Hindsight and Foresight about Safe and Sound Banking

Robert A Eisenbeis. Economic Review - Federal Reserve Bank of Atlanta. Atlanta: First Quarter 2007. Vol. 92, Iss. 1/2; pg. 124, 5 pgs
Abstract (Summary)
The author reflects briefly on several different issues discussed in the study "Perspectives on Safe and Sound Banking." He focuses on the issues that were probably, in hindsight, overemphasized, those that were perhaps underemphasized, and those that were not fully appreciated but subsequently turned out to be important. A key issue in the finance literature and in the study was the desirability of gearing deposit insurance to risk and using options pricing theory to price that risk appropriately. Over the past twenty years the financial system has evolved in ways that have changed its structure and risk profiles, significantly changing the way that institutions take on risk and control their risk exposures. The author notes several issues that would be appropriate to consider as potential agenda items should a similar study be undertaken in the future. These include: 1. accounting reform, 2. identity theft and privacy issues, 3. shrinking role of intermediaries and the growth of capital markets, 4. consolidation risks, and 5. role of the lender of last resort.
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Copyright Federal Reserve Bank of Atlanta First Quarter 2007
After hearing both the papers prepared for this conference and the discussions that followed the presentations, I want to reflect briefly on several different issues discussed in Perspectives on Safe and Sound Banking. I plan to first focus on the issues that were probably, in hindsight, overemphasized, those that were perhaps underemphasized, and those that were not fully appreciated but subsequently turned out to be important. Finally, I want to raise issues that should be on any agenda for the future.
Issues Overemphasized in the Study
Risk-based deposit insurance. A key issue in the finance literature and in the study was the desirability of gearing deposit insurance to risk and using options pricing theory to price that risk appropriately. While risk-based premiums were adopted in the Federal Deposit Insurance Corporation Improvement Act (FDICIA), implementation has proved to be problematic. Premiums are arguably too low and are collected only from more risky institutions. Beyond this, however, are two issues that limit risk-based pricing as a useful means to control risk taking. The first is the realization that appropriate pricing depends upon not only the ability to measure risk but also to close an institution promptly when it becomes insolvent. Second, effective risk monitoring and control involves a trade-off between the costs of monitoring a bank's risk exposure continually against both the expected costs of that monitoring and expected losses should an institution become insolvent between examinations or inspections.
Revisions to regulatory agency structure and lender of last resort. The report recommended several changes in bank regulatory agency structure, including creating a competing deposit insurance option to be administered by the Office of the Comptroller of the Currency, parceling out lender-of-last-resort administration to the insurance agencies using funds drawn from the Federal Reserve, and taking the Federal Reserve out of the prudential supervision area. It probably is not practical to consider such reforms, given that the United States has still not seen fit to combine depository institution insurance funds, and only the central bank can provide credible lenders-of-last-resort funds. However, two issues are important. First was the suggestion that the insurance funds should have a primary role in banking supervision because they have the strongest incentives to monitor bank risk exposures. In the United States, the Federal Deposit Insurance Corporation (FDIC) is in the first loss position should a failure occur. It also, under FDICIA, is acting as the agent for other banks that stand to lose should FDIC funds be exhausted. Second, this view on supervision stands in stark contrast to how deposit insurance and supervisory responsibilities are apportioned in the European Union, where generally deposit insurers are not involved in supervision.
Issues Underemphasized in the Study
Prompt corrective action. While the study did argue that institutions should be closed via a prompt corrective action (PCA) scheme before net worth fell to zero, the importance of PCA combined with structured early intervention and resolution (SEIR)-a concept that evolved later-as perhaps the best way to protect taxpayer interests was not fully realized. These concepts and their link to banking soundness have proved important not only in the United States, where they have been codified under FDICIA, but also as a framework for dealing with supervision and prudential soundness issues in a cross-border banking world.
Accounting issues. The report argued for market-value accounting, which, when combined with PCA and SEIR, is necessary to protect the taxpayer from the costs of regulatory forbearance. The importance of market-value accounting, or at least the need to calculate the market value of banks' equity, has yet to gain much traction in regulatory circles. Much attention has been given to the problem of implementing market-value accounting. But more focus has been directed to capital adequacy, which turns out to be diverting the attention of regulatory agencies from the fundamental problems of measuring net worth. Putting the valuation issue front and center, especially in a global environment with more and more derivatives and other exotic financial assets coming together, looms as the critically important-but as yet unrecognized-problem for banking supervisors.
Controlling regulatory incentives. One of the key problems in the past has been the tendency of regulatory and supervisory agencies to engage in forbearance toward troubled institutions. FDICIA requires the FDIC to minimize failure costs to taxpayers and requires disclosure and explanations when losses do occur. However, banking regulators-with differing mixes of goals and responsibilities-can still be faced with conflicts of interest and agency problems, which can sometime lead to less-than-optimal decisions in dealing with troubled institutions. Indeed, Eisenbeis and Wall (2002) have shown that many institutions are still closed with losses to the insurance fund, suggesting that PCA is not always having its desired outcome. Kane, for example, has devoted considerable attention to controlling regulatory incentives, which remains a problem both in the United States and abroad (see Hovakimian, Kane, and Laeven 2003; Kane 1988, 1989, 1991, 2000, 2003, 2006).
Consolidated risk management. The report argued that regulatory approaches that attempted to separate risk taking within a bank holding company structure- either to protect bank subsidiaries from risk taking in sister banks or from risks in non-banking subsidiaries-were fruitless. Subsequent developments show that increasingly banking organizations are consolidating risk management and operations functions so that subsidiaries and affiliates are not operationally independent of each other. This trend suggests that the report's conclusion about how conceptually to approach the supervision of complex institutions rings truer today than ever and should be an important focus of banking supervision and risk control going forward.
Underappreciated Issues
Over the past twenty years the financial system has evolved in ways that have changed its structure and risk profiles, significantly changing the way that institutions take on risk and control their risk exposures. Three such developments were underappreciated by authors at the time in terms of either the speed or significance with which they might affect bank safety and soundness. The first was the removal of McFadden Act restrictions on interstate banking and the speed and manner in which the banking system structure changed. Within a few short years, bank mergers significantly reduced the number of banking organizations, increased the size of the largest institutions, and concentrated their headquarters, principally in New York and Charlotte, North Carolina. The events of 9/11 in particular exposed the potential vulnerability of such concentration and the risks to a smooth functioning of our financial markets should one or more large institution experience financial difficulties.
The second underappreciated development was the spread of computer-related technologies in combination with the explosion of intellectual technologies in the form of financial engineering. This development radically changed both institutions' risk profiles and their ability to evolve and price assets and liabilities that had previously been provided only in bundled form or not at all. The resulting decoupling of the apparent risks-through the use of new derivative instruments-associated with given assets and liabilities traditionally inferred by looking at balance-sheet measures or direct inspections via the examination process no longer necessarily reflects an institution's true riskiness.
The third development was the growth and expansion of truly global institutions, which now suggest that the origins of risk and vulnerabilities are not only more complex but may oftentimes be more associated with developments in other parts of the world rather than in domestic markets. As a result, better communication, coordination, and sharing of information with non-U.S. regulators are now a necessity. Effective PCA and SEIR procedures to close institutions before net worth becomes negative combined with bankruptcy procedures that empower regulators to close institutions and resolve them promptly hold the greatest promise to limit systemic risk problems and to control financial crises.
Concluding Remarks and Some Key Issues for the Future
Having reflected upon the study and the papers prepared for the conference, I note several issues that would be appropriate to consider as potential agenda items should a similar study be undertaken in the future. The following is a brief list of concerns, in no particular order of importance.
Accounting reform. As mentioned earlier, the key to risk monitoring and control is effective valuation of net worth, which requires not only the ability to value assets and liabilities but also to appropriately consider the interactions among subsidiaries and affiliates within complex organizations and to understand the implications for valuation posed by new derivative instruments and contingent liabilities.
Identity theft and privacy issues. As financial markets become more global and dependent upon electronic transactions, the speed with which funds can be withdrawn from individuals' accounts and from entire banking entities is accelerated. Finding ways to both verify and protect individuals' identities is crucial to ensuring confidence in electronic payments media. There may be an important role for regulators in this sphere that has yet gone unexplored.
Shrinking role of intermediaries and the growth of capital markets. Many countries are now producing financial stability reports, and increasingly these reports are focusing on the risks and implications of potential systemic problems emanating from financial markets rather than from financial institutions. This concern is a natural reflection of the growing role that capital markets play in financial intermediation relative to financial institutions. Attention now needs to turn to what role regulators and central banks may need to play in dealing with such risks as well as the need to better understand cross market and cross-institution linkages that arise from the trading of instruments, such as derivatives, which now separate out some of the risks that typically had been embedded in financial instruments and loans.
PCA and SEIR as ways to enhance Basel I and Basel II initiatives. Present Basel I and Basel II initiatives have concentrated on the definition and measurement of capital for regulatory purposes and ways to employ them to limit bank risk taking. The benefit of this exercise has been that institutions are now more systematic and concerned about their internal risk measurement schemes and capital allocation methods. Going forward, attention should be given to how to deal with troubled institutions as their capital positions deteriorate and the role that PCA and SEIR might play to limit the negative spillover effects of failure and to better protect the taxpayer from potential liability should major institutions fail and exhaust their deposit insurance funds.
Consolidation risks. The relaxation of interstate banking restrictions and the resulting consolidation of the banking industry has resulted in more concentration in U.S. banking, with most of the nation's largest organizations headquartered in either New York or Charlotte. Should one of these large institutions experience financial difficulty, not only would the prompt resolution of such an institution be extremely difficult, but also the potential drain on the FDIC fund could be enormous because of the large size of these mega-institutions. Additionally, the experience of 9/11 has shown that certain events can actually close down U.S. financial markets and institutions. The concentration of our largest institutions reduces the geographic diversification that our banking system once had. So close attention now needs to be paid to how regulators and the Federal Reserve would respond to a similar event and how we can best ensure that our markets and institutions are robust.
Role of the lender of last resort. As risks to the smooth functioning of the financial system and markets are increasingly likely to be associated with liquidity problems or shocks to particular capital and instrument markets rather than to risks coming from banking organizations, additional consideration should be given to what role, if any, the Federal Reserve should play as lender of last resort in limiting the spread of these risks. In particular, what channels should be employed to provide liquidity? To whom should this liquidity be available? Would basic open market operations be sufficient to cushion markets? What role should central banks generally play in dealing with market liquidity shocks that are transnational in origin?
Cross-border banking. Cross-border banking is growing, and U.S. banking organizations are playing an increasingly important role in the financial systems and markets of other countries. At the same time, most of the world's largest banks are now conducting significant operations in the United States. As a result, these institutions are now faced with myriad different regulatory regimes, regulators are increasingly dependent upon their counterparts in other countries for information, and the failure of such institutions will have spillover effects in not only their domestic economies but perhaps even greater implications for financial systems that are hosting them (see Eisenbeis 2006; Eisenbeis and Kaufman 2005, 2006). Regulators need a better understanding of how to measure and monitor the risks that these institutions pose as well as to seek ways to harmonize their legal, bankruptcy, regulatory, and supervisory regimes.