The regulatory framework should be simplified and transparency increased, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said Tuesday.
"I believe, there is merit in developing simpler, more transparent regulatory solutions designed to work reasonably well in a wide range of situations," Plosser told a conference in Philadelphia, according to prepared text of his remarks, released by the Fed. Plosser suggested if regulations are easier to follow, there is a better chance they will be enforced consistently, leading to financial stability.
"Our regulatory framework is becoming increasingly complex, which has led to rising compliance costs as well as enforcement costs," he said.
Usually, he said, markets evolve faster than regulations, which makes for a never-ending rule writing cycle.
"Yet, we should consider that causality can work both ways. Regulations themselves give rise to incentives to evade the rules," Plosser said. "Such regulatory arbitrage can result in increasingly complex financial structures designed to fall outside existing rules. This activity then begets more complex rules that markets once again seek to avoid."
This cycle increases the cost of compliance and enforcement, he said. "For example, higher capital requirements based on the leverage ratio, as opposed to overly complex risk-weighting schemes, might lower both compliance and enforcement costs while achieving similar or better outcomes in terms of the safety and soundness of individual institutions as well as overall financial stability."
Also complex rules make "consistent enforcement" difficult, which, in turn, makes "it harder for financial institutions to predict how regulators are likely to behave. Such uncertainty can make the financial system less efficient and can undermine the credibility of the regulatory regime, thereby making the regime less effective in fostering financial stability."
Plosser also called for increased transparency, both by firms and regulators. He said, "it is entirely appropriate to require adequate disclosure and transparency regarding the structure and risk of both the instruments and the institutions." With transparency comes the ability "to better price the inherent risks of the securities and the firms."
Disclosure of once-confidential information "would enable market participants to better assess the risks of counterparties and thereby exert more effective market discipline."
If regulators made supervisory practices more transparent, firms would be more confident about what is and isn't allowed. "This would reduce regulatory uncertainty and the inefficiencies of regulatory arbitrage as firms try to guess what's on the minds of regulators. When firms have a better understanding of regulatory requirements, they can appropriately evaluate the economic costs and benefits of their decisions," Plosser said.
Too much transparency, he noted, "can have unintended consequences. The added information could lead to instability by creating runs on financial institutions if market participants misunderstand or overreact to negative news."
Firms could react by cutting the "quality and quantity of information" shared with regulators. Plosser said, "While these concerns may be legitimate, I would argue that revealing more information about individual firms will reduce the likelihood of contagion and runs, as such events generally arise from a lack of information, rather than too much information, about the riskiness of an individual firm."
Finally, Plosser turned to the role of market discipline. "I believe that market discipline can be a powerful tool in controlling the risk-taking of financial institutions. Notice that transparency is an important ingredient in effective market discipline, since a more informed market is likely to function more efficiently and set the prices of securities and firms more accurately."
He added, "As we seek to improve and strengthen financial stability, we should think about mechanisms to make market forces more effective, not just write rules that attempt to substitute for market forces. Creating incentives for markets to monitor and price risk-taking by financial institutions, rather than have markets simply assume that regulators have monitored the risk for them, is a desirable outcome. A complex and nontransparent regulatory regime can create its own form of moral hazard. Thus, efforts to enhance the effectiveness of market discipline are beneficial as they reduce the necessity of rules and interventions that can create perverse or unintended consequences and the potential for moral hazard."
Firms could be forced to issue subordinated debt, whose holders would be motivated to "monitor risk-taking by these firms," since they'd be paid last in the event of failure. "Others and I have argued for contingent debt that would convert to capital, in response to specific market triggers indicating that the firm was under stress. Such automatic recapitalization would help prevent firms from failing in the first place. Managers would have a strong incentive to avoid taking on risks that might lead to such events, as they would dramatically dilute existing shareholders."
Information provided to regulators can also aid supervision. "Markets aggregate many risk assessments into a single measure, such as the price or quantity traded of a security. These market measures can be compared across institutions to provide an indication of relative risk," Plosser suggested. "The measures can also be monitored over time to provide indications of changes in risk. Market participants have strong financial incentives to correctly price a firm's risk. Since market prices of securities tend to be forward-looking, they reflect investors' expectations given the current information."
The problem of too big to fail must be solved, Plosser said, "If creditors perceive they will be rescued, then market discipline is undermined and moral hazard will lead to greater risk-taking by the institutions."
