NEW YORK – Calling it “the most important element in fixing our financial system,” Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said financial firms must be allowed to fail even if they are big and interconnected.
If there is the expectation of a government bailout, there’s “little incentive to exert market discipline and discourage a firm from taking excessive risk,” Plosser told a conference here today, according to prepared text of his remarks, which was released by the Fed.
“Eliminating too big to fail should be the first priority of any regulatory reform,” he said. “This is easier said than done. As the crisis has taught us, when the systemic risks are perceived to be large — and regulators are prone to see systemic risks under every rock — they will be very reluctant to close down insolvent firms or impose losses on creditors.”
Plosser outlined “two complementary approaches” that will allow firms to fail. “First, we must seek ways to ensure that a financial firm that is susceptible to creditor runs has a capital structure that reduces the likelihood of insolvency. The second is to ensure that if such firms do become insolvent, there is a credible way to allow them to fail without disrupting the entire financial system,” he said.
Explaining, Plosser said, in the first approach “corrective mechanisms” would automatically start when firms fall into trouble, but while it still has “positive economic capital.” Regulators need not be the driving force, he said, “The mechanisms could exploit market forces to address developing problems without requiring regulatory interventions.”
Despite these mechanisms, some firms will have no option but failure. “Thus, the second approach is to design a resolution mechanism that will close failing financial firms when early intervention has not led to the firm’s recovery,” Plosser said. “I believe the best model for this mechanism should be bankruptcy, which imposes an orderly resolution of counterparty claims according to predetermined rules. In addition, certain forms of early intervention can help to lower the costs of permitting firms to fail. For example, a regulatory requirement that financial institutions develop living wills will help make it easier to unwind these firms in an orderly fashion, consistent with their complex corporate structures, and at lower costs. Furthermore, living wills can provide insight into the degree of systemic risk that these firms impose.”
Rules to keep firms in line can be sidestepped, creating risk elsewhere, and regulators would have to keep up with financial markets’ evolution. “Discretionary supervision and regulation alone are not sufficient to prevent excessive risk-taking or prevent future crises,” Plosser added. “Thus, I think reform must seek ways to strengthen market discipline rather than seeking to override or replace markets in controlling risk-taking.”
He suggested using “reverse convertible securities that would function as debt in normal times but would convert to equity in times of stress,” with conversions triggered by a single firm’s financial woes.
Plosser said he prefers a single trigger system to a double trigger. “Waiting for regulators to declare a crisis before debt could convert would be a mistake, since regulators may be too concerned that the announcement itself will worsen the crisis. Moreover, having the securities convert earlier and imposing the cost of dilution increases incentives for managers to avoid risky actions that might precipitate or encourage a market run or systemic event. And while earlier conversion may lead to cases in which this event occurs when the firm is healthy, this may not be such a big problem. The firm can simply buy back the equity, if the market turns out to have taken an excessively pessimistic view of the firm’s prospects.”
Also, reverse convertibles with a double trigger may not be as much in demand. “Securities analysts and investors will need to consider not only the health of each bank, but also the health of the banking system as a whole, and the prospects for regulators to intervene. This conditioning on discretionary behavior by a regulator makes the security much harder to evaluate than a convertible security with a single trigger based on the firm’s observable financial condition.”
