The banking business is changing so quickly that regulators can't effectively supervise the riskiest institutions, Kansas City Federal Reserve Bank president Thomas M. Hoenig warned Friday.
The future may see banks involved in complex derivatives forfeit access to deposit insurance and the central bank's discount window. In return, these institutions could operate with much less government interference.
"It may have come time to sever the link between these institutions and the safety nets, making it possible to significantly scale back bank regulatory oversight of their operations," Mr. Hoenig told the World Economic Forum in Switzerland.
Regulators, freed from their job of protecting the deposit insurance fund, no longer would feel compelled to heap scores of new restrictions on banks, he said.
In his wide-ranging speech on the future of bank regulation, Mr. Hoenig said this new regulatory setup would give bankers freedom to invest in whatever type of financial instruments they preferred. But, it also would mean that regulators would let the bank fail if the investments turned sour.
The new systems also would benefit regulators, who are finding it difficult to understand the complex instruments and risk-management models banks are developing, Mr. Hoenig said.
"This difficulty is not meant as a criticism," he said. "Rather, the point is that the private sector has significantly more resources, both human and financial, than the regulators for keeping pace with changes in the financial markets."
Barings Bank and Daiwa Bank demonstrate just how hard it is for examiners to prevent massive bank losses. Their only hope of stopping these banks from losing billions of dollars was to understand every facet of their operations, he said. It's unreasonable to expect regulators to know this much detail about every major institution, he said.
The agencies would leave existing regulations in place for traditional institutions that qualify for the safety net, he said. This would include the vast majority of banks, whose main business is lending money.
Banks that want to innovate should do so with their own money, he said. They either could sell or insulate their traditional banking businesses, he said. The rest of the institution could invest however it saw fit.
Regulators would take several steps to prevent a failure from causing a financial panic, he said. For example, they would require banks to post collateral on some deals and pay higher interest on short-term, interbank credit.
"Individual institutions could be permitted to fail because financial stability would be less threatened," he said. "At the same time, the cost of protecting the safety nets would be better confined because traditional regulation would focus on traditional banks that chose to have access to the safety nets."