Fed Regional Presidents Criticize Treasury Reform Plan for Not Addressing Too Big to Fail

While acknowledging that financial regulation reform is needed now, two regional Federal Reserve Bank presidents said that the Treasury legislative reform proposal fails to come to grips with the doctrine of too big to fail (TBTF). They believe that any reform legislation that fails to properly address TBTF will leave the financial system considerably more vulnerable in facing future bouts of market instability. In recent remarks, Minneapolis Fed chief Gary Stern called the Treasury’s proposal "status quo plus." While the Treasury plan envisions more capital, more liquidity, better regulation, and a far-reaching resolution authority for the largest financial institutions, noted Mr. Stern, these steps will not succeed in reining in TBTF effectively over time because they do not change the incentives which created the problem. In fact, he continued, there is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss. Instead, he urged implementation of systemic focused supervision.

Echoing these sentiments, Dallas Fed President Richard Fisher said that that, unless the Treasury plan focuses on incentives, the legislation will not only fail to address what he called ``this most troublesome pathology’’ but may make it worse. As policy makers grapple with the too big to fail doctrine and with the overall regulatory treatment of the proposed systemically risky Tier 1 financial institutions, said Mr. Fisher, they must create a system that marries risk taking to consequences and make sure that the consequences for mismanagement are loss of managerial positions and the capital of shareholders and creditors, including uninsured depositors, rather than a second chance that only further concentrates financial power.

According to Gary Stern, the too big to fail doctrine has been a severe and growing problem for some time. It was not addressed effectively by the FDICIA legislation of 1991, and eventually and inevitably led to excessive risk-taking and turmoil in the financial markets. In his opinion, the doctrine became a self-fulfilling prophecy in that creditors of complex financial institutions expected, on an understanding of policymakers' motivations, protection if failure threatened. As a consequence, they had little incentive to be concerned about the condition and prospects of these large institutions, leading to under pricing of risk taking in the market. With risk under priced, these institutions took on excessive amounts of risk, leading eventually to the precarious position of some of them. And policymakers, fearing massive, negative spillover effects to other institutions and the financial markets more generally, provided protection, thereby validating creditor expectations.

Just as incentives were at the heart of the TBTF problem, reasoned the Minneapolis Fed official, they necessarily must be at the heart of the solution. That is, any proposal which purports to correct TBTF must address the incentives which lead to the problem. He advocated systemic focused supervision which, unlike conventional regulation, focuses on reduction of spillovers. It consists of three pillars. The first two, early identification and enhanced prompt corrective action, seek to increase market discipline by reducing the motivation policymakers have for protecting creditors. But creditors will not know about efforts to limit spillovers, and will not limit risk and their exposures unless the contours of systemic focused supervision are revealed to them. Thus, communication is the third pillar of the regime.

Early identification is a process to identify and to respond to the material exposures among large financial institutions and between those institutions and capital markets. Enhanced prompt corrective action works by requiring regulators to take specified actions against a firm if its capital falls below specified triggers. One of its principal virtues is that it relies upon rules rather than a regulator’s discretion. Thus, according to Mr. Stern, this regime offers an important tool to manage systemic risk. But more than just limiting systemic risk, the plan takes the next step of directly trying to address TBTF by putting creditors at risk of loss. If we do not do this, he warned, we will not limit TBTF.

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