For release: Oct. 11, 2001
Contact: Charles B. Henderson, (314) 444-8311

Market Discipline: The Third Pillar of Banking Supervision?

ST. LOUIS -- When Fed Chairman Alan Greenspan uses the phrase "market discipline" in the context of supervising banks, some people think in terms of the savings & loan crisis of the 1980s in other words, the market can't be trusted to contain risk. An analysis of the concept by three economists at the Federal Reserve Bank of St. Louis, however, demonstrates how market discipline may become an additional tool by regulators to enhance the safety and soundness of banks.

The economists, William R. Emmons, R. Alton Gilbert and Mark D. Vaughan, analyzed market discipline for the October issue of The Regional Economist, the St. Louis Fed's quarterly journal of business and economic subjects.

Traditionally, banking supervisors have contained risk with supervisory Reviews and capital requirements. The Reviews include both on-site and off-site surveillance. Capital requirements direct each bank to keep the owner's stake in the enterprise above a minimum level so he or she will keep a watchful eye on the business and not be tempted to take inappropriate risks with insured deposits.

These tools, however, have had problems. Capital requirements, for example, created four different risk categories for assets. Problems arose because assets inside each category were not equally risky. As a result, banks with relatively safe commercial loans had to hold the same amount of capital as banks with relatively risky commercial loans. Also, some large banks tried to "game" the requirements by investing in the riskiest assets in each category, thereby increasing their risk without having to increase capital.

Emmons, Gilbert and Vaughan also noted that the swift pace of change in the financial industry convinced some bank supervisors that any capital standard, no matter how frequently updated, will always lag behind current practices.

Under recently developed proposals known as the New Basel Capital Accord, Emmons, Gilbert and Vaughan believe financial market discipline should enhance traditional supervision in four ways:

1. Financial markets should supplement supervisory assessments of bank risk. "Investors and analysts face powerful incentives to price risk correctly, because careers and fortunes are at stake with every transaction," they said.
2. Financial markets penalize risk more incrementally than bank supervisors, "adding a basis point here or subtracting a basis point there when risk premiums need tweaking."
3. Financial markets update their risk assessments more frequently than bank supervisors. "The prices of bank securities change every day, whereas most examinations take place in 12-to-18 month intervals, and fresh surveillance reports come out at quarterly intervals."
4. Financial markets should help insulate supervision from politics. It will be more difficult for politicians to pressure supervisors to overlook risky practices as was done during the savings-and-loan debacle of the 1980s if the financial markets are sending up "warning flares."

The economists emphasized that three conditions must hold, however, before market

discipline can complement supervisory Reviews effectively:

1. Holders of bank debt, such as private investors or mutual funds, must price bank risk.
2. Bank debt holders must believe that the federal government will not bail them out if failure occurs.
3. Either bank management or banking supervisors must respond to risk signals sent by bank debt holders.

A potential key to establishing market discpline, they argued, is for banks to issue a standardized form of subordinated debt. This debt would offer interest payments over time and principal at maturity, but the debt holders would be last in line to get reimbursed if the bank fails. "Facing the full brunt of losses should the bank fail gives the holders of subordinated debt strong incentives to police risk," said Emmons, Gilbert and Vaughan.

They admitted that the proposals for mandatory subordinated debt focus primarily on large banks, because these institutions account for a large share of total banking assets and are more complex than smaller banks. For example, 93 percent of large banking organizations (those whose total assets exceed $1 billion) own non-bank subsidiaries, while only 33 percent of small banks control non-bank subsidiaries. At the same time, the notional value of derivatives securities at large organizations averages about 700 percent of assets. The comparable figure for small organizations is less than 1 percent.

Emmons, Gilbert and Vaughan said that even if regulators reach a consensus on the details of incorporating market discipline into the supervisory process, a number of training hurdles will remain. Banking supervisors will have learn to read market signals, for example, learning to distinguish between movements unrelated to bank condition and movements that alert them to a potential safety-and-soundness issue.

They concluded that harnessing market forces as a third pillar of supervision demands that banking examiners, as well as the public, will have to learn a new way of thinking.

"Perhaps," they said, "the public will have to get used to hearing the words 'market' and 'government supervision' in the same breath."

Subscriptions to The Regional Economist are free and can be obtained by calling (314) 444-8809.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. In addition to serving as a bank for depository institutions and the U.S. government, each Reserve Bank monitors economic conditions in the District, participates in formulating monetary policy, and supervises state-chartered member banks and bank holding companies to foster safety and soundness of the District's banking and financial institutions and to protect the credit rights of consumers.

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