Philly Fed's Plosser Speaks: Too Big To Fail Must End
Charles Plosser speaks before the Global Interdependence Center. In a nutshell while the Fed member decries regulatory reform and says the Fed must not lost any powers in supervising banks, he notes that new bureaucracies are not needed (as expected) and that the Too Big To Fail concept must finally end. He says
Good morning and welcome to the Federal Reserve Bank of
Philadelphia. The Philadelphia Fed has had a long relationship with the
Global Interdependence Center. For more than 30 years, we have
participated in GIC meetings with policy leaders from around the globe.
We have benefited from the many good ideas that have emerged from these
That is why the Philadelphia Fed is proud to host today's event —
part three in this timely conference series on financial
interdependence in the world's post-crisis capital markets.
As you see in the agenda, we will hear perspectives from members of
Congress, investment experts, and economists. I am particularly pleased
that the keynote speaker is my colleague Eric Rosengren, president of
the Federal Reserve Bank of Boston.
The financial crisis of the last two years will alter the structure
and performance of global capital markets in many ways. Competition and
market forces will change many financial products and the way they are
delivered. Financial products and innovations that failed the market
test will disappear or change. And that is how it should be. We should
not underestimate the power of the market and its adaptability.
Yet global financial markets will also be shaped, for better or
worse, by the nature of financial regulatory reforms under
consideration by lawmakers in numerous countries. For example, recent
discussion in Washington has centered on which regulatory agency should
have which supervisory powers and over what types of institutions. One
proposal would eliminate the Fed's oversight of state-chartered member
banks in favor of a focus on the largest institutions. Other proposals
would transfer all bank supervision and regulation to a separate,
single bank regulator. Taking away the Fed's supervisory role on Main
Street or Wall Street would be unwise. As the central bank, the Fed has
the depth of experience and expertise to monitor banks of all sizes.
And these responsibilities support and complement the central bank's
ability to meet its Congressional mandates for financial stability and
In 1997, the U.K. took bank regulation from the Bank of England and
gave it to the Financial Services Authority. Based on its experience
with a separate regulator during this crisis, the U.K. government is
considering moving regulatory activity back into the central bank —
just the opposite of some U.S. proposals.
Chairman Bernanke submitted a report to Congress that clearly
outlines the sound reasons for retaining bank supervision in the
The current crisis underscores the importance of having a regulatory
framework that addresses both the safety and soundness of individual
institutions and the macro-prudential risks of the financial system as
a whole. Given the Fed's traditional central banking roles, including
having lender of last resort responsibilities, overseeing the stability
of financial and payment systems, and setting monetary policy, it is
uniquely situated within the government with the necessary expertise to
deliver on both pieces of this regulatory mandate.
In my view, the proposals for regulatory reshuffling, at best, miss
the point of what is required for meaningful reform and, at worst,
weaken the current regulatory framework. The real danger is that such
proposals increase the likelihood of future crises rather than fixing
the problem. Instead of elaborate restructuring, I suggest we focus on
three key initiatives that will truly improve our regulatory system.
First, I believe Congress should amend the bankruptcy code to
include a new chapter for large nonbank financial institutions. In my
view, the most important issue any reform must address is the
too-big-to-fail problem. Without a credible resolution mechanism to
allow the orderly failure of large and interconnected financial firms,
we will be setting the stage for the next crisis.
Foremost on the agenda should be the recognition that no firm should be too big to fail.
Any resolution mechanism should address systemic risk without
requiring taxpayer support. To foster market discipline and reduce
moral hazard, the resolution mechanism must ensure that a failed firm's
shareholders are wiped out and that creditors bear losses. Most
important, the resolution mechanism must be credible. Managers, owners,
and creditors must believe that firms on the verge of failure will, in
fact, be allowed to fail. Therefore, we must limit regulatory
discretion or forbearance and the potential for political interference.
The resolution regime must not become a mechanism for more bailouts. I
am concerned that the current legislative proposals allow far too much
discretion and could lead to more bailouts, not fewer.
Given these criteria, I believe a modified bankruptcy process would
be a better mechanism than proposals to expand the bank resolution
process under FDICIA to cover nonbank financial firms and bank holding
companies. It seems far too easy in the heat of a crisis to deem that
systemic risks are too high to let an institution fail. Yet, as we have
seen, when firms expect to be protected from failure, they take greater
risks at the taxpayer's expense and, in so doing, sow the seeds of
No doubt, lawmakers will need to work out the details of a new
bankruptcy chapter, including who would force an institution into
bankruptcy. I would favor allowing not only the regulator, but also
creditors, to place a troubled financial firm into bankruptcy when it
is unable to meet its financial obligations. This would enhance market
discipline and lower regulatory discretion.
Another issue involves how to handle qualified financial contracts,
including swaps, repos, and derivatives of those firms in bankruptcy.
Current law exempts these contracts from various provisions of the
bankruptcy code, including the automatic stay provisions. In other
words, the contracts are permitted to close out even though the firm is
in bankruptcy. Some argue that these exemptions prevent systemic risk.
Yet others argue that these exemptions actually raised the systemic
risks surrounding Bear Stearns, AIG, and Lehman.2
The international nature of these large financial firms means that
we must work to ensure international coordination of a bankruptcy
process. Yet it is not uncommon or impossible to fail international
firms. We also need to ensure a timely bankruptcy process, so the
bankruptcy proceedings do not drag out for years. I do not think that
either of these challenges is insurmountable.
I am not arguing to replace the current process of resolving small
and medium-sized bank failures outside of bankruptcy — the FDIC has
demonstrated its ability to resolve these institutions quickly (usually
over a weekend) and at relatively low cost to the taxpayer. However,
the handling of the largest financial institutions during this crisis
has persuaded me that the system cannot easily expand to encompass
large firms without biasing the outcomes toward bailouts rather than
resolution. Thus, I favor a bankruptcy mechanism as a more credible
solution to the too-big-to-fail problem.
My second recommended action is to clarify the Federal Reserve's
umbrella supervision role for financial holding companies. Under
current legislation, the Federal Reserve supervises bank holding
companies and serves as umbrella supervisor of financial holding
companies, while the appropriate functional regulators supervise the
subsidiaries. For example, the SEC supervises an investment-banking
subsidiary, while a state insurance commission supervises an insurance
subsidiary, and the designated federal or state bank supervisor watches
over the commercial banking subsidiary.
To reduce regulatory burdens, the Gramm-Leach-Bliley Act
limits the Federal Reserve's power to examine subsidiaries that have a
functional regulator. So the Fed has relied on the functional regulator
for information about holding company subsidiaries. I believe Congress
should clarify that the Fed has umbrella supervisory powers and the
responsibility to exercise them, including collecting supervisory
information on the holding company and all of its subsidiaries on a
routine basis. These changes would not broaden the supervisory powers
of the Fed — or any other agency. Indeed, under Gramm-Leach-Bliley, the
Fed has been given authority to examine and take action against any
subsidiary that may pose a material risk to the financial safety and
soundness of an insured depository affiliate, or the domestic or
international payment systems. Clarifying the Fed's umbrella
supervisory role would encourage regulators to work together to take a
comprehensive look at the systemic risks of consolidated financial
organizations. This thorough review of each firm would help the Fed in
its macro-prudential mission to help ensure financial stability and the
integrity of the payments system.
Further, I believe Congress should also clarify the Fed's financial oversight responsibilities by requiring a semi-annual Financial Stability Report for Congress and the public, much as it requires the Fed to submit its Monetary Policy Report.
This report would also improve the transparency and accountability of
the Fed's financial oversight responsibilities, which would help ensure
public trust and credibility.
My third recommended action is to integrate market discipline into
our regulatory structure rather than relying solely on more
regulations. Consider regulations governing financial institution
capital. One of the lessons of the financial crisis is the speed with
which capital ratios can decline. A firm can move from
"well-capitalized" to "undercapitalized" almost overnight, and then
face enormous difficulties in raising capital during a crisis. This
argues in favor of raising regulatory capital ratios for financial
Yet, rather than simply raising capital requirements, regulators
should marshal market forces by requiring financial firms to hold
contingent capital in the form of convertible debt that would convert
into equity in periods of financial stress. Contingent capital would be
less costly than simply raising capital requirements, since it is
triggered only under bad economic conditions, when capital is most
costly to obtain. Thus, it reduces the incentives for financial firms
to seek ways to evade dramatically higher capital requirements. The
ready contingent capital also avoids the need for fire sales of assets
to raise capital, which can exacerbate an economic downturn. And
perhaps most important, it can reduce the necessity of government
rescues and bailouts.
Contingent capital would enhance both regulatory supervision and
market discipline. The market price of such debt would provide
regulators with a valuable signal about the financial health of the
firm and about the market's perception of systemic risk. In addition,
the threat of the debt's conversion to equity would mobilize creditor
discipline. We should also consider requiring higher levels of capital
for banks that pose greater systemic risks. This might be done by
basing capital requirements not only on credit risk but also on
liquidity risk and asset growth. These steps would strengthen market
discipline and improve financial stability. And regulators can add
these capital requirements without additional legislation.
I believe these three actions would go a long way toward improving
financial stability. Enacting a credible bankruptcy process to solve
the too-big-to-fail problem, clarifying the Fed's umbrella supervision
and financial stability roles, and enhancing market discipline are
steps we must take to lower the probability of a future crisis. We
could simplify the entire financial regulatory legislative initiative
by focusing on these three key elements. We do not need huge new
bureaucracies, or a complete restructuring of our regulatory agencies.
These are a few of my own thoughts on post-crisis reform. Today,
we'll have the opportunity to hear many more and consider how to
progress toward a sound solution that will safeguard the integrity of
our market mechanisms. I look forward to the presentations and
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