Full text of Statements and Speeches of W. Lee Hoskins : The Need for Reform : The Garn Institute of Finance, Annual Conference, Salt Lake City, Utah

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T,p Nd for Reîotm

W. Lee Hoskirs, President
Federal Resele Bank of Clevelatú

THE NEED FOR REFORM

Today, the United Sfafes

is faced with a largely insolvent thrift industry, a

fragile banking system, and a regutatory structure whích many, inctuding myself,
belíeve has aggravated the very problams

it

was intended to

solve. The blueprint

for our current financial system was drawn up in the I g30s

in response to the

collapse of the financial sector which was triggered by the Great Depression.
Banks were deemed to be "special" and, consequently, were províded wíth an
expanded safety net and a high degree of government regulation. Market forces
were supplanted by a web of regulations, restrictions, and federal guarantees.
The continuing conflict between regulation and market forces has raduced the

efficiency, stability, and competitiveness of the tJ.S. financiat system.

As financiat

markets continue to evolve, regutatory poticies and practices become /ess effective

and the subsidized financíal safety net more costly. IJnder the "arthritic' hand of
public policy, banks have lost market share to unregulated providers of financiat
seruices- The combination of regutation and the safety net has encouraged banks
to take more risks, and the cosfs of bearing those risks have been transferred to

the taxpayer. Clearly, it is tíme to reassess and revamp the current system of
financial regulation.

2

The goal

of

fínancial reform shoutd

international competitiveness
exposure

be to maximize the efficiency

and

of the IJ.S. fínanciat system white minimízing the

of the federal financiat safety

net,

and hence the tJ.S. taxpayer.

To

achieve this goal, I propose narrowing the safety net and reducing government
ínvolvement

in financial markets. ln fact, narrowing the safety net must be

precondition for further deregulation of the banking industry. The degree

of

a

safety

net reform will dictate the extent to which broader powers can be granted to
banks. Market forces should shape the structure and performance of the fínanciat
seruices industry, and market particípants should bear the risks

of the decisions

they make.

This afternoon

I will discuss how the web of regulatory

taxes

and subsidies

has hampered IJ.S. banks' abitity. to compete in the growing financial seruices
marketplace and how the expandíng federal safety net has contributed

to instabitity

in financial markets. I witl propose reforms to reduce the cost and scope of the
financial safety net, paving the way for banks to become more competitive.

Reoulaîìon and lls Ilnìnta¡vlsl Flacrrlte

Lawmakers and regulators have attempted to achieve financial stability by
setting up a delicate and complex web of regulatory taxes and subsidies. ln the

of banks, lawmakers and regulators have sought stabitity by prohibiting
banks from engagíng in certain activities (G/ass-Sfe agatt restrictíons) and by
subsidizing the banks' access to market funding (through federal deposit
case

insurance). Over time, however, market forces have weakened regutations, often

making them íneffective,

ot

even counterproductive. These effects are
accentuated by exogenous shocks to the linancial system, such as surges of
inflatìon and advances in technology.

3
Not surprisingly, the response of regulators has been

adiustìng the sìze and mix

to absorb the

shocks by

of restrictions, taxes, and subsidies. Regutatory

changes tend to tag devetopments ín the marketplace and are typically piecemeal,

usually with the effect of either vatidating market innovations or rcregutating areas
where market forces have made existing regulations obsolete. New regutations
may be designed to limit or prohibit activities that are deemed "too risky," such as

thrifts' investments in hígh-yield bonds. Regutations that are unenforceable or
politícally costly may be removed, such âs, deposit-rate ceitings. Other
regulations, such as capital standards may be modified.
Essentially, these responses deal only with tha symptoms without making the
basic structural adiustmenfs necessary to allow tha banking system to fulty adjust.
Often this results in policies aímed at protecting the regulator's weakest ctient fírms

at the expense of the efficient firms in the industry and, hence, the stabitity of the
banking system. Moreover, regutatory interuentions in the banking system have
thwarted market-oriented forces so often that normal market outcomes have
become díffícult to achieve. Consequently, increased subsidies from the public

purse become necessary to suppo¡l an inefficient financiat services industry.
While this system may reduce the number of failures in the short term,

it

increases

the loss of efficiency and the pubtic exposure to loss

in the long term. The

unintended result of regulation is a banking system that

is less competitive and

less stable in the long run than one governed by market principles.

Eroslon

ol Banks' Market Share

lncreased competitíon from both foreign banks and nonbank providers of
financial seruíces has reduced banks' share of the financial seruices market. For
example, banks compete with the financing subsidiaríes of General Motors and
Ford in the market for car loans, with General Etectric and prudentiat in the

commercial loan market,
d epo sit-g athe ri ng

m arkets.

and with Merritt Lynch and Sears

Roebuck in

4

Transactions deposits are no longer the exclusive domain of commercial
banks,

as

can

be seen by comparing

Funds (MMMF)

to their bank

(MMDA). Both

of

these types

introduced about ten years ago.

the aevebpìment

of Money Market Mutuat

equivalent, Money Market Deposit ,accounts

of

accounts grew phenomenatty when first

ln 1984, MMMFs held $168 billion, while MMDAs

held û417 billion. By 1989, the respective numbers had increased to $30g biilion
and $487 billion. Some other financial institutions a/so compete with banks here,

lhough /ess directly. For example, non-term tife insurance--praæiums

ar€,

comparable to a savings account.
Banks today rely less on ordinary retail deposits and more on "bought money"

obtained from the wholesale credit markets. Banks acquire such funds primarily

by issuing large CDs. Between 1980 and 1989, CDs outstanding more

than

doubled, from $256 billion to $541 bíllion. tn this type of tiabitity, banks also face

substantial competition from other wholesale credit market participants, though
banks are holdíng their own in a rapidly growing market. For example, between

1980

and 1989, U.S. Treasury bills have increased from $200 bittion to

8407

billion, and commercial paper outstanding has increased from ûr24 biltion to 8s2g
billion.

On the assef srUe of the balance sheet, banks and nonbanks

compete

vigorously. Nonbanks make consumer and commercial loans. For example, GE
Financial Seruices has

a

commercial loan portlolio second

in size onty to

Citibank's. Among all lending institutions with financial receivables above û3
billíon

in

1987, nonbanks held 46 percent of alt financial receivables and 44

percent of the consumer loans. Banks held the remaining 54 percent and 56
percent of loans in those respective categories. These numbers should not be

that surprising: the largest consumer lenders (in order of importance) were
General Motors Acceptance Corporation, Citicorp, Ford Motor Credit, and
American Express.

5

ln the commercial lending arena, the large nonbank companies extended 4g
percent of the commercial loans. For example, Ford Motor CredÍt makes real
estate loans and buys credit card receivables via thrift and finance company
subsidiaries. And insurance companies accounted for over hatf of the commercíal
loans made by the nonbank lenders of this group.

The development of more actíve and broader capitat markets has enabted
corporate borrowers to obtaín funds dírectly from investors without goíng through a

bank. lndeed, looking

at

the credit market claíms against the

domestic

nonfinancial sector, banks' share has dropped (as has S&[s') from 33 percent ìn
1980 to 27 percent

in 1989. Bank loans, not inctuding mortgages, dropped

17 percent of nonfinancíal business credit

in

1980

to

15 percent

in I ggg. A more

dramatic decline occurred in lending to large corporations, those best abte

the capital markets. From 1975

to

1986, banks' share

from

to

use

of the short-term debt of

large corporations fell by nearly half, from 50 percent to 27 percent.
This erosion of market share seems to indicate that, though commercial bank

lending and deposit-taking has íncreased since l gAO, banks have failed

to

keep

pace with a very active and expanding financiat servíces market. The restrictions
on organizational form, geographic location, and öusrness activities, coupled with
access to federal deposit guarantees, the Federal Reserue's discount window, and

the Federal Reserue'operated payments system have made banks less efficient
and less able to adapt to changes ín the economy than they would be if they were
more subiect to markat incentives. lf current restrictions and regulations and the
safety net are not reformed, banks' share of the financial seruices market witt
continue to erode.

6

The Fær of Systenic Rbk

The typical rationale for the safety net and restrictions and regulations is fo
safeguard against financial panic and cottapse, that is against systemic risk, by
protecting individual depositors and banks

.

Systemic risk conjures up the image

of widespread failures of banks, where one bank failure causes other banks to fail,
and so forth. The closure or failure of institutions carries negative connotations,

but what does failure actually mean?

tt

does not mean that the physicalassefs

disappear. Rather, the resources of the faited institution are put to more eflicient
uses. The failure of an individuat bank does not automatically result in a cascade
of failures. The systemic problem is more one of gaining time and information for
the resolutíon of potentiat /osses than of a vast evaporation of capitat through
actuallosses.
Exposure
holdings

of

of the banking system to systemic rÍsk depends on

cash, liquìdity, and capitat

of each bank. Permittìng

the prudent

banks

to

fail can

strengthen the banking system and the nation. The very possibitity of faiture

provides strong íncentíves

to bank management to follow

sound banking

practíces. The economic reorganization, even the tíquidation, of a bank prompts
the reallocation of scarce tabor and property resources fo more efficient uses, and
removes the need for taxpayer subsidies to prop up the bank.

Ratrnal vs. l¡tat*nal Bank Rutts: When examining the issue of systemíc risk, a
distínction must be made between rational and irrational bank runs. A rational
bank run is one that occurs because depositors have information that their
depository institution has (or nay) become insolvent. This type of run shoutd not
be contagious and shoutd not be prevented by regulators. ln fact, it is one of the
methods the markef uses to weed out weak institutions. Because rational bank
runs are essentially a market-driven closure rule, they act as a form of market
disciplìne on bank management and shareholders.

7

An irratìonal bank run ìs one that occurs because poorly informed depositors
mistakenly believe that their deposítory institution has (or may) become insolvent.

lnstitutions that are truly solvent can stop an irrational run

by

demonstrating their

solvency. Although these runs theoreticalty could be contagíous, it is untikely that
they would be (except, possibty, to other insolvent institutions) because other

banks and thrìfts have incentives to provide tiquidity

to

solvent institutions

experiencing runs.
A properly functioning central bank,

in

its capacity as lender

of

last-resort, can

prevent írrational bank runs from becoming systemic runs by providing tiquidity
to
the financial system through open market operations or lending dírectty to any

solvent institution experíencing runs. tn doing so, the central bank relieves
pressures on solvent institutions and removes any potentiatly destabitizing effects

of irrational bank runs without

prectuding rational bank runs

on

insolvent

institutions. The Federal Reserve's role in providing tiquidity to financial markets
during the October 1987 stock market crash iltustrates how a property functioning
central bank can prevent spiltover effects to the overall economy from crises in
financial markets without propping up individuat institutíons.

Tl¡€ Paymenfs S¡rsbm.' The second source

of

systemic risk

is

related

to the

effects of a bank faílure on the payments system. Because banks are the conduit

for payments

in

this country, some people fear that the faiture of

a major

depository institution could cause the failures of other banks connected to the
payments system, topple the payments system itself, or at least shut it down for an
unacceptable period of time. However, there is no reason that the faílure of any
institution, Iet alone
system.

a large one, should

result

in the collapse of the payments

I
Even today, the loss on assefs associated with large bank failures is typicatty

small, certainly not approaching

'1OO

percent. Therefore, banks

payments'related exposure to the failed ínstitution shoutd realize only

a small

with
loss,

and the threat of loss from paymenfs-sysfem defautts shoutd cause banks to limit

their exposure to other banks that are considered to be excessively risky.
Participants in the payment system can protect themselves against the rísk of
adverse developments by estimating and controtting their susceptibítity to potential

failures of their counterparties. They shoutd be encouraged to do so

by

the

knowledge that policymakers witl protect financial system liquidity but not individuat
ínstítutions.
The myth that exposure to systemic risk can only be controtled by government

inteiventíon is debunked by the extensive private ctearinghouse and other private
contractual arrangements.

successful

ln the past, these arrangements seem to have been

in managíng risk exposures among

interdependent counterparties.

After all, banks routinely do this today in the federat funds markat and similar
measures have been adopted by the Clearing House lnterbank Payment System

(CHIPS). This electronic foreign exchange payments network, operated by the
New York Clearinghouse, handles volume of payments rivaling Fedwire funds
transfers. This past October, CHIPS implemented an agreement for loss-sharing,
with a $4 billion pool of participants'liquid coltaterat to back that agreement.

of any private arrangement must be a contractual
agreement placing risk of loss squarely on the parties to the arrangement.
The crucial feature

Consequently, participants have an incentive to monitor the creditworthiness of

their counterparties and enforce standards that timit the risk being assumed.

I
Some of the underlying financíat market transactions that now generate payments

may no longer be feasible because prívate partíes wítt not be witling to assume the

risks of failure to which they would be exposed
transacting parties. ln addition, the lender

on terms acceptable to

tha

of last resort can immunize the rest of

the payments system from the faíture of a single bank by lending (with

a "haircut")

to banks against their claims on the faited instltution until those claims are
realized. Furthermore, as I mentioned earlier, systemwíde tiquídity needs arising
from the faílure of a large bank could be addressed through the Federal Reserue's
Open Market Desk.

ln short, systemic risk, properly viewed, is not a

catastrophíc problem, unless

the misguided efforts to protect against systemic risk diminish proper
private'sector provision against risk. ln my view, that

is

close to being the case in

the United Sfafes. For the past two decades, the safety net has been substituted
for private capital and liquidity. The safety net is peverse because

it undermines

the very essence of financial exchange -- counterparty scrutiny. tn the absence of

the safety net, managers of banks would maintain larger cushions in the form of

cash, liquidity, and capital, raising the threshold of payments gridtock, and
electronic bank runs, and reducing interbank exposures. Moreover, private
risk'control measures would be developed and adopted as bank managers seek to
deal with failures in an orderly way.

t0

ffiv

Ì,Iet Refonn and lncreaæd MaftA D/s;cþtine

The current system of regulations and restrictions along with the expanded

safety net have raduced the competitiveness of the banking system and have
contributed

to

instability

in financial markets. The alternatíve to continuing down

this path rs fo reduce the federal safety net and increase market discipline by
having debt and equity holders

of banks act as a

constraint on management's

risk-takíng behavior. Under this approach, bank management wotid decide what

financial activitíes
organizational

to engage ifl, what type of

to offer, and what
form to adopt. The end result would be a more efficient and
products

competitive banking system that does not depend on government subsidies to
survive.

To achieve this result,

I advocate the adoption of a four-part package

of

reforms. The essential elements in my reform package are: 1) reforming the
deposit ínsurance system; 2) restraining the discretion of regutators to transfer risk

from the private to the public sector by adopting mandatory closure rutes;

S)

providing the public with better information; and, 4) separating the insurance and
superuísory functions of the FDIC. These reforms would reestablish the market as

an additional source of díscipline on the behavior

of

insured depository instítutions

and thereby increase the effectíveness of, and reduce the need for, government
superuisíon.

ln additíon, by returning risk-bearing to the private sector,

these

reforms will lead to an íncrease in capital at those banks holding risky portfolios.

11

One caveat to note
overnight.

A

is

that the reforms

phase-in perìod will

deposit'insurance reforms.

A

I

propose cannot be adopted

be required. This ,b especialty true of

transition period

,s

required

reorganize, or close insolvent and unsound institutions. But

to

recapitalize,

a successful transition

will require decisions, up front, to timit the safety net. Atthough these transitional
cosfs may complicate the reform process, they shoutd not be allowed to delay it.

As we have seen with the thrift crisis, the longer the delay in dealing with the
cosfs, the larger the costs become.
Reforming tlro

Dryit lnsurance S¡æbm

Key to any market-oriented system is extensive reform of federal deposit
insurance. The degree to which fundamental reforms to federal deposit insurance
are implemented will determine the nature and scope of reforms to the remaining

regulatory structure. Restoring market disciptine as an effective constraint on
bank and thrift activities shoutd be the key objective of deposit insurance reform.
This entails changíng the coverage and pricing of deposit insurance to eliminate or

reduce the degree

to which the taxpayer

subsidÍzes risklaking

by

fínancial

institutíons.

An unintended side effect of deposit insurance has been to make managers
and shareholders less responsive to market incentives and to redírect the flow of

capÍtal and market funds away from well-managed instítutions toward poorty
managed ones. This system most assuredly resulted in fewer bank failures from
the mid'1930s through the late 1970s, but did so

at the expense of

the tong-run

stability of the financial system, as evidenced by the escalation of probtems

in the

banking and thrift industries in the 1980s. Heduced access to capitat and funds by

marginal firms in a market setting would have been

an

important self-correcting

force that would have helped achieve long-run stabitity in our banking system.

t2

To restore proper disciplíne to an institution's shareholders and managers,
federal deposít insurance coverage must be timited. At the very least, the current
statutory limit of $100,000 per insured deposit account

at each insured institution

should be strictly obserued. Deposit insurance coverage must not be extended in
any circumstance to uninsured depositors, unsecured creditors, and stockhotders.
To truly reap the benefits

of deposít-insurance reform,

the current limít should

be reduced, and coinsurance shoutd be made avaitabte for coverage

that exceed the

limit.

Deposit insurance shoutd provide

a

on balances

ceriain amount of

protection to small depositors. Such protection woutd be quíte consistent with
market discipline, reduced subsidies to regutated firms, and reduced tiability for
taxpayers. lt should not be used to provide competitíve advantages to one class
of providers of financial services. As policymakers consider the appropriate
maximum level of deposit insurance coverage, they should keep in mind that
the
original 82,500 limit, adjusted for inflation, is roughty 025,000 today. Moreover, the
average ínsured deposit account in banks is g12,000; and in thrifts it is
9g,500.

by the Federat Reserue Board of Governors
that only 1.4 percent of American families would be affected by a

Suruey evidence compiled
suggesfs

lowering of the ceiling betow 8lOO,OOO, and that these famities coutd exert a hígh

degree of discipline on the banking system because they control over

2g

percent

of total bank deposits. According to private estimates, 98 percent of

deposit

accounts are less than 840,000 and of these accounts, the median account is /ess

than 83,000.

t3

ln additlon to lowering the insured deposit ceiling, a

coínsurance feature

should be added for additionat dàposit balances above the 825,000 per depositor,

full'insurance level. Coinsurance was

deposit insurance program.

I

a

feature

of

the oríginal (lggg) interím

propose that the Federat Deposit lnsurance

Corporation (FDIC) provide g0 percent coveraga

for

balances between 825,000

and $50,000, and 70 percent coverage for barances in excess

of gsZ,loo.

An important feature of coinsurance ,s that it would estabtish minimum
recoveries on deposit balances in excess of the futty insured timit. Thís woutd
remove an important constraínt on the FDIC's ability to resolve bank failures
quickly without extending forbearance to uninsured depositors. W¡th coinsurance,
the federal deposit guarantor would not need to estimate in advance /osses to the

unínsured depositors; rather, the coinsurance haircut would
depositors' balances.

lf the

institution's total /osses

did

be applied to

not exceed

the

haircut

amount, the receiver would rebate to the uninsured depositors their share of the

difference. Thus, coinsurance would alleviate financial hardshíp for uninsured
depositors by paying them a predetermined portion of their deposits up front.
The strict enforcement of any deposit insurance timit requires some changes

to the failure'resolution policies of the FD\C, including statutory constraints on the
authority of the FDIC to rescue large insolvent financial instítutions. These
constraínts would preclude the use

of faiture-resolution

techniques such as

open'bank assistance and purchase-and-assumption transactions, which provide
de facto coverage to uninsured claimants.

14

The Role of PtÍvate ltsuranæ: Private insurance could play a role in the above
proposal if the statutory limits on federal coverage are strictty adhered to and there

is a well'defined closure policy. IJnder these conilitions, private insurers could
step in and provide coverage for the coinsurance deductible portions

of

the federat

coverage. Presumably, the insurance would be offered to depositors through their

bank. Private deposit insurers would have to be wetl-capitatized and operate their
insurance funds in an actuarially sound manner.

Prívate insurers should be given access to examination reports and must have

the right to conduct their own periodic audits of privatety ínsured depository
institutions. Furthermore, they must have the right to cancel theír coverage with a

60'day notice for existing deposit balances, and

to

implement immediate

cancellation for new deposits or additions to deposit balances. Note that smatt
depositors would enjoy full protection by the FDIC so they would not be materiatty
affected by the cancellation rights of the private insurer.

Hiskþaæd Premiums: Congress should require that the FD\C adopt a risk-based
deposit insurance premíum schedule for banks and thrifts. Currenily, there are
several proposals that outline methods for doing

this. Each fias ifs merits and its

problems. However, the method selected for doing this shoutd tie the deposit
insurance premium as closely

as

possible

to the risk premium the market would

assess.

A@ing Mandatory Closure Rutes
The current failure-resolution poticies of the FDIC encourage risklaking by
large banks and create competitive inequities for smaller banks. When regulators

15

seek to minlmìze insured deposit payouts by attowing insolvent banks to remain

open, uninsured claimants are protected by extension. This practice eventually
allows banks to evade the market disciptine of faiture and, as we are seeing now,
greatly increases long-term exposure to both insured and uninsured claims.

Rules dictating the terms and conditíons under which bank regulators
intervene must be adopted. The approach t advocate is one of early and active
intervention. Under this approach, regulators would

be assígnad the task of

enforcing a few basic rules (for example, minímum capital requírements, periodic

reporting and public disclosure requirements, outside audits, and market-value
accounting), and monitoríng efforts would be directed at ensuring that those rules

were obserued. As bank's capital levels decline, mandatory supervisory actions

would be required. Weak, but generally sound banks would

on

be

subject to

and on activíties which reduce capital. Bank
management would be required to submit ptans to increase capitat. Thínty
limitations

expansíon

capitalized banks would be prohibited from expanding and would be required to

restore capital. Owners

of

banks falling betow the minímum capitat adequacy

guidelines would be given the option to immediately recapítatize the bank or
surrender it to the government for sale or liquidation. Banks, regardless of size,

determined to be insolvent would be immediatety taken into receivership for
government sale or liquídation. Any profíts from the sale or liquidation of
depository institutions would be rebated back to the original owners.

I suggest that the minimum capitat level required to operate a

bank be

market'value equity equal to three percent of totatassets. Given the reduction ín

explicit and implicit deposit insurance coverage, the amount
banks

in

of

capitat hetd by

excess of the regulatory minimum would be determined by

After adiustment to the reforms,
minimums.

it

woutd certainty be

the market.

in excess of regulatory

16

This mandatory closure policy would mìnimize the exposure

of the deposit

insurance fund and would restore market discipline. under fhis policy, no
institution is "too big to fail" and deposit insurance guarantees would not be
extended to uninsured depositors or unsecured creditors

of banks. The

risk impacts raised by such a policy can be managed over

will reduce the threat

systemic

time. Earty interuention

of systemic rÍsk because an institution wilt be closed while it

is still solvent and before depositors are at risk.

As

I mentioned

earlier, by effectívely carrying out its lender

of

tast resort

function (providing liquidity to the financial system through open market oprations

or lending directly to a solvent institution), the Federat Reserue can also contain
risks stemming from contagìous deposit runs. However, providing liquidity to a
non-viable instítution where no immediate resolution plan is in ptace

is tantamount

to regulatory forbearance. Therefore, a criticat element ol an effective

early

interuention program ís an expticitly stated policy that the Federat Reserue witt not
lend to an ínsolvent or non-viable institution.

Pnviding the Public with Better tnformalÍon
Under the current deposit insurance system, information about the condition
of an institution is not in demand by depositors. lnstead, depositors are interested

in finding insured ínstitutions offering the
depositors were

at

risk when

highesf rafes

an institution failed,

on deposits. lf

large

the depositor woutd certainly be

interested in the financiat condition of the institution. lnformation on the condition

of institutions would become more important than information on deposit rates.

t7

Central to ìncreased market disciptine in the banking industry
disseminatíon

of information.

is the timety

Savers and investors should be provided with

adequate information for decisionmaking. The regulatory community can improve
the ínformation available to markets by movíng from the suppression of information

fo rïs timely dissemination. FIRREA takes an important step in this direction as it

mandates that cease-and-desist orders, supervisory agreements, and other
regulatory actions are to be published by the appropriate superuisory agency.
However, I would go even further and advocate that banks and thrifts shoutd have
the right to release their examination ratings and reports to the pubtic. ln addition,

annual audits by independent accounting firms shoutd be required for alt financiat
institutions and

the results of these

audits should

be made pubtic. For

well'capitalized institutions for whom this rule could prove to be

a

hardship (for example, consolidated entities with less than 0100 míttion

in

small,

financial
assets),

outside audits could be required only every second or third year.

I also propose the

use of market-value accounting. At the very least, banks

and thrifts should be required to file a regulatory net worth statement based on
market-value accounting

in addition to the quarterly reports of condition and

income they currently file with the federal bank regulators, and closure rules
should be based on the market valua of capitat.

Traditional accounting systems like GAAP (generally accepted accounting
principles) and RAP (regulatory accounting princíples) result in unnecessary noise
in the information system because they attow firms to carry assefs and liabititíes at
their par value (usually, historical cost) and do not reflect the subsequent changes

18

in theír market value. Therefore, GAAP and RAP may not be good measures of
the true solvency of

a

øaàl. or

thrift. To make matters worse, both GAAp

and RAp

tend to be high-biased measures of solvency for banks and thrifts experíencing
solvency problems, and the degree

of error in

GAAP and RAp measures

íncreases as solvency deteriorates.

Critics

of market'value accounting

correctly point

out that

market-value

accounting systems themselves are not perfect, as there are many assets and
liabilitíes on the balance sheets

of banks and thrifts for which estimates of market

value are not readily available. However, it
values for changes

is possible to

adjusf assef and tiabitity

in interest rates and, as markets develop for securitized bank

assefs, the ability to make reasonable, market-based adjustments to the value of
similar assefs in bank portfolios increases. I want to emphasize that market-value
accounting should apply to both assefs and tiabitities.

lt

does not make sense to

apply market'value accounting to onty the asset side of the batance sheet. These

adiustments should be made as

a first step toward full market-value accounting.

Note that the Comptroller of the Currency's new nonperforming-performing toan
distinction is essentially a mark-to-market

rule.

Att

new activities authorized for

banks and bank holding companies shoutd be booked on

a

marked4o-market

basis.

Market'value accounting is not a panacea and stilt resutts in noisy information

streams. Nonetheless, if is a /ess-noisy information stream than the one that flows
from both GAAP and RAP. Over time, market-value accounting should become
less noisy as financial markets evolve.

19

@raìng

anl St4nwìæry Funclbns
My final proposed reform is to separate the insurance and the superuisory
the ltlsiwanæ

functions. This separation

ris

necassary to ensure free exít from the índustry and to

provide a check on regulatory forbearance. By separating the insurance function

from the superuisory function, we remove possibte conflicts of interest between
those functions. For example, the deposit insurer could adopt a policy

of

capitat

forbearance to cover up superuisory errors.

As an ínsurer, the deposit-insurance agency seeks to maintain the value
insurance

ol

its

fund. The deposít ínsurer would monitor and audit the insured industry

as a means for collecting information on the risks posed to the fund by individual
depository instítutions. Through its pricing decisions and its power to terminate or

limit insurance for banks and thrifts that are being operated in

an

unsafe and

unsound manner, the deposit insurer can lorce the primary regulator
corrective action or force the closing of an unsafe

to take

or unsound instítutíon.

The

deposit insurer could even factor into its premium-pricing decisions the loss
experience associated with each regulator, thereby estabtishing

a

pseudo-market

price for regulatory services.

ln addition to eliminating the deposit

insurer's superuisory responsibitities,

using the deposit insurance function as a check on overly permissive supervisory

and regulatory forbearance policies requires some basic changes. First, the
deposit insurer must have the right to terminate insurance coverage immediatety

for new deposits (or new additions to otd deposits above the accrual

of

interest)

when it determines that an institution is being operated in an unsafe and unsound

20

manner. Second,

it must be able to charge differential pramiums to institutions

based on risk, includíng regulator risk. Third, the insurance and receivership
functions should be separated. Splitting the receivership function into

a separate

agency would remove the íncentive for the deposit insurer to forbear by extending
implicit coverage to uninsured claimants or to take on contingent lÍabititÍes in order
to minimize short-run failure-resolution costs.

Øndusitn
Financial sarvices industry reform has reached

a crossroads.

The current

system of regulatory taxes and subsidies ís unworkable and, as evidenced by the
enormous and growíng price tag for resolving the thrift crisis,
very costly.

it

has proved to be

lt is time for us to make a choice between a regulatory structure that

relies more heavily on markets or one that relíes on bureaucratic rules and politícal

judgments. For me the choíce is clear. lf we want to have an efficient and stabte
financial system and want to avoid FSLTC-type bailouts

in the future, we must

choose a market-oríented solution.

The set of reforms I have proposed would reduce the cost and the scope of

the financial safety net and thus, serve to reduce the socialization

of risk and

reestablish the market as an important part of the financial institution oversight

process. Rather than blocking or attempting to circumvent market forces, these
reforms would rely on market forces

to

reestabtish the risk-return trade-off in

fínancial services, so that those who benefit from the upside gains

of

risky

strategies would also bear the down-side losses when these strategies did not pan
out.

2t

With adequate safety net reforms In place, we can embark on

a

path of

deregulation that would allow financiat seruices providers a free hand Ín choosíng
what products to deliver, where to detiver them, and how to delíver

them. The end

result will be a more effÍcient, competitive, and stable financiat system that witt not

need to rely on taxpayer subsidíes to compete, or even suruíve, in the increasingty
global marketplace.
What do we do íf safety net reforms are not adopted? The answer
Banks do not get new powers, and regulations

see

a continued

erosion

of

ís

simpte.

on banks are tightened. We wilt

banks' market share. lJltímately, we

restoration of an unregulated competitive

will see a
financial seruices índustry as banks

is not my preferred alternative. The need
for reform is clear and the time to act is now. Congress should phase in
disappear from the marketplace. This

appropriate reductions in the federal safety net and free the banks to compete.