Regulatory Moral Hazard and Cross-Guarantee Contracts

Remarks made at the St. Louis Banking Conference by Mr. Bert Ely *

I want to start off by talking about the too-big-to-fail issue and then move into the issue of moral hazard. Too-big-to-fail exists in a situation where a bank becomes insolvent, but instead of the protection for depositors being limited just to the statutory $100,000, all deposits are protected against loss as well as many other liabilities of the failed bank. One thing that is interesting about this is that the United States, I believe, is the only country where the notion of too-big-to-fail has actually been incorporated in statutory law. This policy was enacted in 1991 as the "systemic risk exception" of the FDIC Improvement Act ("FDICIA"). This provision in FDICIA stated that if the Federal Reserve and the FDIC agree, after achieving the signoff of the Secretary of the Treasury and the President, that a troubled bank is too-big-to-fail, then it would be protected with regard to all of its liabilities. The cost of that protection would be levied across the rest of the banking industry.

Now, there is a lot of controversy about too-big-to-fail. Many people, including possibly my fellow panelists, do not believe in too-big-to-fail. I do believe in too-big-to-fail. I think it is a very sound policy. I want to talk about why that is the case.

First, it is important to realize that too-big-to-fail is a reality of the industrialized world. In no industrialized country today will a large bank, let's say one of $50 billion or $100 billion or more in assets, be allowed to fail with losses to its creditors. That is a given, as we have seen in a number of situations in recent years. Credit Lyonnais in France, and, of course, the whole Japanese banking system are prominent examples.

The reason for too-big-to-fail is that there is a legitimate concern by policy makers, particularly the people that have to make the decision at the time, that if they close a large institution and try to impose losses on bank creditors in any fashion, there will possibly be some systemic disruption, specifically in the payment system.

Now, the risk of that happening may seem slight, but if it does happen, the consequences could be so severe that there is a concern that it could happen. Consequently, politicians and regulators err on the side of caution. That is what we saw in 1984 with Continental Illinois in Chicago. The rationale of the regulators and the politicians for invoking too-big-to-fail in the Continental situation was very sound.

But I am troubled with too-big-to-fail in this regard — it discriminates against smaller institutions that are "TSTS," that is, too-small-to-save. If a TSTS bank fails, and, again, the FDICIA legislation in 1991 reinforced this point, the bank will be dealt with in a manner that imposes losses on uninsured depositors and other creditors.

This difference in response poses this problem: Where do you draw the line? What is above the line and too-big-to-fail and what is below the line? This creates lots of uncertainty for bankers and others. Regulators actually prize this notion, which they call constructive ambiguity. That is, they will never say in advance who is too-big-to-fail. Rather, it is like obscenity: We are not going to define it, but we know it when we see it.

I am troubled by the notion of constructive ambiguity because it is destabilizing. When there is uncertainty, depositors will fear the worst and run. We have seen this most recently in Japan, particularly after the closure of some of the jusen, or housing finance corporations. These closures created some concerns about systemic stability. Consequently Japan has, I would argue, a too-big-to-fail policy in force across its entire financial system.

There is a more fundamental point here, though, that gets to the other aspect of this topic — regulatory moral hazard. That is, I question the notion that bank creditors should be liable for what clearly is regulatory failure. Let me expand on this point. The concern about too-big-to-fail is that it creates moral hazard, that if large, sophisticated depositors and other creditors of a bank are protected against a bank's insolvency loss, that will remove a crucial source of financial discipline on banks. That is, depositors are bank creditors and as such they should exercise creditor discipline over banks.

Now, I am all for creditor discipline; it is a great idea. And, of course, we do have creditor discipline throughout the economy. Industrial corporations and retailing firms are subject to it. However, when creditors invoke their discipline, often a bankruptcy proceeding soon follows.

But, as has been noted before, banking is different. And the difference is that the state has imposed solvency regulation on banks that is not imposed on any other industry except the insurance industry and securities brokerdealer firms. By imposing solvency regulation on banks, the state assumes the responsibility for preventing banking failures. If you don't think that is the case, then why have bank regulation? The purpose of solvency regulation is to prevent failure.

In a sense, what the government has done is appoint itself as the agent, if you will, on behalf of bank creditors, to discipline a wayward bank management, or, to look at this from another perspective, regulatory discipline has been substituted for creditor or depositor discipline.

Not only has government designated the regulators as the agent for bank creditors, but it also has given these regulators some unique powers to enhance regulatory discipline. For instance, regulators have unique, ongoing access to nonpublic data about a bank. The regulators can live in a bank, if they want. In fact, at the large banks, the regulators now have permanent teams in place. They are there every single day monitoring the bank's financial condition.

The regulators also have been given something else that private sector creditors don't have and that is some very strong enforcement powers. These powers were reinforced in the FIRREA legislation in 1989 and again by FDICIA.

Now, if the regulators batted a thousand and were successful 100 percent of the time in preventing failures, we wouldn't be here today talking about the issue of too-big-to-fail and moral hazard because it wouldn't be an issue. If banks didn't fail, we wouldn't worry about losses to depositors, we wouldn't worry about losses to creditors, and we wouldn't have FDIC insurance. The reason these are issues, that too-big-to-fail is an issue, as is deposit insurance, is because the regulators have failed to perform adequately as the government-designated agent for depositors and other bank creditors.

If you look upon regulators as producers, they are providing a service. Consequently, deposit insurance, and by extension, too-big-to-fail protection, represents a product warranty. If you buy a car, it has a warranty on it. If it breaks down, the manufacturer is liable for the repairs, not the owner of the car. I look upon deposit insurance in the same way — it is a product warranty that protects people against losses because of their agent's failure. That is, a government designated agent, the government banking regulator, failed to do its job in a satisfactory manner.

This leads to the question of what do we mean by moral hazard. I want to suggest that moral hazard should not be viewed as depositor moral hazard, which I might add is the argument for depositor discipline and for not having too-big-to-fail. Instead, the real moral hazard and, therefore, the underlying issue in the too-big-to-fail debate is regulatory moral hazard: that is, the hazard that the regulators will fail to do their job properly.

Those who oppose too-big-to-fail bailouts for large banks effectively want large depositors, that is, uninsured depositors, to run from a troubled bank, with the hope that if the run is bad enough, it will wake up the regulators to do the job that they were hired to do. That essentially is what a bank run is, it is knocking on the door of the regulators and saying, hey, folks, wake up and take prompt corrective action in the bank to deal with this problem.

The question that I pose is this — why is it necessary to rely upon creditor discipline to make regulatory discipline work? Why do we have to have creditor discipline as a back up to regulatory discipline when the regulators are being paid to do that job? They are supposed to respond to fires when they occur.

The notion of depositor discipline or, if you will, runs on a bank, can be very serious, for every time that happens, we risk systemic instability in order to wake up the regulators. That kind of risk is very serious. That is what constitutes regulatory moral hazard. The moral hazard is that we risk systemic instability, which I consider to be highly undesirable, in order to get the regulators to wake up in time.

The public question is what to do about this problem. Well, one idea is, of course, to have the regulators function more effectively. This was what Congress intended in the 1991 FDICIA legislation. I was there that year and followed FDICIA's progress through Congress quite closely and I know the legislation reasonably well, so I have a good sense of what was happening that year. What Congress said was we do not trust the regulators. Therefore, we must write rules, including some rules for which George Kaufman helped to develop the underlying philosophy, specifically the notion of prompt corrective action. In other words, Congress specified the basis on which the regulators were to intervene in a troubled bank. In doing so, they set out some very specific trigger points.

But I suggest that this was not a very efficient way to deal with this problem, because we are still dealing with a government bureaucracy. Worse, with rare exceptions, banking regulators do not suffer personally, either financially or from the standpoint of reputation, when they fail to do their job. One of the best examples of this is in the 1989 FIRREA legislation, the S&L bailout legislation, in which Congress made a down payment on what ultimately turned out to be a $125 billion payment by general taxpayers to clean up the S&L mess. Under FIRREA, Congress exempted the bank regulatory agencies from the civil service pay scales. In effect, Congress gave the regulators a pay raise in the aftermath of a massive regulatory failure.

Now, I realize that also has happened in some banking situations where bank executives have received large severance payments when their bank was taken over. But I would suggest that such payments are not healthy for the private sector or for the public sector.

What I want to talk about in the few minutes that remain is the crossguarantee concept for privatizing banking regulation. Again, it is the notion of looking at banking regulation as a business. The notion of a delegated agent, of delegating the monitoring of a bank to a particular agent, rather than relying on masses of depositors to provide that discipline, is a very sound idea, because banks are opaque. That is, it is hard to know from the outside what is going on inside a bank. As someone said earlier today, this is a function of the nature of bank assets. So the idea of having a delegated agent to monitor a bank's financial condition is a very good one. What I merely suggest is that we privatize that function.

The reason to privatize is to make banking regulation subject to market forces, to make it more subject to the commercial marketplace. I will run through some of the high points of the cross-guarantee concept in a few minutes. I might add that in the paper which I distributed earlier today, called, "Regulatory Moral Hazard, the Real Moral Hazard in Deposit Insurance," the last section of the paper does discuss cross-guarantees briefly. It also makes reference to my web site where you will find more on the crossguarantee concept than you will ever want to read.

But I might add just one other thing parenthetically — I have not just written a few papers on cross-guarantees, but also have had very comprehensive legislation drafted that would implement cross-guarantees. Rep. Tom Petri from Wisconsin has introduced this legislation on several occasions. It hasn't gone beyond the introduction stage, but we have thought through this concept in great detail.

The cross-guarantee concept delegates the regulation of a bank to a third party who protects all deposits and all other banking liabilities. In other words, it comes back to the idea that we don't want depositor discipline, which is a second best way of trying to minimize banking problems. In effect, we embrace the concept of too-big-to-fail, we eliminate constructive ambiguity, and we say no matter how small a guaranteed bank is, every dollar of deposit will be protected against loss.

The second feature of cross-guarantees is that we move away from the military draft that we have in federal deposit insurance. That is, every bank today is a guarantor of every other federally insured bank. Instead, we give every bank the right to decide which other banks, if any, they will voluntarily agree to guarantee. This guarantee commitment will be spelled out under a negotiated cross-guarantee contract between a guaranteed bank and its voluntary guarantors.

Third, these cross-guarantee contracts will specify the safety-and-soundness practices that make sense for that bank and its business strategy. In terms of monitoring a bank's compliance with the contract, we provide for the designation of a private sector firm called a syndicate agent to ensure enforcement of the contract. There will be competing syndicate agent firms. So we make the process of bank regulation and the monitoring of banking conduct a competitive, marketbased system.

Now, guarantors will not do this for free. They will be paid a premium, just like FDIC is. We heard some discussion in the previous panel about the politicization of the premium-setting process. However, by privatizing banking regulation and the associated guarantees, then it is possible to rely upon the marketplace to establish premiums so that genuine real risk sensitivity is introduced into premium rates. In my opinion, pricing, in the form of risk-sensitive, marketplace-determined cross-guarantee premiums, will be the most effective banking regulator of all.

The problem with government regulation is it cannot use the best regulator there is, which is price. Essentially, the crossguarantee concept merely privatizes the bank regulatory process. By doing that, by privatizing it, we minimize regulatory moral hazard, which is the real moral hazard we should be talking about. We also eliminate the too-big-to-fail discrimination against smaller banks.

* Mr. Ely heads Ely & Company, Inc., in Alexandria Virginia (, and serves as Chairman of the Monetary Policy/International Issues Subcommittee of the Society's Financial Institutions Practice Group.


2001 The Federalist Society