FDIC Chairman Says Critical Financial Reforms Needed

In remarks to the International Institute of Finance, FDIC Chairman Sheila Bair cited the need for critical financial reforms that combine stronger regulation and market discipline.   Ms. Bair stated that the “first task” should be to scrap the “too big to fail” doctrine by establishing a new resolution mechanism to handle the failure of large financial institutions without cost to the taxpayers.

Critical Reforms Needed

Critical reforms needed according to Ms. Bair include the following:

We need macro-prudential reforms so that firms that pose systemic risks hold larger capital and liquidity cushions.

We need disincentives for unbridled growth and complexity that raise systemic concerns.

We must appropriately ensure that off-balance-sheet assets and conduits count as on-balance-sheet risks. These necessary structural changes should also include, among others,

• An end to compensation structures that reward excessive risk taking
• Expanded capital requirements for high risk activities
• Shifting higher risk activities out of insured banks to clearly separate holding company subsidiaries
• Rules for maintaining stable liquidity
• Limits on leverage
• Minimum securitization requirements
• Better oversight of derivatives, and
• Reform of the rating agencies.

To assure better monitoring and avoidance of macro-prudential systemic risks, a council of national regulatory agencies should be assigned the responsibility to identify, monitor and make recommendations on preventing future systemic risks to the financial system.

We need to establish an effective and credible resolution mechanism to ensure that market players will actively monitor and keep a handle on risk-taking.

In short, we need to enforce market discipline for systemically important institutions.

We must ensure that we have the powers to close troubled financial institutions, regardless of their size or interconnectedness, and without propping them up with taxpayer money.

Ms. Bair noted that largest firms are able to easily access the credit markets without proper consideration of risk since lenders assume that the largest firms will be bailed out.  The belief that the biggest firms will be bailed out distorts free market mechanisms.  The “too big to fail” policy allows firms that are no longer viable to remain in operation when, in fact, they should be closed.  One suggestion by Ms. Bair is to limit the claims of secured creditors which would encourage lenders  to large institutions to more properly evaluate lending risk.

Resolution Powers Necessary To Wind Down Big Firms

In order to close systemically important (but failed) institutions without causing widespread economic disruption, Ms. Bair called for new resolution powers including the following:

To achieve an orderly resolution, the receiver must have very broad authority to assure an orderly and rapid wind down of covered companies without taxpayer exposure.

Like the broad authority provided to the FDIC, these powers should include the ability to reject burdensome contracts, sell assets, resolve claims, and establish and operate bridge financial companies.

This last power to operate bridge financial institutions is essential to preventing a sudden collapse of large firms. These key powers will provide the receiver with the flexibility to protect the public, but avoid a taxpayer bail-out.

A more far reaching proposal to consider is limiting the claims of secured creditors to encourage them to monitor the riskiness of the financial firm.

This could involve limiting their claims to no more than say 80 percent of their secured credits. This would ensure that market participants always have ‘skin in the game’.

In any event, there is a serious question about whether the current claims priority for secured claims encourages more risky behavior.

In a recent paper, the Federal Reserve Bank of Kansas City points out that many commonly used short term instruments, such as commercial paper and repurchase agreements, often increase leverage and make firms more vulnerable to illiquidity and insolvency.

By totally protecting secured claims, and many repo claims as nettable financial contracts, the current priority scheme may encourage greater fragility in the financial markets.

Funding Required But No Bailouts

Not only is there currently no effective mechanism in place to wind down large institutions, there is also no funding available to do so.  Ms. Bair suggests that the cost of large failures be covered by industry risk assessment fees rather than taxpayer bailouts.

It is vital that an effective resolution process for larger financial holding companies have adequate funding to provide working capital so that the receiver can prevent a disorderly collapse of these firms from imperiling other firms.

I believe it is most effective to do so with an ex ante fund established and maintained from risk based assessments on large bank holding companies.

However, the fund should not be available for recapitalizing, re-organizing, or for paying claims against the receivership. Its use for this purpose should be explicitly prohibited by law.

The whole point of the resolution regime is to add a new element of market discipline to the financial system.

We need to end bailouts.

The financial meltdown of 2008 clearly indicated that regulators were ineffective and financial institutions did not properly evaluate the risks of high leverage and poor lending decisions.   Whether or not new regulatory reforms can positively influence future decision making by regulators and financial institutions remains to be seen.