking accounts was mute competition, a or a serious regulatory effort to avoid price wars that might endanger the safety of banks. The Reguìation Q ceiìing on other deposit rates became a genuine difficulty for banks when the ceiling was set permanently below the analogous ceiling for thrift institutions. It was the removal of this Regulation Q restraint marked the first significant step in banking deregulation. that Portfoì io restri ctions, product I i ne restri ctions, and i nterest rate limits all have been defended as means removing temptations of assuring the safety of to engage in "ruinous competition" or to banks by abuse the deposit-raising power of a bank to fund a nonbanking affiliated business. But as the post-war period progressed it became cìear that these restrictions were driving growth and ìnnovation outside the banking system and stimulating growth its of non-regulated financial intermediaries. Abetted by Regulation own federal deposit insurance program, the thrift industry was in a strong position to dominate the competition for savings deposits and the market. Unencumbered by interest rate ceilings or costly requirements, rnoney market mutual funds, and other products grew rapidly nebr mortgage reserve competitors and in the ì970s, aided by the explosion of telecommunications technoìogy. Simi Q and new computer and larly, capitaì requirements, ìimitations on loans to a single borrower and on the kinds of assets banks could hold, as trell as the rate and reserve requirement inpediments to financing themselves, all contributed to the rapid development of non-bank and offshore flnancial -5markets. By the 1970s the term "non-bank bank" had become firmly estabìished in the vernacular of financial markets. Today, there appears to be almost nothing a bank can do that cannot be done by a non-bank bank, while there remain many things to that some non-bank banks can do that banks are not aìlowed do. The intent of bank regulations may have been to insure safety. Some reguìations undoubtedly have worked in that direction but there have been in the opposite direction. Regulation, by encouraging the entry of non-reguìated suppliers of financial services has driven business outside of long-established channels. In some other consequences as well, some which have worked instances risk-taking has been encouraged in banking itself. Overnight financing by large banks in the federal funds and the repo markets has mushroomed, addi ng fragi I i ty compete with new to banki ng and rrìoney entrants, have taken business markets. Banks, seeki ng to off baìance sheets, with devices such as standby commitments and guarantees addlng new elements of risk. In many instances encouraged the results have been perverse -- regulation risk-taking by banks and thrift institutions, especially in conjunction with the federal deposit Deposi t when taken insurance mechanism. Insurance Federaì deposit lnsurance, which was also adopted reduced has in the 1930s, or eliminated the risk of losses to individual depositors has and investors, but at the cost of transferring risk to the deposit insurance sy s tem. Deposit insurance trigger bank runs. that, is intended to defuse crowd psychoìogy that might Insurance whether a bank is forestalls bank runs by assurìng depositors solvent or not, deposits are safe. A deposit insurance hazard -6agency, however, must protect itself from "moral hazard" -- the that deposits wilì be supplied indiscriminateìy to both solvent insolvent banks, increasing the probable ìoss for the insurer. and Supervision of insured banks defends against moral hazard, but as recent events illustrate, the defense has not been effective in preventing losses. and reguìation The insurance funds have been financed by a flat assessment on banks and thrifts -- a practice which ìeaves the cost of funds to a bank ìargely unaffected by the risk profile of its portfolio. All but the largest of depositors can be unconcerned with risk very large institutions, all in choosing among small banks. At depositors and even other creditors beìieve that they are effectively insured because of the reluctance of regulators to allow large banks to fail. Uniform deposit insurance premiums and, until risk-based capitaì standards are implemented in 1992, uniform capital requirements allow management to avoid some of the real risks of their asset decisions and I iabi I i ty management practi ces. Deposi t i nsurance has become a substi tute for a strong capital base in attracting deposits. Depositors, instead of relying of the bank, rely on deposit insurance. The reaction of the regulators to the serious financial problems of some thrifts and banks in the 1980s has not helped the incentive problems. In some on the strength instances, regulatory standards and accounting principles were relaxed, partly to give financial institutions time to recover thelr losses and restore their financial health. Postponing closure gave added incentive for sharehoìders and managers quality. to "go for broke," seeking growth at the expense of asset of the insurance program in effect prevented the cost of funds from reflecting the full risks of loss and encouraged further expansion. The guarantees -7 For whatever reason, forbearance i n clos i ng i nsoì vent i nsti tutions , reìaxed reguìatory tests of performance, and debt guarantees to uninsured credìtors of banks and bank holding companies have worsened an already difficult situation. Despite expansion, the incidence six years of a remarkably robust economic of troubled instìtutions has not diminished. Overalì, the present situation regulation. is the culmination of long years of Banks today are no longer services. Market forces the predominant suppliers of financial have eroded any uniqueness of major banking products liability sides. The distinguishing feature of institutions we call banks today is simply the regulatory taxes and subsidies on both the asset and associ ated wi th them. However innocent their beginnings, many bankìng regulations have inadvertentìy encouraged risky behavior in the market while transferring the risk to insurance programs.Insulating markets from loss by saving losers from loss does not solve problems, but only aggravates the condition. risk-taking is not valuable in itself, what sense does it make If this to subsidize it? The debate about removing financial restructuring most recently has focused on barriers to competition between banks and non-banks in underwriting securities and insurance. tel I us what wi I I Removing barriers succeed and what wi I ì makes good sense. Let the market fai I . But, of course, there's the problem. Market tests of gain and loss have been supplemented by a regulatory blanket. I'lhere To Go From Here l,lhat should our objectives be in restructuring the banking system? is it efflcient, fìexible, innovative financial sector providing services in a stable environment. we really want to accompìish? Ne want an 14hat t -8of capitalism should be our guide: market forces should determine the outcome incìuding the blend of financiaì and nonfinanciaì products offered by a firm, as weìì as the risk profile of firms. Market Basic principìes incentives and risk evaìuation must include possibiìities for gain and the risk of loss and ultimately failure. Before you dismiss remember need to the naivete of the uninitiated, message as past. Surely we Let me mention a few of them. the regulatory problems rre have inherited from the examine alternative approaches. One response past. this to our predicament would be To restore market judgement to when outcomes basic changes in the regulatory structure incentives for management and a clean break with the in allocating resources and market resiliency in dealing with strains and shocks make make -- are bad, we must changes which restore depositors alike to avoid problems. The guiding principìe in this evolution should be to create opportunities for market tests of gain and loss, and success and failure. As a practical matter, our choices 'will be severely constrained by the kind of federal deposlt insurance system we ' choose. How can we promote the appìication about the future of of deposit insurance? market tests rhen maklng decisions Some suggest that federal deposit insurance should be eliminated, but others argue that vouìd be undesirable, or politically infeasible. Another suggestion business. International agreements are is to adopt risk-related deposit insurance premiums. Under this system, the cost structure of fìnancìal institutions offering insured deposits would reflect the risk profile of their something comparabìe in setting minimum currently being reached to capitaì standards. This approach is consistent with my guiding principle, but arguable. Risk analysis is compìex do its effectiveness in practice is to begin with and political mechanisms are 9not noted for their abiìity to set or change prices in accordance with in market circumstances. settjng An Some doubt that risk analysis would prevai in outside pressures on the insurance agency. premiums over aìternative (or an adjunct) to risk-based deposit insurance would be more I changes stringent limits on insurance and the enforcement of limits in practice. If we keep the maximum insurance can't price it all, those limit it. If we wish to we should limit it to $.l00,000 we might ljmit at $100,000 per person, not per account. After premiums the Federal Reserve can stem a true liquidity to solvent but iììiquid depository institutions. Enforcing this limit in coverage urould increase general bank run by providing emergency market discipline on financial institutions by prompting depositors to closely scrutinize the financial condition of those to entrusted their funds, and to return. In so doing, whom they shift their deposits when risk more have seems higher than they force key changes in a bank's operation and capital levels through graduaì changes in the cost of attracting deposits. The focus of reguìatory resources would be to support these changes by closely monitoring and strongly enforÄng capital standards. This approach would require regulators to move aggressively its capital is depìeted. merge the bank before Regulatory resources would be shifted away from surveillance and examlnation bank capi to reorganize or of nonbanking activities towards enforcement of taì standards. Greater reìiance on market forces would be assisted by making public condition of financial institutions. This might be as simple as releasing ratings, the kind of report card on each depository institutÍon that regulators norr onìy share among themselves. Keeping information on financial condition secret prevents market forces from signalling to depository institutions the true costs of their funds. Readily and continuousìy _ t0 _ available information could tend to refocus market judgments, prompting bank managements to redress deficient practices. 0f course, impìementation some ìead time for of such an announcement program wouìd be appropriate in order to alìow depository institutions an opportunity to impove their financial condition. final A approach would be it is today, and to greatly to retain the federal insurance system much as strengthen the regulatory apparatus in order to risk from being transferred to the taxpayer. This would not be my preferred approach. First, it wouìd extend the range of regulation to wider and wider set of financial activitles as banks and thrifts gain nevr prevent private powers, either by ìegislation, court decision or Second, the enlarged regulatory effort a technoìogy and new products. would continue outside of established financial channels. Finaìly, I to push doubt activities that regulators can, as a practical matter, over time, provide protection against perverse incentives, especially in a setting as dynamic as today's financial markets. of retafüng thê deposit insurance system in its present form is a substantial stepup in regulation. I am not especiaìly apprehensive about letting market forces operate more The logical outcome fuìly. Open market operations and the discount window, properly administered, of a liquidlty freely represent a substantiaì defense against the classic crowd psychology generalized bank run. to markets and to significant earìy .l930s same way it body These sound central bank tooìs can provide institutions to counteract a crisis. There is of opìnìon that the collapse of the banking system in could have been avoided behaved ìast October. if a the the Federal Reserve had behaved in the -il The Federal Reserve is not, however, are insolvent, their assets may a deposit insurance agency. If banks not be sufficient to withstand a run even liquified at the discount window. Regardless of the specific form of deposit insurance rte choose, it would be counterproductive when the for the Federal to I iquify insoìvent institutions. By so doing, it would enabìe fìeet-footed creditors to get their money, leaving others to absorb all losses. It is not the function of the Federal Reserve to interfere in the Reserve distribution of losses among the creditors of an insolvent bank; that is the function of a receivership. is more at stake here than the reassertion of market tests in banking and regulation, critical though those tests are. The Federal Reserve is a central bank vith the unique pobrer to create fiat base rrìoney. Liquidity crises are rare. The normal job of the central bank is to supply base money There over time at a rate consistent with price stabiìity. The independence of the Federal Reserve within our federal government, the removal of authority to make direct loans to the Treasury, and the limitation of discount windou to sound instttutions, are access to all vital protections the against attempts to divert money creation to uses that would endanger price stability. Conclusion The obJectìve should be to restructure financial regulations in a way that builds on market forces. Financial reform so far has been less a choice made by Congress and the regulators resuìt of to seek the benefits market forces successfully seeking straightjacket. As I of market forces than to avoid the regulatory have argued, lve are nearing a crossroad. a -12hle must push ahead financial reform with financìaì reform. Obviousìy, the setting must be changed. The must be shifted from the insurer for true rìsks of loss in financial decisions to those financiaì shareholders they represent) who make the managers (and the decisions. It wilì be essential, in this, to re-establish the right to fail and the risks of that fate for financial ìnstitutions of all sizes and for aìì uninsured deposltors. doing Regulatory resources need to be shifted towards maintaining capital to protect the insurance fund. Other changes will necessary be necessary, too--more information about the condition of financial institutions and reductions or at least limitations on the amount of deposit insurance are but a few. changes may not be popular, but they should be the guiding principìe financial reform is to continue. Such if true
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