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Financial Reform At A Crossroads
l.l. Lee Hoski ns , Pres ident
Federaì Reserve Bank of Cleveland
Pi
Pi
ttsburgh
ttsburgh,
NABþl
Pennsyl vani a
January 6, 1989
Financial
Recent
At A Crossroads
efforts to reform ìaws and regulations governing the financial
services industry remind
open
Reform
his chute on his
me
of
an anecdote. A novice parachutist couldn,t
first iump. As he was falìing toward the ground, he
noticed another individual
flying
upward past
him.
He caìled
out to
the
passerby, "Do you know anything about parachutes?" The passerby replied,
Do you know anything about gas stoves?,,
,,No
I
beìieve that policymakers have reacted to the problems of the financlal
industry in a similar manner. Instead of taking the necessary precau¡ons
before the jump, policymakers have tried
to solve problems in mid-flight with
new reguìations and restrictions. This piecemeaì approach
of responding to
immediate problems and pressures is unlikeìy to create a flexible and
eff icient structure for our dynami c f i nanci al servi ces i ndustry. In my vl errr,
taking the necessary precautions before the jump means estabìishing
pri nci pl es
to
gui de
fi
nanci
al reform.
The pri nci pl es shoul
d be
ìi
t¡
economic
e
different from those at work in other industries, i.e., market forces and
incentives. Relying more heavily on market forces, though, requires making a
clean break w'ith the
past.
As we consider
legislation to reform the financial
services industry, rre are idllng at a crossroads. One road leads to a
reinvigoration of market principìes and incentives to guide the industry.
The
other leads to further reliance on the regulatory apparatus.
My message
today
is two-fold. First, the laws and regulations
governing
the financial services industry are in need of a comprehensive reform.
Second, this reform should build on market forces rather than override or
suppress
them.
The chalìenge
is to eliminate regulations
to strengthen regulations where necessary.
where possible and
-2-
This
ls not to say that government
vital role ln the
financial servlces lndustry or in other areas of our
economy. A political
legal framework is indispensable for assuring individual
liberties and
does not pìay a
property rights, and settlng the rules of
the
Hithin that framework'
owners
of capltal
game
and labor
for
markets
and
to operate.
wiìl dlrect their resources
toward uses vhere opportunities seem
greatest. Generally speaking, private
declsions made with full comprehension of possìbilities
for gain and risks of
will produce the best results.
If resources throughout the economy are to flow to acilvities where they
loss
are of greatest value, competitive standards should not
differ significan¡y
across the various banking markets or between banklng
and other industries.
Reguìating some
activities
and precluding others
alters the possibility of
gain and the risk of ìoss and affects choices
wlth respect to resource use.
central architect designed the regulatory system or laid
out a slngle set
of principles' The current banking regulatory system developed prlmariìy
in
response to financial crises and other historical
and political events. As a
No
consequence, bank
i
n confl I ct
wi
regulation has been designed to serve goals that often
are
th one another.
In general, poìicymakers have adopted regulations to achieve two major
goals' First, pol icymakers want to avoid extensive losses
to depositors.
Public pressure to protect depositors'funds grew as
banks played a larger
role in financial transactions and indlviduaìs held a larger portion
of their
funds
in banks. A second goar of
framework
system
that
encourages
policymakers
is to create a reguratory
efficiency and competition.
efficient financial
wlll give the consumer the highest quality services at minimum cost.
An
-3-
confìicting. In a competi¡ve environment, risk
and the failure of firms, banks included, is inevitable.
These two goals can be
taking
In
is encouraged
to protect depositors from financial hardship, however,
regulations were adopted that were intended to prevent bank failures.
an attempt
unfortunately, policymakers ignored important market principles in the
construction of the regulatory system. Consequently, our regulatory system
itself ls
responsible
for
much
of the turmoil in the financiaì industry
today.
For lnstance, federal deposit insurance, adopted ln the 1930s, has reduced
or eìiminated the risk of loss to individual deposltors and investors. To
stablllze the
protect depositors from "runs', on banks, insurance
was establlshed to guarantee the creditors of failed banks against
loss.
Insurance
system and
forestalls
safe, whether a bank
bank runs by assuring depositors
ls
that their
money
is
not. At the same time, risk is transferred
solvent or
from bank management to the deposit insurance system.
l'lith respect to the safety of funds, depositors need not worry about the
condition of financial institutions. The two federaì insurance funds, the
originally were designed to cover deposits up to $2,500 (which
translates into about $22,000 today). Over the years, the maximum was raised
FDIC and FSLIC,
by Congress
to its current level of
depositors can be unconcerned with
very ìarge lnstitutions,
all
$lOO,OOO.
All but the largest of
risk in choosing among small banks.
At
depositors and even other creditors believe that
they are effectively insured because
of the reluctance of reguìators to allow
large banks to fail. l'{ith today's high level of protection, the condition of
financial institutions is of no concern to the depositor and creditor.
Deposit insurance also alleviates risk concerns for bank management. The
insurance funds have been financed by a fìat assessment on banks and thrifts
--
a practice which leaves the cost of funds to a bank largely unaffected
by
-4-
the rlsk proflle
practices
of its portfolio. If federal deposlt
of private insurers,
insurance followed the
risk characteristics
with a deductible and premium established for each divislon. Moreover, a
private insurer periodically examines the behavior of those insured to
determine lf insurance should be ìimlted or even denied. Incen¡ve problems
surface as the real risks of asset decisions and liabillty management
practices are not factored lnto the cost of insurance. Deposit insurance has
become a substitute for a strong capital base in attracting funds.
The reaction of the regulators to the serious financial problems of some
thrifts and banks in the 1980s has not helped the incentive problem. In some
banks would be divided by
instances, regulatory standards and accounting princlples were relaxed, par¡y
to give financial institutlons tlme to recover their losses and restore their
financial health.
Postponing closure gave added incentive
for broke," seeking
growth
for
at the expense of asset quality.
managers
to
The guarantees
,,go
of
the insurance program in effect prevented the cost of funds from reflecting
the full risks of loss and encouraged further expansion.
Bankinq Resulations
regulations, justified as a rray to assure sound banking
practices, also have underestimated the importance of market incentives.
Many bank
charters typicalìy calì
portfoìios.
for
minimum
Slnce the .l930s,
certain kinds of activities
and securities
of
capital holdings and broad restrictions
to be risky, including generaì
Subsequent one-bank holding company
loosened some restricions by permitting a holding company
insurance
legislation
to offer a sìigh¡y
of products than lts bank subsidiary could offer direc¡y. In
addition, banks in this country have been almost universally excluded from
being affiìiated in any way with firms involved in commerce and industry.
broader set
on
course, banks have been precluded from
deemed
underwriting.
Bank
-5Eanks were
also forbidden to pay interest on regular checking account
deposits or to pay more than a ceiling rate on other deposits. There
debate about whether the
l{as a convenient device
effort to avoid price
prohibitlon of interest on regular checking
for
wars
banks
ceiling
was
accounts
to mute competition, or a serious regulatory
that might
endanger
the safety of banks.
Regulation Q ceillng on other deposit rates became a genuine
banks when the
is still
The
difficulty for
set permanently below the analogous ceiling for
thrift institutions. It was the removal of this Regulation
marked the first significant step in banking deregulation.
Q
restraint that
Portfollo restrictions, product line restrictlons, and interest rate
limits all have been defended as means of assuring the safety of banks by
removing temptatlons
to
engage
in "ruinous competition" or to
abuse the
deposit-raising power of a bank to fund a nonbanking-affiliated business. But
as the post-war period progressed
ìt
became
cìear that these restrictions
were
driving growth and innovation outside the banking system and stimulating
growth
its
of
own
non-regulated
financial intermediaries. Abetted by RegulatÍon
federal deposit insurance program, the
thrift
industry was in a strong
position to dominate the competition for savings deposits and the
market.
Unencumbered
mortgage
by interest rate ceilings or costly reserve
requirements, money market mutual funds, and other new competitors
products grew
Q and
rapidly in the 1970s, aided by the explosion of
teìecommunications technoìogy.
and
computer and
Similarìy, capital requirements, ìimitations
on loans to a single borrower and on the kinds of assets banks could hold,
as
well as the rate and reserve requirement impediments to financing themselves,
all
contributed to the rapid development
of
non-bank and offshore financial
-6markets. 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 allowed
do.
in guiding the financial
industry? In a static setting where entry into closely competing endeavors is
l'lhy have regulations been so unsuccessful
expensive, technology
regulation may
seem
is
unchanging, and lnnovatlon sìuggish, the costs of
small
or
slow to appear, perhaps because they are hidden
in public subsldies. In such circumstances, the intrusion of
regulation in the marketplace
results that otherwise
wou'ld
may be
able to achieve
government
politically
determined
not be achieved. In a more dynamic setting,
such
for financial services, where competition has been strong
has grown rapldly, the outcome can be quite different, as we
as today's market
and technology
are notr seeing.
Regulation, by encouragÍng the entry
financial services,
In
some
of
non-regurated suppriers of
has driven business outside
of
long-established channels.
instances risk-taking has been encouraged. Overnight financing by
large banks in the federal funds and repo markets has mushroomed, addlng
fragility to banking and rnoney markets. Banks, seeking to compete with new
entrants, have taken buslness off balance sheets with devices such as standby
commitments and guarantees adding new elements of risk. To sum up, instead of
strengthening the safety of the system and guardìng against bank failure, the
combination of regulation and federal deposit insurance has encouraged
ri sk-taki ng i n the fi
nanc i
al
i ndustry.
-7l{he¡e To Go From Here
Although
the
I
have taken issue with our means, our ultimate end has remained
over the past 200 years. þle are striving for an efficient, flexible,
innovative financiaì sector providing servlces in a stable environment. To
same
get there, basic principles of capitalism should be our guide. MarKet forces
should determine the outcome including the blend
of financial and nonfinancial
products offered by a firm, as welì as the risk profile of firms. Market
incentives and risk evaluation must include possibilities for gain and the
risk of loss and ultimately failure.
As Congress ponders
savings and loan
its agenda for 1989, financial
crisls, deposit
the top of almost everyone's
and the
first
industry issues - the
lnsurance, and Glass-steagall reform
list.
-
are at
Financial reform must be comprehenslve,
step should be to recognize and resolve the confìict in current
public policy goals. Let me now be a little more specific and ouiline two
possible paths for reform - relnvigoration of market incentives or increased
rel iance on regulation.
To restore market judgement
in dealing with strains
in allocating resources
and shocks when outcomes are bad, we must make basic
changes in the regulatory structure
management and
--
changes which
success and
failure.
Risk-based Deposit
when making
suggest
that
market tests
As a practical matter, our choices
severely constrained by the kind
tests
restore incentives for
depositors al ike to avoid problems. The guiding principle in
this evoìution should be to create oppor:tunities for
loss,
and market resiliency
Insurance.
of federal deposit'insurance
How
of gain and
will
be
system we choose.
can we promote the application
of
decisions about the future of deposit insurance?
market
Some
that federaì deposit insurance should be el'iminated, but others
would be undesirable,
argue
or politicalìy infeasìble. Another suggestion is
-8-
to adopt risk-based deposlt lnsurance premiums. Under this system, the cost
structure of financlal lnstitutions offering insured deposits would reflect
the risk profile of their business. The implementation of international
capital standards
aid a risk-based system, but the effectiveness of such
a system in practice is debatable. Risk analysis is complex to begin with and
political
in
would
are not noted
mechanisms
accordance
with
changes
for their ability to set or change prices
in market circumstances.
Some
doubt that risk
analysis would prevail in setting premiums over outside pressures on the
i
nsurance agency.
Limitinq
t
Deposi
Insurance.
An
alternative, or an adjunct, to risk-based
deposit lnsurance premiums would be more stringent limits on insurance and the
enforcement
of
those
limits ln practice. If
we
can't price
it,
we
might lìmit
it' If we wish to keep the maximum insurance limit at $loo,00o we should
limit it to gloo,000 per person, not per account. Enforcing this limit ln
coverage would increase market
discipìine by prompting depositors to more
closely scrutinize the financial condition of those institutions to whom they
their funds, and to shift their deposits when risk seems hlgher
than return. In so doing, they force key changes in a financial institution,s
have entrusted
operation and capital levels through gradual changes
deposits-
The focus
of regulatory resources
in the cost of attracting
would be
to support these changes
by closeìy monitoring and strongly enforcing capital standards. This approach
wouìd require regulators
to move aggressively to reorganize or
financial institution before
wouìd be
shifted
away from
activities towards the
capi
tal
merge
a
its capital is depleted. Regulatory resources
surveillance and examination
assessment
of asset quality
of
nonbanking
and the enforcement of
standards.
.
Greater reliance on market
forces would be assisted by making public the condition
institutions. This
of financial
might be as simple as releasing a financial ìnstitutìon,s
-9-
ratings, the kind of report card on each depository ins¡tu¡on that
regulators notr share only among themselves. Keeplng information on financial
condition secret prevents market forces from signalling to depository
institutions the true costs of their funds. Readiìy and continuously
available informatlon could tend to refocus market judgments, prompting
managements
to redress deficient practices. 0f course,
implementation
of
some
lead time for
such an announcement program would be appropriate
to allow depository institutions an opportunlty to
impove
bank
in order
their financial
condition.
The other
option
is to retain the federal insurance system much as it
is
today, and to greatly strengthen the regulatory apparatus in order to prevent
private risk from being transferred to the taxpayer. This would not
be my
preferred approach.
First, it
would extend the range
of regulation to a wider
of financial activities as banks and thrifts gain new powers,
either by legislation, court decision, or technology and new products.
and wider set
Second, the enlarged regulatory
effort would continue to push activities
outs i de of establ i shed fi nanci al channel s. Fi nal ly, I doubt
that reguì ators
can' over time, provide protection against perverse incentives, especial ly in
a setting as dynamic as today's financial markets. The logical outcome of
retaining the deposit insurance system in
step-up
its
present form
is a substantial
in regulation.
The Central Bank's Role
I
am
comfortable
letting
market forces operate more
fully.
gpen market
operations and the discount wÍndow, properìy administered, represent
a
substantial defense against the classic crowd psychoìogy of a generaìized bank
run' These central bank tools can provide liquidity freeìy to markets and to
sound
institutìons to counteract a
crisis.
There
is a significant
body
of
_l 0_
oplnion that indlcates that the collapse of the banklng system ln the early
1930s could have been avoided if the Federal Reserve had behaved ln the same
way
it
behaved
in October
The Federal Reserve
1987
foìlowing the stock market crash.
is not, however,
a deposit insurance agency.
If
banks
are insolvent, their assets may not be sufficient to withstand a run even
when
liquified at the discount window. Regardless of the specific form of deposit
insurance we choose, it would be counterproductive for the Federal Reserve to
lquìfy
vent i nsti tutions. Doi ng so vould enabl e fleet-footed credi tors
to get their money, 'leaving others to absorb all losses. It is not the
ì
I nsol
of the Federal Reserve to lnterfere ln the distribution of
arnong the creditors of an insolvent bank; that is the function of a
function
losses
receivershi p.
There
is
more
at stake here than the reassertion of
critical
market
tests in
are. The Federal Reserve
is a central bank wìth the unique power to create fiat base money. Liquidity
crises are rare. The normal job of the centraì bank is to supply base money
over time at a rate consistent with price stabilfty. The independence of the
banking and reguìation,
though those tests
Federal Reserve within our federal government, the removal
of authority to
make direct loans to the Treasury, and the llmitation of access to the
discount window to sound institutions, are all vital protections against
attempts to divert money creation to uses that would endanger price stability.
Conclusion
Our
objective 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,
to
seek the benefits
of
market forces than
result of market forces successfully seeking to avoid the regulatory
straightjacket.
a
-t tl'le are
at a crossroads.
Ne must push ahead
risks of loss in financial decisions
financìal
managers and
with financial reform.
The
must be shifted from the insurer to
the sharehoìders they represent. In do'ing
essential to re-establish the right to
fail
and the
this, it
risks of that fate for
financial institutions of
all
Regulatory resources need
to be shifted towards maintaining capital
sizes and for
all
uninsured depositors.
necessary
to protect the insurance fund. Other changes will be necessary, too -provision of more information about the conditlon of financial institutions
and reductions,
or at least limitations, on the amount of deposit
insurance
are but a few.
Piecemeal solutions are
publ
ic
pol
icy
goal
s.
poìitically
However,
is
appealfng due
to the conflicting
a comprehensive solution based on market
principìes is our only hope for true financial reform.
@FedFRASER