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Fed President Says Banking Supervision Will Rely More on Market Forces

Federal Reserve Bank of Cleveland President Jerry L. Jordan predicts that regulatory agencies will change the way they supervise banks, making greater use of market forces to discipline individual bank’s behavior. In addition, he expects that banking supervisors will pay more attention to the functioning of the financial system as a whole, and less attention to the operation of individual institutions.

Writing in the Bank’s Economic Commentary, Jordan says that it has become impossible for any individual or supervisory agency to fully comprehend the real time risk profile of a diverse and complex financial institution. Thus, it has become essential and inevitable that banking supervisors enlist the collective knowledge of many market participants to evaluate an institution’s risk bearing capabilities and to exert discipline on its business practices. For market forces to be effective, ample information about the assets, liabilities, and practices of banks must be disclosed to the public. Furthermore, there must be credible assurance that the information released is accurate and complete.

Jordan notes that banking supervisors have traditionally attempted to ensure the safety and soundness of the financial system by ensuring the viability of each bank, or at least the viability of the largest and most complex banking organizations. He suggests that a more manageable and less intrusive approach would be to require sufficient capitalization and collateralization and to limit interbank exposures, an idea that he says was recently suggested by Federal Reserve Bank of Kansas City President Thomas Hoenig. This system would enhance the prospect that the failure of even the largest financial organization could be resolved without unacceptable degrees of disruption to the financial system or the economy.

Jordan says that, as part of this supervisory approach, deposit insurance would be provided only to banks that limit themselves to traditional banking activities, and safety and soundness supervision would be continued for those firms. Banks that chose to engage in riskier activities would forfeit access to deposit insurance. Because this approach would continue insurance for most banks while not inhibiting the activities of banking organizations that want to broaden the scope or increase the riskiness of their activities, Jordan says it would blend an increase in market freedom with political feasibility.

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