Bank regulation would be cheaper and more effective if it were augmented by the forces of market discipline, said Gary H. Stern, the president of the Federal Reserve Bank of Minneapolis President, on Wednesday.

Market-based assessments of a bank's soundness should be built into the current regulatory structure, Mr. Stern said in a speech sponsored by the American Enterprise Institute. "I think it is irresponsible not to do so as a matter of public policy, because of considerations both of effectiveness and of resources."

Mr. Stern advocated developing "credible market signals of bank riskiness" by requiring large banks to issue subordinated debt or enter into co-insurance or re-insurance agreements. "The idea underpinning all of these is to give creditors ... the incentive to pay attention to the caliber of the institutions with which they are doing business," Mr. Stern said.

The levels of interest or premiums demanded by a bank's counterparties would indicate the market's assessment of the institution's soundness, he said.

Those signals could then be incorporated in the regulatory structure, he said. For example, a bank's failure to maintain a specified credit rating could require regulators to take corrective action, or could trigger an increase in the bank's deposit insurance premiums. Another possibility, he said, would be to prevent banks with deficient ratings from entering new areas of business. -- Rob Garver

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