Disincentives to Risk-Taking Called Key to Deposit Reform

SAN FRANCISCO - Overcoming imbalances of risk in the deposit-insurance and payment systems would strengthen the nation's financial structure, according to Robert T. Parry, president of the Federal Reserve Bank of San Francisco.

"Excessive risk-taking is arguably the major source of the problems plaguing the [banking] industry today," Mr. Parry said. He noted that one of the most important elements of bank reform is reducing banks' incentives to take on excessive risk.

He said the current deposit insurance system is linked to this excessive risk-taking by creating a "moral hazard," whereby weak banks have little to lose and, potentially, much to gain by taking excessive risks with their fully insured deposits.

|Weakened Market Discipline'

"Unfortunately, our current system, by protecting nearly all deposits, has weakened market discipline," Mr. Parry said in a speech last week to the Visa International annual meeting.

The regional Fed president said the U.S. Treasury's current bank reform proposal recognizes that capital requirements play an important role in controlling the moral hazard problem and that market discipline needs to be enhanced to prompt corrective action when a bank's capital becomes deficient.

"I'm very sympathetic with the aims of the proposal," he stated. "But I don't think the measures go far enough" because too much latitude is left for regulatory forbearance in allowing large institutions with weak capital positions to remain open.

Making the Treasury Pay

"I'd make it more difficult to decide a bank is too big too fail, possibly by making the Treasury itself, rather than the Federal Deposit Insurance Corp., bear the cost of saving the bank," Mr. Parry said.

He added that if it were not for Federal Reserve controls, there could be a moral hazard problem on the Fed Wire, the large-dollar electronic funds transfer system managed by the central bank.

Since banks can overdraw their accounts at the Fed without incurring any interest expense, and the Fed's guarantee of Fed Wire payments shields the receivers of such credits from the risk of default by the sender, banks may have little incentive to avoid creating these daylight overdrafts.

Currently, the Fed controls some of the risk associated with daylight overdrafts through self-determined "caps" and by prohibiting overdrafts for problem institutions.

Overdraft Pricing

Mr. Parry stated that banks would have a stronger incentive to avoid overdrafts if they were priced. "Pricing of overdrafts would be even more effective because it would introduce a more sensitive incentive structure," he said, adding that the Fed has proposed a phased implementation of overdraft pricing possibly as soon as 1992.

"Pricing would directly link increased overdrafts to increased costs for banks," he said.

Mr. Parry cited the New York Clearing House Interbank Payments System, or CHIPS, as an example of a large-dollar system in the private sector that uses self-regulation and a loss-sharing formula to help control risk.

Each CHIPS member sets individual limits on the net payments that it will accept from each other member. If a member defaults, the loss is covered according to a formula based on the credit limits.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.