Banking and Finance Law Daily Wrap Up, FINANCIAL STABILITY—Disclosure of more regulatory information could advance financial stability regulations, Plosser says, (Apr 9, 2014)

By Richard A. Roth, J.D.

Market discipline is a powerful tool for controlling financial institutions’ risk taking, and it can become more useful as the markets have access to more information, according to Philadelphia Federal Reserve Bank President and CEO Charles I. Plosser. In remarks prepared for a conference titled “Enhancing Prudential Standards in Financial Regulations,” Plosser raises the idea of making regulatory information that currently is confidential available to the markets so that risks could be better assessed and market discipline strengthened.

Plosser lays out three principles he believes should be considered as part of efforts to make prudential regulation more effective: simplicity, transparency, and market discipline.

Simplicity. Plosser warns against excessively complex regulations, asserting that they can increase instability rather than reduce it. “[M]arkets often evolve faster than the regulations,” he says, forcing detailed revisions to complex regulations that otherwise would become obsolete.

Complex regulations can lead to complex financial structures that are designed to evade those regulations, Plosser says. This can result in increasingly complex regulatory responses, which in turn give rise to even more complex financial structures. The result is increasing compliance and enforcement costs.

As an example, Plosser points to the effort to impose capital requirements based on the risk arising from a financial institution’s assets. While this may seem like a good course in principle, in practice it could induce institutions to structure assets in ways that appear to reduce risk and thus are not properly accounted for.

Basing capital requirements on an institution’s leverage ratio could reduce both compliance and enforcement costs while advancing financial stability at least as well as risk-weighting, Plosser claims.

“Increased regulatory complexity can make consistent enforcement of the rules more difficult,” Plosser also says. Simpler rules are easier for institutions to follow and easier for supervisors to enforce, which increases the likelihood that those rules will be effective.

Transparency. Information about the structure and the risk of a financial institution and that institution’s investments helps the markets price that risk more appropriately, according to Plosser. This function could be enhanced by making regulatory information more available, he proposes.

Plosser notes that the federal prudential regulatory agencies acquire detailed information on how institutions assess and manage risk. They also use “a host of sophisticated models and techniques” to assess risks. Increased public disclosure of information about an institution’s condition and risk, and of regulators’ supervisory assessments of the institution, would enhance the market’s ability to price the risk of dealing with that institution, Plosser believes.

Increased transparency about supervisors’ activities also would give financial institutions more certainty when making business decisions, Plosser adds.

Market discipline. Transparency is a necessary part of market discipline, Plosser continues, as it enables the markets to price risk more accurately. More effective regulations will take advantage of market discipline, not attempt to replace it. It would be better if the rules give the markets an incentive to monitor risk than if the rules lead the markets to believe regulators have done so.

Requiring financial institutions to issue either subordinated debt or contingent debt would use market forces to promote stability, Plosser says. Owners of subordinated debt would be the last to be paid if an institution failed, and that would give them an incentive to monitor the institution’s risk. Plosser prefers contingent debt that would be converted to capital if the institution was under stress, since that would work to prevent a failure.

Markets also can provide information that supports supervisory activities, he points out. Regulators could monitor changes in a bank’s subordinated debt or credit default swap spreads for indications the market sees increased risk. The Federal Reserve Board has proposed using such market information as a threshold that would trigger early remediation requirements, Plosser notes.

Too big to fail. Market discipline cannot be relied on if the market believes an institution is too big to fail, Plosser says. Whether the money to bail out a failing institution comes from the government or from some other source is irrelevant, he asserts, so taxing large institutions to create a resolution fund would not solve the problem.

According to Plosser, the Federal Deposit Insurance Corporation’s new authority to resolve the largest, most interconnected institutions will not end the too-big-to-fail problem. The FDIC’s resolution authority is perceived as being too subject to political pressure, he charges. Plosser advocates the creation of a new bankruptcy code chapter tailored specifically to the circumstances of financial institutions.

RegulatoryActivity: DoddFrankAct FederalReserveSystem FinancialStability Receiverships