Market Discipline Can Reduce the Cost of Future Crises
Randal Quarles is expected to be nominated as the first Federal Reserve Vice Chairman for Supervision, a post created (but never filled) under section 1108 of the 2010 Dodd Frank Act. Until recently, the functions of that post had arguably been fulfilled by now former Federal Reserve Board Governor Daniel Tarullo. With the change, perhaps going forward the policy debate concerning federal regulation of the banking system can turn to restoring market discipline and reducing the cost of future crises. How do market discipline and the cost of crises relate?
As Professor Eugene White pointed out in a recent study, we had market discipline when banks were subject to contingent liability, such as double, triple and even unlimited liability. Bankers had incentives to liquidate their troubled bank early rather than face the threat of losing their initial investment and being asked to pay even more to creditors and depositors. [Banks were also more capitalized, and these were not the risk-weighted measures we find in the current regulations.] By way of contrast, Professors Larry J. White and Rebel Cole have recently showed how, in spite of attempts to address ongoing problems associated with regulatory discretion through the Federal Deposit Insurance Corporation Improvement Act of 1991, prompt and corrective action still results in delayed closure of weak banks.
Eugene White estimates that the cost of bank failures during the entire 1865–1913 pre-Federal Reserve period was only about $1 billion in 2009 dollars; and that was during a time when banks were already fragile because state laws and regulations prohibited interstate banking and even branching. The Great Depression from 1929–1933, according to one estimate he provides, cost $39 billion in 2009 dollars. The S&L Crisis cost $200 billion in 2009 dollars. By his estimates, the 2008–2009 crisis cost $1.7 trillion, a very conservative estimate compared to the $6-$14 trillion estimate that Governor Tarullo offered in his thoughtful, brief retrospective of what went wrong during the recent crisis.
Irrespective of the estimate, one thing is clear: we have relied more on regulatory discretion during the last three crises than we did before, and the cost of each subsequent crisis has ratcheted upward. As I have recently written, the rise in costs coincided with the move toward bank holding companies and away from market discipline. Along with the rise in costs have come more regulatory discretion and complex mandates. After the last crisis, the official response has focused on ensuring financial institutions have adequate capital and liquidity, that they manage risks well, and that taxpayers see an end to Too-Big-to-Fail.
If anything, however, capital requirements are too complex. Bank of England Chief Economist Andrew Haldane made this point several years ago in a still relevant speech. James R. Barth, the Lowder Eminent Scholar in Finance at Auburn University, and I have showed just how complex U.S. capital requirements have become under Basel capital adequacy standards.
The liquidity coverage ratio was put in place to ensure that banks hold safe, liquid assets. Of course, many people (including regulators) thought highly rated collateralized debt obligations and private label mortgage backed securities were safe and liquid prior to the crisis. A 2012 study put out by the Federal Reserve Bank of Philadelphia showed just how not true that turned out to be. Moreover, the theory behind liquidity requirements is still being worked out. The net stable funding ratio aims to close the maturity mismatch facing banks, considering the longer-term nature of their assets and shorter-term nature of their liabilities. Yet if capital in the form of equity and/or long-term bonds, were measured at market value, a higher capital ratio could introduce market discipline.
In spite of lawmakers’ and regulators’ best efforts, financial crises, while less frequent, have become more severe and the costs of each subsequent crisis have skyrocketed relative to its predecessor. As we go forward, hopefully efforts to reform the financial regulatory system will emphasize market discipline even more than we have in the recent past. Market measures of capital and/or contingent liability can ensure investors in financial firms, rather than tax-payers, face the consequences of their risk-taking.
