Nestled in the heart of the Philadelphia historic district, near such storied landmarks as Independence Hall and the First and Second Banks of the United States, is the Federal Reserve Bank of Philadelphia. It is one of 12 Federal Reserve Banks across the nation that, together with the Board of Governors in Washington, form the Federal Reserve System, whose mandate is to ensure stable prices, a strong economy, and a sound financial system. The nation’s decentralized central bank formulates and implements monetary policy, supervises and regulates financial institutions that contribute to economic growth, and supports an efficient payments system. The Federal Reserve also provides financial services to depository institutions and the federal government. PACB President and CEO Nick Francesco led a roundtable discussion with Philadelphia Fed President Charles Plosser, who shared his views on monetary policy, the economy, and the changing regulatory climate.
Capital Standards/Basel III
You have been an advocate for less complex regulations and a return to simple, straightforward rules. Do you think the new Basel III framework for U.S. financial institutions achieves that by effectively creating a tiered regulatory approach?
I believe we need to simplify regulation to make it less costly in terms of compliance and enforcement. Moreover, I think that mechanisms that use market forces to discipline a firm’s behavior are superior to an elaborate list of rules that seeks to cover every possible outcome. Simple and transparent regulatory mechanisms make it easier for markets and for institutions to predict how regulators are likely to act and make it easier for regulators to credibly commit to implementing them.
In general, the most effective preventive measure to reduce the probability that a financial firm will fail in the first place is adequate capital. The approach taken by the Basel framework is to emphasize risk-weighted assets as the primary measure of the asset base and focus on the ratio of Tier 1 capital to risk-weighted assets as the core measure of capital adequacy. Honestly, there’s probably no better example of rule writing that violates the basic principles of simple, robust regulation than risk-weighted capital calculations.
To illustrate this point, Andrew Haldane and Vasileios Madouros of the Bank of England counted the pages in the Basel regulations associated with risk-weighted capital calculations as a proxy for their complexity. Basel I had 30 pages of documentation on risk weighting, Basel II had 347 pages, and Basel III had a massive 616 pages. I am concerned that this increasing complexity is unlikely to lead to more effective or more efficient regulation.
I’ve become more skeptical of elaborate risk-weighted capital calculations, partly because we have learned that two banks with the same portfolio of loans and assets can often obtain different estimates of risk-weighted assets. This should make us suspicious of such calculations. I would prefer a framework that places more emphasis on the simple leverage ratio — the ratio of capital to unweighted assets. We should also require these simple ratios to increase with the size, interconnectedness, and complexity of the institution. Regulators would worry less about what activities or products a firm could engage in but would impose a “tax” in the form of more capital for becoming more systemically important.
To be honest, while my preference is to simplify regulation, I’m not terribly optimistic that legislators and regulators around the world are so inclined. Complexity seems to be on the rise, not on the wane.
Read the full interview in September’s issue of Transactions. Aren’t a subscriber? Visit the Transactions page on this website or call PACB at 717-231-7447 to start receiving the magazine.