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CtE:\¿ELiAliD. ADDRESSES. HOSKINS.
12.
23,
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9:00 a.m., E.S.T.
May
IJ
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Rethl nki ng the Regulatory Response
to
Ri
sk-taki
ng
in
Banklng
!,1. Lee Hoskins, presldent
Federal Reserve Bank of Cleveland
a Bankers Associ ailon
Annual Convenilon
Pennsyl vanl
Baltirnore, Maryland
May
23,
I 989
EDEßAL RESERVE BANK
OF IGNSAS
ul{ 0 v
Cfl
1sg9
RESEARCH LIBRARY
RETHINKING THE REGULATORY RESPONSE TO RISK.TAKING
IN
BANKING
ls a simple one. The underlying shortcoming of the
present flnanclal regulatory system is that it ignores, and attempts to
override, market forces. As we consider regulatory reform of the flnancial
industry, hre are idling at a crossroads. One road leads to reinvlgoration of
My message
today
to guide the industry.
market principles and incentives
to further rellance on the regulatory
I
belleve that the
would
will
first
course
other road leads
apparatus.
of action ls the correct one, and today I
lÍke to discuss my vlew of the regulatory
take us down that road.
The
system and
Flrst, banking regulators
the approach that
must emphasìze
supervlsion rather than regulatlon. The essentlal dlfference between these
lles'ln the nature of.the limits placed on the'dlscretlon of
the management of banklng flrms. Regulatlon amounts to placlng uncondltional
two,approaches
llmits on the dlscretlon of
bank management. Thls approach lmplles
that
the
of the management of the regulated firm cannot be trusted.
Supervlslon lmplles conditlonal llmits on their freedom of actlon, actlvated
only when management actlons threaten to impose costs on the lnsurance fund or
Judgment
taxpayers. Thls approach presumes that
management
is
competent unless they
demonstrate otherwl se.
Second,
agencles
I
belleve that the current framework of multlple regulatory
offers a number.of
advantages over proposed, streamllned alternatlves
and should be preserved and flne-tuned, rather than dlscarded.
Thlrd, the deposlt insurance
system must be reformed so
that the
market
plays a larger role in assessing and pricìng bank rlsk. The current method of
deposlt lnsurance prlclng encourages bank
and substltute lnsured deposlts
for
management
to take addltlonal rlsks
uninsured debt and
equlty. It
reduces the
-2lncentives
it
for
insured depositors
to care about the riskiness of theìr
of monitoring and restraining
entirely in the hands of regulators.
And
leaves the tasks
REGULATION AND
At present,
ITS
risk-taklng
bank
banks.
almost
COSTS
rre are
essentially following the approach adopted nearìy
years d9o, amid the financial fallout
achlevlng the social goal
50
of the Great Depression. Specifically,
of a safe and sound flnanclal
system has been
entrusted largeìy to a regulatory process, rather than to prlvate
in free markets. Regulators
decisionmakers operating
achieve a strong
'cl asses
banks
of
have attempted to
flnanclal sector by controlllng the actlvitles of certain
f i nanci al i,i ntermedl ari
es, .the
most .notabl
e
exampl
e
bei ng commerci al
.
Numerous
constraints on the discretlon
rlsky competltlve actions
controls were
imposed on
of
bank management
were imposed malnly through acts
priclng, products, location,
of
to
undertake
Congress.
and balance sheet
composltlon. These restrlctlons were deslgned to prevent the failure of
indlvldual banks. Moreover, deposlt llabtlitles were lnsured (up to a llmit)
to reduce the incentlves for deposlt holders to run ln the unlikely event that
a fal I ure occurred.
For several decades after the Depression, the ftnanclal system appeared to
be
relatlvely safe and sound.
was erected appeared
against the fears
The supervisory and regulatory apparatus that
to be an effective, inexpenslve,
and permanent bulwark
of chronlc financlal lnstabllity fostered
by the experlence
of the 1930s. The regulators appeared to be doing their Jobs well. Bank
fallures were few ln number and not costly. However, as the 1970s began, a
confluence of forces, most notably volatlle inflatlon and hlgh nomlnal
-3-
interest rates along with a substantial decline in the costs of information
processing and transmission, produced an envlronment
system
of
bank
in whlch the existing
regulation could be seen as one containing substantial flaws
and social costs.
l'lhat have we learned from
regulation?
It
economic goaìs
this
should be obvious
experience
of exclusive relìance
on
that using government regulation to
entails both substantial costs and a number of
the risk that a system of, regulatlon
risks.
achieve
Ihere is
will not be as effectlve as desired,
both
lnitlally lmplemented and over tlme. There is also the risk that
regul ation wi I I have unÍ ntended, perverse effects.
when
The present system
:market.mechanism:and
and
of
bank regulation includes numerous constraints on the
so,'is inevitably
costly.
'expllclt. rRegulated'.lnstitutlons'incur
Some
,costs:ôt^ê highly
vlslble
compliance costs,' and regulators
bear monitoring
costs. Other costs are not so vlslble.
assoclated with
restrictlons on permissible actlvities that can prevent
economies
regulated
There are costs
of scale and scope from being reaìized, thereby raising the costs of
firms. Restrlctlons on activitles, products, and locatlon decrease
the optlons available to consumers and artificially raise prices by limiting
competi
tlon.
Regulatory barriers
costs
of
of
regulated
to competltion
flrms.
may have
a further subtle effect on the
Protection from competitlon reduces the incentlves
costs. It also reduces the need and
deslre to seek out and adopt lnnovations that could result in lower costs in
regulated flrms to minlmlze current
the future.
There are other costs
of
of regulatlon.
Regulatory rules
limlt
the abillty
regulated firms to take certaln actlons but do not elimlnate management's
deslre to pursue profitable buslness opportunltles. The lure of proflts,
comblned
wlth
changes 1n technology, conduclve economlc
condltlons, and the
-4existence
of
domestic and foreign competitors
subject
to different degrees of
regulation' give regulated flrms
the means, motive, and opportunity
to avoid
existing reguìatory constraints.
Inevitably, regurated financial institutions
will search for substitute ways to engage
in rucrative,
activities'
prohibited
activity is a cosily endeavor. tven if
the end resurt is the ineffrcient
provision of financiar services.
successful,
Regulators are contlnually faced
wlth a dlremma: acquiesce
regulaton to pr ug the roophor es.
The r atter restarts
add more
However, such
or
the cosry cycr e.
In addition to the inevitable costs,
regulailon can have unintended,
perverse
effects.
For exampre, reguratory rimitations
on the abirity of
commerclal banks to diversify,
both geographically and lnto addjtional
lines
of buslness,.were supposed to reduce
the riskiness of banks by limiting
competltlon and preventlng bank
involvement in acilvriles where
rarge rosses
could be lncurred' Astute use
of diversification by banks ,,as presumably
viewed as unllkely' The
huge losses realized by banks wlth
undiversified
portfolios in the 1980s lllustrates
the misguided, unintentional rnpact
of
regulation. Another wet-known exampre
of reguraron with unintended,
perverse effects i s flat-rate
deposlt lnsurance. I wi r r di scuss this
more
fully in a moment.
Regulation' then,
resul
t.
ls costly and cannot be relied on to produce
So what should be done?
flnanclal markets
I
do not
thlnk that
the deslred
government lnvolvement ln
shourd be ended. To be sure,
a
po'ilcar
and ìegar
ls lndlspenslble for assurlng lndivldual llberiles
and property
rights' and for settlng the rules
of the game withln whlch
framework
loan
markets operate.
But detalled regulation should
not be used to guard agarnst the normaì
rrsks
c
of a competitlve marketplace.
Such
decislonmaking, and inevitably
exanp'les are
plentiful
'
dlrect controls adversely affect long-term
hurt those they were intended to help. ïhe
Rai lroads, sheltered by rate-of-return
reguration,
eventually whithered into near-complete
decay. The u.S. steel industry, once
protected from the rest
of the world by a government-guaranteed price
floor,
soon became a world leader
in inefficiency.
The same seems to be
market share
dominated
true for the banking industry.
Banks have rost
to ress regurated competitors in areas that
they had rong
ike commercial lending, consumer instal
lment credit, and retai I
deposits' In addition, the banking industry's
profitability has been falìing
durlng the rgg0s, reaching revers
not seen since
I
rg5g.
I
believe that a safe and'sound financial
system can be attalned at
substantaily rower cost rf we rery
ress on reguration and
a
more on
supervlslon' Thls requlres a sharp reversal
in the attitude of government
authorities' Rather than lmposing unconditional
limlts on the discreilon of
bank management'
or regulatlng their behavior, the authoriiles
should
condltionally cede discretlon to
bank management. That is, the authorities
should
let
regulatlon
bank management manage. A supervisory
approach recognrzes that
ls costly; lt also recognizes that bank management
has the skllls,
informatlon, and incentlve to make
opilmum use of thelr resources, whlle
bank
regulators do not' The amount
of discretion extended to management could vary
across banks, dependrng on a number
of factors, such as the supervrsory
authority's assessment of the quality
of the instituilon,s lnternal controls
and management' the lnstltution's
current and expected financial
evldenced by
lts capltal
strength
and earnings, and the size
to the provislon of the federal safety
net.
of
as
subsldies attrlbutable
The recent debate about
the appropriate response to bank involvement
ln
leveraged buyouts (LBos) lllustrates
the dlstinctfon between these two
approaches' Some people are urglng
that
bank involvement
ln
LBos be regulated
-6-
--
restricted or precluded.
accurately evaluate
These
critics
presume
that
bank management cannot
rlsk.
others argue that bank participation in LBos
can
generate a number of benefits for
banks, firms and the economy. proponents
ò supervisory
approach argue
that
bank management has substantiaì
of
expertise in
evaluating risks and should be free to
take risks commensurate with expected
returns' Happiìy, we have refrained from regulating
LBo lending by banks,
choosing instead to supervise.
The appropriate
role of banking authorities in a world where supervislon
is emphasized is to distill the existing body of regulations
into a compact,
effective set, and to monitor and supervise
the behavior of firms under their
Jurisdiction as unintrusiveìy as posslble. Ideal ly, the
arrangement wouìd
closely resemble bond or loan.covenants
-- private market arrangements:that
are designed to effectively influence management
behavior wlth minlmal
restralnts on thelr dlscretion. The amount
of discretion granted in these
arrangements depends on
Judgments about
thei
r
the capabilities of
management and
resources.
supervisory authorities need timely, accurate
informailon to be able to
identify and close troubled lnstltutlons as
they become insolvent. prudent
use
of closure wlll
ensure
that the costs of
bank
fallures are not
and are borne by unlnsured credltors
and stockholders,
insurance funds or taxpayers. Government
excessive
not transferred to
the
authorities need to ensure that
deposltorles suppry adequate, accurate,
and timery informailon on therr
financlal condrilon not onry to the supervisor,
but arso to the pubrc.
Depositors and creditors wlll have incentives
to more carefully
moni
tor the condl tlon of
supervlsors
choose and
f i nancl
wlll be a vltal
al i nst'ituilons.
Informailon provi ded by
input to these decisions. In turn, lnformailon
generated by markets ln the form
of rates banks need to offer to obtaln funds
from deposltors and credltors,
supervi sory process.
wlll complement the informaHon from the
-7-
The structure
of the bank regulatory
in the u.S. is unique in
number of respects. As you
know, banks can choose to be regurated
or
system
supervised by one or more federal
and state agencies. These agencies
different goals and incentives due to
a
have
differences in theÍr authority and
responsibiìities' For example, a chartering/regulatory
authority has the
i ncenti ve to mai ntai n or i
ncrease i ts consti tuency. To accompì
i sh thl s, they
might offer broader powers or prevent
the closure of insolvent instituilons.
failure of institutions could be interpreted
by some as ineffectiveness on
the part of the government authority.
A deposit insurer has an incen've to
prrotect rts fund; conseguenily,
if abre, it may arso prevent or deray cos¡y
The
fai I ures.
critics
persistenily argued that the murilpre
agency system is
seriously flawed and largely to blame
for cos¡y and lneffective
have
regulation' In particular, it has been
primari
bank
charged
ly responslble for the unwl I I ingness or
that thls structure ls
lnabl I lty
of reguìators to
in hlgher costs for
abillty of banks ln thts system to
promptly close institutlons
that are insolvent, resulilng
the insurance funds and taxpayers. The
alter thelr regulatory status also allegedly
induces,,compeililon in laxlty,,,
where regulators compete for
constituents by relaxlng their standards. The
implicatlon
is that consolldation of regulatory,
supervlsory and lnsurance
functlons lnto fewer, perhaps even
one agency is a deslrable and necessary
change.
I
dlsagree wlth thls
vlew. It is not clear that regulatory consoìlda¡on
would result ln lmproved, less
costly regulailon. Given the lnevltable
lncentlves of the lnsurlng agency
to protect the lnsurance fund, lt would be
parttcularry dangerous to concentrate
the charterrng, reguratory, supervrsory,
and insurlng funcilons ln a slngle
enilty.
-8-
It
has been alleged
failure resolutlon
that closures
would occur more quickly and costs of
if the Federaì Deposit Insurance corporation
(FDIc)' the insurer, arso
had reguratory, supervisory, and cìosure
powers.
Ïhe Federal savings and Loan Insurance
corporation (FSLIC)/Federal Home Loan
Bank Board experfence indicates
that thls is unlikely. ïhe FDIC, like any
insurer' has incentives to maintain
the varue of its insurance fund and
therefore rnight delay closures that would
materially reduce the vaìue of the
fund' Indeed, in the recent past both the FSLIC
and FDIC have been strong
advocates
litigation
wou'ld be lower
of forbearance poilcies. Further, existing
stemming from
recent closure decisions
and threatened
fiike those at First
Republic, MCorp, Gibraltar savlngs,
and Llncoln) indlcate that acilons taken
by regulators to close troubled instltutions
more quickly are viewed by some
as vlolatlons of'the property rlghts
of individuals. Thus, it is not cìear
that the FDIC acting lndependently can resolve
fairures any faster or at less
cos
t.
structure of the regulatory framework would
be less crlilcal ln
world where deposlt insurance dld
not exist or rras perfecily
The
priced.
given mlsprlced deposlt lnsurance
and the attendant need
a
However,
for regulailon, the
multlple regulator system and the abllity
of banks to alter their regulatory
status appears to work reasonably
I
offers a number of advantages over
proposed consolldated alternatlves.
In partlcular, compeiltive pressures can
wel
and
be introduced by havrng more than
one reguratory opton.
Each government
authorrty has a different vrew on the best way
to
implement regurailon due to varrous
incentives, goars, and powers. Because
each regulator's authorrty rs vague
and can overrap, rnter_agency
disagreements can surface about
the approprlate type and extent of supervlslon
and regulatlon and also about
the extent to whlch market dlsclpllne on
regulated flrms shourd be reiled
upon. Thrs encourages hearthy, ongorng
-9-
public debates about the merits of alternative
strategies and contemplated
changes (e'g., the recent debate between
the occ and FDIC about minimum
cap i
tal requ i rements )
.
such a forum may encourage regulatory innovation
and experimentation. ïhe
existence of multipìe regulators and the
conversion option has encouraged
regulatory competition, creating pressure
of particularly
burdensome, obsolete
for regulators to
regulations. For
lessen the impact
exampìe, states are
able and have been willing to expand securities
underwriting powers for
state-chartered' non-member institutions, and this
inevitably puts pressure
other regulators to follow suit.
The system
of
mul
ti pì e authorl ti es offers other benefi
ts.
Muì
on
ti pl e
regulators with overlapping authority might be more
likely to discover
problems within a holdlng company
and prevent problems at one unit from being
transmltted to others. In this way, multiple regulators
could serve as a
useful double-checking device. Another advantage
of the present system of
multiple regulators is that the ìender-of-last-resort
function is not belng
exercl sed by el ther the charteri ng authori
tl es or the i nsuri ng agencl es.
Thi
arrangement, coupìed wlth col
that the dlscount wlndow
llllqutd
lateral requirements, reduces the probabi I ity
wlll be used to support insolvent rather than
banks.
There
is llttle
evldence that,'compeililon 1n laxlty,,has occurred
present multlple regulator system. In
ln
the
fact, historically, banks have not
frequently changed thelr regulatory status.
The multlple regulator framework should
not be abandoned slnce it has a
number of deslrable features. However,
the present structural conflgura¡on
and
distrlbution of
powers and
unchanged' A number
responsibiìiiles
need
not be
left totally
of alternatlve arrangements have been proposed over the
years and mlght work as lrell or better
than the current system. At a mlnimum,
s
_
l0_
there should be more than one agency chartering
and regulating/supervising the
activities of banks' Regulated institutions should be al
lowed to
regulator' Given the inevitable incentives of the insuring
choose
agency
the insurance fund,
Í
jt
would aìso be wise
n both charteri ng and regul ation/supervi
their
to protect
to limit the insurers, involvement
sion. It i s parti cul arìy
dangerous
to vest aìì functions in a single agency. However, it
might be desirable to
allow the insurer to influence the choice of an instìtution,s
supervisor.
Deposit insurance premiums could
seìected by a
differ
dependlng on which supervjsor
was
bank. Supervisors with records of early closure and other
actions that protect the insurance funds would be
associated with lower
premiums. Final]y, it is a good idea
to have the lender_of-last_ resort
function performed by an agency that is not invoìved
in either chartering or
the provl sion of insurance.
To reap the benefits
government
system
of a supervislon-based
authoritles, deposit insurance
of deposit
insurance rras adopted
transactlon and savlngs balances
of
system coupled
wlth mul¡ple
must be reformed. The current
ln 1933.
By guaranteelng the
small deposltors (orlglnally llmlted to
$2,500), deposlt lnsurance removed the incenilves
for
these lndlvlduals to
participate in runs and, consequently, increased
the near-term stablllty of
the financial system. unfortunately, the way federal
deposlt
insurance is
priced and admlnlstered has created governmentaì
subsidization of the risks
undertaken by lnsured banks and thrifts.
These subsidies reinforce
the
perverse incentives
of regulatlon.
of the regulator and regulatee in a controlled
r,rhat's more, deposlt insurance
Jusilfles regulatory
constralnts and contributes to the reguratory diarecilc.
envlronment
-t t-
of frat rate, risk_invariant pricing of deposit
insurance allows risk to be shifted to
the taxpayer. This subsidization of
market risk allows flnancial institutions
to seek out and pursue
The current method
excessively
risky business opportunities. Institutions' partìcipation
in risky ventures
justifies regulators use of regulation to guard
against such instab.i lity.
it is only a matter of time before institutions find ways around
the
constraint, alded by technologicaì change and
apathy toward market rlsk. This
However'
behavior forces the regulator
entlre
to add regulatory constralnts,
renewlng the
process.
Deposit insurance also discourages the government
authority from closing
poorly run' insolvent instltutlons. The
extension of deposit insurance I imits
(currently at $l0o,ooo) comblned
wlth the willingness of the FDIC and FSLIC to
routinely guarantee the deposlts of statutorily
uninsured depositors and other
uninsured clalmants, has caused deposltors
and credltors - big and small to
-
become unconcerned about
of thls
the financlal health
of lnstitutions. l,llthout threat
dtsclpllne, authorlties can choose to push problems off
lnto
the future in hopes that they will heal over
time. Therefore, although some
market
headway can be made
to correct the perverse incentives
its
lmpìementatlon, attention must also be paid
provlded by deposit lnsurance.
due
to regulailon
and
to the perverse incen¡ves
pollcymakers have proposed deposit insurance
premiums that reflect
market risk. r{hile rt rs uncrear whether
risk-based premiums can be
Some
implemented
easlly and efflciently,
it is feasible to alter the system so that
a larger proportlon of deposltors and shareholders
are exposed to a credlble
rlsk of loss' Thls creates lncentives for private
funds suppllers to assist
regulators ln thelr efforts to monltor and
constraln rlsk-taklng by bank
management' Monltoring mlght be more
people wlth funds at rlsk.
If
efflcient
and
effecilve
the deposit lnsurance system
lf
done by
ls altered ln thls
12-
directìon, the need for ancillary reguìatory restrlctions
activitÍes
and corporate organizational form
The recent adoption
of
- for example, on
- is correspondingly
risk-based capital requirements
is
reduced.
an exampìe
of
a
in this direcilon.
A number of changes have been proposed to better align risk incenilves.
one alternative to risk-based deposit insurance premiums would be more
stringent limits on lnsurance and the enforcement of those limits ln
practlce. Another reasonable proposal ls some form of co-lnsurance. Another
posslbllity is higher capital requ'lrements. These types of changes shlft risk
movement
from the lnsurance agency and taxpayers to private indivlduals supplying bank
funds. All of these changes would lncrease market disclpllne by promp¡ng
deposltors, creditors, and shareholders to more closely scrutinize the
financlal .condition of banks.
CONCLUSION
Recent events have ralsed questions about the safety and soundness
flnancial system.
large, extremely cosily
of
the
thrlft fallures
have become comîþnplace ln the 1980s. Additional regulailon is not the
appropriate response. The costs of regulatlon, both expl tcit and impl lclt,
Numerous,
bank and
hlgh. Regulators cannot hope to completely and permanenily constrain the
actions of regulated flrms, partlcularly when competitors are unconstralned.
are
However, glven the
federal safety net that exists,
interventlon ln the affalrs of financial insiltuilons
Supervision
is preferable to regulation.
to market forces.
lnformation to the
ls required.
Supervision appropriately treats
banklng as a business, leavlng bank managers
respond
some government
to pursue nerú opportunf¡es
and
role of the supervlsor should be to provlde
of ftnanclal lnstltutlons and markets and to
The
management
close lnsolvent lnstltutlons promptly. A multlple agency framework, rather
_13_
than a consolldated one,
is
compatible wlth a system
that relies
more heavily
on market forces and supervlsion. And, a multiple agency framework
less likely to foster "competition in ìaxity"
regulation and wlth deposlt insurance reform.
Reform
when
is far
it is combined with less
of deposit lnsurance i s the key. l,llthout
such reform, ìess
reliance on regulation and more reìiance on supervision and
market discipìine
may not be feasible. And without reform, the
conseguences of excesslve
rìsk-taking
will
remaln
wlth the taxpayer.
@FedFRASER