The push for market-based supervision of banks received a big boost last week from two top Federal Reserve officials.
Fed Governor Laurence H. Meyer on Friday outlined how the government could use subordinated debt and revised capital rules to reduce the need for regulation. A day earlier, Federal Reserve Bank of Richmond President J. Alfred Broaddus Jr. advocated more market-driven approaches to deposit insurance.
The officials' comments build upon proposals made early this year by the Bankers Roundtable and the Federal Reserve Bank of Minneapolis to limit the federal safety net and enable market-based supervision.
"The more effective is market discipline and the more effective are capital standards, the less there is a need to invoke the more intrusive and burdensome components of the regulatory portfolio," Mr. Meyer said at the University of Tennessee, Knoxville.
Mr. Meyer laid out one of the most comprehensive plans to date by a regulator to use subordinated debt as a substitute for some safety-and- soundness regulation.
He proposed that "large, internationally active banks" be required to issue a minimum amount of subordinated debt to investors. The price paid on the debt would depend on the market's evaluation of the bank's investment strategy. Because debtholders would lose their investment if the bank failed, they would closely monitor its activities, much like the Federal Deposit Insurance Corp. currently monitors banks on behalf of the insurance funds.
"Observed risk premiums on subordinated debt could perhaps be used to help the FDIC set more accurate risk-based deposit insurance premiums, and such debt would provide an extra cushion of protection for taxpayers," he said.
Also, sudden spikes in the price of a bank's subordinated debt could serve as an "early warning" to regulators that the bank was encountering financial trouble, Mr. Meyer said.
Mr. Meyer said he would oppose requiring midsize and small banks to issue subordinated debt, saying that these institutions generally are not involved in complex financial deals and that their failure would be unlikely to cause systemic troubles.
Still, the Fed governor said the program may be tough to implement because the market for subordinated debt is quite small. "This suggests that the development of an operationally feasible market for mandatory subordinated debt would require a considerable amount of careful thought," he said. "Still, in my judgment, it is thought that might prove very worthwhile."
Mr. Meyer also advocated an overhaul of the Basel capital rules, calling it a "very high priority" that must be put on the "fast track."
Of particular concern is loan securitizations, he said. The capital rules were created when banks kept most loans on their books, he noted. Today, however, banks sell the best loans and book the more risky assets. As a result, "one-size fits all" capital rules no longer make sense, he said. Regulators need new rules that tailor capital requirements to the riskiness of a bank's portfolio, he said.
Finally, he urged lawmakers to enact financial reform legislation that eliminates the barriers between the banking, securities, and insurance industries, restricts bank operating subsidiaries, bars affiliations with commercial firms, and appoints the Fed as the umbrella supervisor of financial companies.
"Working together, the markets, the political process, and the regulators can ensure that we take advantage of the new opportunities while maintaining the safety and soundness of our banking system," he said.
Mr. Meyer spoke a day after the Richmond Fed's Mr. Broaddus told his local chamber of commerce that the recent megamergers have exacerbated the "too big to fail" problem.
The worry is that very large banks will engage in risky activities because they know the government will bail them out rather than risk a financial crisis by allowing them to fail.
"The current merger wave has intensified the need for a fresh review of the safety net-specifically the breadth of deposit insurance coverage-with an eye to reform," he said.
In an interview Friday, Mr. Broaddus supported the Minneapolis Fed's approach to limiting "too big to fail". Under this plan, the government would require depositors with more than $100,000 at a bank to suffer at least some loss if the institution fails. It also would require banks to issue a small amount of subordinated debt so the FDIC could use market prices to set insurance premiums.
"I'm not suggesting we eliminate the safety net," he said. "But we want to reduce the risk associated with it. To the extent that markets can be used effectively and efficiently to achieve that goal, we want to move in that direction."