WASHINGTON — Regulators trying to minimize the impact of too-big-to-fail institutions need to use more metrics, however flawed, to demonstrate progress to the public and Congress, Minneapolis Federal Reserve Bank President Narayana Kocherlakota said Monday in Minneapolis.
"Supervisors and regulators have been made accountable by Congress for ending the TBTF problem," Kocherlakota said in prepared for presentation at a Federal Reserve Bank of Minneapolis workshop. "They need to be able to demonstrate clear progress to the public with respect to that responsibility."
Kocherlakota, who is a non-voting member of the Fed's policymaking Federal Open Market Committee this year, didn't discuss current monetary policy. But he did liken the regulators' use of imperfect metrics in determining the progress on minimizing too big to fail risk to the FOMC's use of inflation and unemployment data.
The FOMC, charged with promoting price stability and maximum employment, uses "relatively uncontroversial metrics" to track progress on the former objective, Kocherlakota said. "But it is not as obvious how we should track progress with respect to the latter objective. Every possible metric — be it the unemployment rate or the employment-population ratio — has its own flaws."
But the FOMC response, in trying to fulfill its dual mandate isn't to "is hardly to abandon metrics altogether," Kocherlakota said. "Instead, monetary policymakers track labor market performance using a large number of measures."
When it comes to combating too-big-to-fail — which he is defining as "the expectation of government transfers that creates the problematic distortion, not the realization of those transfers" — policymakers shouldn't use a single metric such as size.
"This kind of approach would suggest that society can best manage the too-big-to-fail problem by capping the size of financial institutions," he said.
But while the size of a financial institution is "likely to be a useful source of information about the magnitude of that institution's too-big-to-fail problem," Kocherlakota said "policymakers should guard against relying too much on this single metric.
"We should always keep in mind that the term too-big-to-fail is highly misleading," he said. "The TBTF problem is about creditor perceptions of loss protection."
Defining the TBTF problem as the subsidy to debt finance created by the possibility of governmental loss absorption, Kocherlakota said "policymakers can only claim success with respect to the TBTF problem if the current measures of that subsidy are low."
But "they may want to accomplish more," he said. The too-big-to-fail subsidy to a financial institution is generated by its creditors' perceptions of government loss absorption, he said.
"The subsidy will be worth little if creditors believe that the institution's assets have little risk, so that it is highly unlikely that the institution will ever incur losses for the government to absorb," he said.
Kocherlakota continued: "It may be prudent for supervisors and regulators to also check that the subsidy remains small if creditors begin to perceive the institution's asset risk as materially larger. I see such robustness checks as being challenging to implement with existing too big to fail metrics."
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