JOB - Hindsight and Foresight about Safe and Sound Banking

Introduction
This paper → "Perspectives on Safe and Sound Banking."
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
Risk-based premiums were adopted → in the Federal Deposit Insurance Corporation Improvement Act (FDICIA) → Premiums are arguably too low and are collected only from more risky institutions
Two issues that limit risk-based pricing as a useful means to control risk taking.
First → 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
Revisions to regulatory agency structure and lender of last resort
The report recommended several changes in bank regulatory agency structure
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
Taking the Federal Reserve out of the prudential supervision area
Two issues are important.
First → suggestion that the insurance funds should have a primary role in banking supervision → because they have the strongest incentives to monitor bank risk exposures.
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 (PCA)
PCA combined with Structured Early Intervention and Resolution (SEIR) → perhaps the best way to protect taxpayer interests → was not fully realized
Accounting issues
Report argued for market-value accounting → when combined with PCA and SEIR → is necessary to protect the taxpayer from the costs of regulatory forbearance
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
Controlling regulatory incentives
One of the key problems in the past → 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
Consolidated risk management
Regulatory approaches → 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
Increasingly banking organizations are consolidating risk management and operations functions → subsidiaries and affiliates are not operationally independent of each other → supervision of complex institutions rings truer today than ever → should be an important focus of banking supervision → risk control going forward
Underappreciated Issues
Financial system → evolved → 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
First → removal of McFadden Act restrictions on interstate banking and the speed and manner in which the banking system structure → changed
Bank mergers significantly reduced the number of banking organizations
Increased the size of the largest institutions
Concentrated their headquarters especially in New York
Second → The spread of computer-related technologies in combination with → explosion of intellectual technologies in the form of financial engineering → This development radically changed both institutions' risk profiles → their ability to evolve → and price assets and liabilities that had previously been provided only in bundled form or not at all
Third → 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
Concluding Remarks and Some Key Issues for the Future
→ Several issues that would be appropriate to consider → as potential agenda items → should a similar study be undertaken in the future
Accounting reform
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
Finding ways to both → verify and protect individuals' identities → 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
Attention now needs to turn → 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
Basel I and Basel II initiatives → the definition and measurement of capital for regulatory purposes → and ways to employ them to limit bank risk taking.
The benefit of this exercise → institutions are now more systematic and concerned about their internal risk measurement schemes and capital allocation methods
Going forward → role that PCA and SEIR → limit the negative spillover effects of failure → and to better protect the taxpayer from potential liability
Consolidation risks
Relaxation of interstate banking restrictions → and the resulting consolidation of the banking industry → resulted in more concentration in U.S. banking → most largest nation's organizations headquartered in → 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
Role of the lender of last resort
Risks → of the financial system and markets are increasing → with liquidity problems → risks coming from banking organizations → Federal Reserve should play as lender of last resort in → limiting the spread of these risks
Cross-border banking
U.S. banking organizations are playing an increasingly important role in the financial systems and global markets + world's largest banks are now conducting significant operations in the United States =
these institutions are now faced with myriad different regulatory regimes
regulators are increasingly dependent upon their counterparts in other countries for information
failure of such institutions will have spillover effects in not only their domestic economies