Speech here
Many of you likely are frustrated, and rightfully so, by the impact that the financial crisis and economic downturn has had on your banks, as well as on the reputation of bankers more generally. You may well have built your reputations and institutions through responsible lending and community-focused operations, but nonetheless, you now find yourselves facing higher deposit insurance assessments and increasing public skepticism about the behavior of bankers–outcomes that you perceive were largely caused by the actions of larger financial institutions. Many of you managed your businesses prudently and shunned more exotic instruments and activities. And many of your customers–households and businesses–avoided excesses and are able to meet their financial commitments on a timely basis.
No doubt this frustration has been heightened by the problems caused by financial firms that are too big or too interconnected to fail. Indeed, the too-big-to-fail issue has emerged as an enormous problem, both for policymakers and for financial institutions generally. Creditors of a firm perceived as too big to fail have less incentive to monitor and restrict the firm’s risk-taking through adjustments to the price at which they lend money to the firm. If left unaddressed, this weakening of market discipline creates an unlevel playing field for smaller institutions, which may not be able to raise funds as cheaply, even if their individual risk profiles are better, or at least no worse, than those of their larger competitors. The erosion in market discipline distorts market behavior and can give firms an incentive to grow–either internally or through acquisitions–in order to be perceived as too big to fail.
Government rescues to prevent the failure of major financial institutions also have required large amounts of public resources. These actions have involved extremely unpleasant and difficult choices, but given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets, and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures. That said, these episodes have shown clearly that the problem of too-big-to-fail is extremely serious. To address this issue, which should be a top priority for financial reform, policymakers will need to act on several fronts.
First, supervisors–as we are already doing–must vigorously address the weaknesses at major financial institutions with regard to capital adequacy, liquidity management, and risk management. Firms whose failure would pose a systemic risk must receive especially close supervisory oversight and be held to the highest prudential standards. Aside from its direct benefits for the safety and soundness of these large institutions, such an approach also would help offset financial firms’ incentive to grow until they are perceived to be too big to fail.
Second, supervisors must pay close attention to compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers. As the Federal Reserve and other banking agencies have noted, poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization. Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons.3
Third, as the recent financial crisis has highlighted, risks to the financial system may arise not only in the banking sector, but also from financial firms that traditionally have been outside the regulatory and supervisory framework applied to banking organizations. Under federal law, all banking organizations–regardless of size–are subject to consolidated supervision for safety and soundness purposes. At a minimum, policymakers must ensure that a similar statutory framework is put in place for all systemically important financial firms organized as holding companies. The agencies responsible for implementing this framework also must vigorously exercise their authority to help ensure the safety and soundness of nonbank firms whose failure could threaten the stability of the financial system. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.
Fourth, continued strong and concerted efforts are needed to improve the financial infrastructure–or “plumbing”–that supports the trading, payments, clearing, and settlement activities that are so critical to the functioning of the financial system. I have described elsewhere the various steps that the Federal Reserve is taking in coordination with other supervisors and market participants to improve the resiliency of over-the-counter derivative markets and the market for triparty repurchase agreements.4 Improvements in these areas should reduce the likelihood that the failure of any individual institution would have substantial spillover effects on other financial institutions or the broader markets, and thereby make it less likely that the government would need to intervene.
Finally, an important element of addressing the too-big-to-fail problem is the development of an improved resolution regime in the United States that permits the orderly resolution of a systemically important nonbank financial firm. We have such a regime for insured depository institutions, but it is clear we need something similar for systemically important nonbank financial entities. Improved resolution procedures for these firms would help reduce the too-big-to-fail problem by giving the government the option of safely winding down a systemically important firm rather than keeping it operating.