NEW YORK – Viewing some institutions as “too big to fail” creates a competitive advantage, that will lead to “an ongoing moral hazard problem” and market structure “distortions,” Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley said today.
“Currently, some large systemically important institutions may have a competitive advantage because they are perceived to be `too big to fail,’” Dudley told an Institute of International Bankers luncheon, according to prepared text released by the Fed. “Unless we address this disparity, we will have an ongoing moral hazard problem and inevitable market structure distortions as institutions take steps to become systemically important in order to gain a competitive advantage.”
Two options are available regulate away this problem: first, improving the resolution mechanisms for large, complex institutions to decrease the costs of failure, or imposing higher capital requirements on these institutions, he said. “Increasing the size of the capital buffer would make the system more stable by reducing the incentive for firms to get big just to capture the perceived benefits from achieving ‘too big to fail’ status.”
Dudley noted, regulators “need to be realistic about the difficulties in building a resolution regime that would be sufficiently robust to allow the failure of any institution under any circumstance and in designing a capital regime that imposes differential requirements on large, systemically important institutions.” It would be difficult, he said, to “build resolution regimes that can operate effectively across different geographic jurisdictions.”
Also undermining the markets, Dudley said, was “limited or ineffective disclosure undermined market discipline and this contributed to the accumulation of risk. In the years leading up to the crisis, the lack of transparency contributed to increased risk and leverage in off-balance sheet vehicles, structured credit products and in over-the-counter securities such as asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) and their associated derivatives. Once the crisis was underway, the opacity of many of these vehicles, structures and securities contributed to the concerns about counterparty credit risk. This uncertainty exacerbated the erosion in market liquidity conditions and further intensified the crisis.”
He said the problem affected valuation, prices and the concentration of risk.
The four changes Dudley suggested for regulatory capital framework were: iproving the risk capture associated with the capital requirements; introducing rules that ensure the conservation of capital during times of economic and financial distress; imposition higher capital requirements for systemically important institution; and developing efficient forms of capital. In particular, contingent capital debt instruments that are convertible into common equity if a bank’s share price were to fall precipitously.
