Rules versus Discretion and Managing Financial Sector Stress

with Michael Moore and Ian Tower

Economic policies are increasingly subject to rules-based frameworks, except perhaps in the financial sector. A growing number of countries conduct their fiscal policies within a rules-based framework that features expenditure, deficit, or debt targets. In many economies, monetary policy is set as a function of forecast and targeted inflation, or is determined by an exchange rate rule. The key reason for these changes is a recognition that self-imposed transparent rules help combat political economy pressures for higher deficits and inflation. When it comes to financial stability, however, practice in Europe generally favors discretionary approaches to oversight of financial institutions and to crisis management and resolution.

As financial institutions and their authorities deal with the effects of the ongoing credit market turmoil and amid much talk about moral hazard, it is worth revisiting the potential benefits of a rules-based framework. With respect to the financial sector, such a framework would not preclude all supervisory discretion. But it does promise to deliver time-consistent policies in a political-economy environment that has tended to favor the public bail-out. For regulators and central bankers dealing with liquidity or solvency problems in banks, the political economy pressures are arguably even larger and more immediate than the pressures facing fiscal policy makers.

Moral hazard may have been increasing recently, as rating agencies, markets, shareholders, and bank managers have come to expect that official support will be available, if needed. The current and historical experience in Europe is that (large) banks will receive the support of public money when they are in serious difficulties. While traditionally viewed as a safeguard against failure, this likelihood of support might well have induced greater leverage by banks than markets would normally allow. Arresting the growing moral hazard—as in the case of arresting deficits and inflationary expectations—argues for a more disciplined approach underpinned by rules.

In the United States, moral hazard became a key motivator for the law[1] that introduced the prompt-corrective action (PCA) framework, which today underpins the U.S. regulatory regime for banks. PCA was the response to the criticism that banking regulators (and bank managers and directors) did not act soon enough to limit losses to the deposit insurance funds stemming from bank failures. Under the PCA framework, banks are grouped into five categories according to their regulatory capital ratios and other supervisory factors. Grouping banks according to supervisory concerns is also common in Europe, but the U.S. differs in the automatism with which increasingly severe actions must be taken as an institution moves from one category to another. The PCA also limits the Federal Reserve’s discretion when extending lender-of-last-resort credit to undercapitalized banks (ranked in the lower two capital categories).

When a bank becomes critically undercapitalized, the U.S. regulators are required to intervene. Importantly, this happens when tangible bank capital is still positive but at or below 2 percent of total assets. The Act also requires that regulators choose the least cost option (to the insurance fund and taxpayers) for resolving failed banks. For example, shareholders, debt holders, and uninsured depositors must absorb the cost of failure before the insurance fund or tax payers bear any cost. Exceptions to this requirement and use of lender-of-last-resort credit are possible to deal with systemic threats, but they face high hurdles. The intention is that the threat of action will forestall excessive risk taking by banks as the franchise value of their shareholders’ business declines. It can support regulators in acting to prevent crises and it limits banks’ incentives to free-ride on the public, which, too often, has to come to the rescue when matters go awry.

Moving to a more rules-based framework in Europe would be controversial. Some regulators would see the rules-based approach as impeding their discretion to manage problems as they choose, recognizing that each instance will be different. And shareholders would resist any loss of rights before capital is exhausted. Of course, the authorities implementing a rules-based approach would remain fully accountable for their actions. And some flexibility could be built in to the basic rule in order to deal with complexity and unexpected events that can occur in banking crises.

Implementation of such a framework raises some complex issues, however. Any approach that links regulatory actions to particular triggers depends on clear and unambiguous rules that are resistant to misrepresentation and manipulation. The rules should promote decisions by managers of banks that long precede the outbreak of crisis. But the need for simplicity and transparency needs to be weighed against the risk of becoming overly crude in regulating a complex business, such as banking. Take, for example, the simple tier 1 leverage ratio used by the U.S. regulators. Using this ratio within PCA focuses the minds of market participants and reassures them that action will be taken when a bank is heading for trouble. But, two banks with very different risk profiles can have the same leverage ratio. So there remains a role for the Basel risk-based capital framework which recognizes such differences in risks. (Analogously, there is a lively debate about the best formulation of a fiscal rule or a monetary policy regime.)

We believe that Europe could benefit from a more rules-based approach, particularly when dealing with troubled financial institutions. Another reason is the increasing share of cross-border transactions in banks’ business and the commitment to create a single EU financial market. With bankruptcies of cross-border banks likely to be complex events, national regulators need to have confidence in how (and when) their counterparts in other countries will act and that those practices will not change over time. A more rules-based system could help build this trust, as well as the trust between market participants that are being supervised by different national authorities. For this, however, it would be essential that the rules-based approaches be compatible across countries and take the external effects of domestic actions properly into account.

[1] The Federal Deposit Insurance Corporation Improvement Act of 1991.