Ben S Bernanke: Financial regulation and the invisible hand
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the New York University Law School, New York, 11 April 2007.
* * *
Market forces determine most outcomes in our economy, a fact that helps to explain much of our
nation's success in creating wealth. Markets aggregate diffuse information more effectively and set
prices more efficiently than any central planner possibly could. The result is powerful competitive
incentives for businesses to produce, at the least cost, the goods and services that our citizens value
most. Writing in the eighteenth century, Adam Smith conceived of the free-market system as an
"invisible hand" that harnesses the pursuit of private interest to promote the public good. Smith's
conception remains relevant today, notwithstanding the enormous increase in economic complexity
since the Industrial Revolution.
Although the market system is the principal source of America's economic dynamism, economic
theory and practice both suggest that targeted government regulation and intervention can sometimes
benefit the economy. In the particular case of financial markets, for example, government regulation
helps to promote general financial stability and to protect investors and consumers against fraud. Of
course, the benefits of regulation come with direct and indirect costs. Direct costs include those arising
from compliance with a thicket of complicated rules - costs that can add significantly to a firms' costs
of production, leading to higher prices for consumers. Indirect costs include reductions in innovation or
competition that can result from overly restrictive regulations. Therefore, before government decides to
regulate in a particular situation, it must weigh the social costs and benefits of the contemplated
intervention.
In recent decades, public policy has been increasingly influenced by the insight that the market itself
can often be used to achieve regulatory objectives. For example, in the area of environmental
protection, the trading of emissions permits has been widely embraced as a cost-effective means of
controlling pollution. That market-based approach is regulation by the invisible hand, as opposed to
the very visible hand of direct government regulation and enforcement. The invisible-hand approach to
regulation aims to align the incentives of market participants with the objectives of the regulator,
thereby harnessing the same powerful forces that allow markets to work so efficiently. In the financial
arena, as I will discuss, this approach often takes the form of creating incentives for market
participants to monitor and control the risk-taking behavior of financial firms - that is, to exert market
discipline - thereby reducing the need for direct oversight by the government.
Today I would like to explore the market-based approach to financial regulation by considering its
application to two important - but very different - types of financial institutions: commercial banks and
hedge funds. For both types of institutions, market-based regulation has proven an effective
supplement to (or substitute for) conventional command-and-control approaches.
Commercial banks
For much of U.S. history, bank shareholders and creditors - not government regulators - were
responsible for overseeing banks' lending and investment decisions. For example, in the years
between the demise of the Second Bank of the United States, in 1836, and the National Banking Act
of 1863, private commercial banks issued non-interest-bearing notes that served as the principal
medium of exchange.
Although the notes issued by each bank were supposedly redeemable for gold (or other safe assets,
such as government bonds), they did not always trade at face value in every location. Instead, notes
issued by different banks traded at variable discounts that depended on (among other things) the
perceived financial condition of the issuing bank and the distance a note-holder would have to travel to
redeem the notes (Gorton, 1996). Banks did not like to see their notes trade for much less than face
value, however, because holders of deeply discounted notes had an incentive to demand the face
amount in gold from the issuing bank. If too many note-holders redeemed their notes, the bank might
have to pay out all its reserves of gold and close down. Concern about potential note redemptions
discouraged banks from taking excessive financial risks that might cause their notes to trade at a
deeper discount and, consequently, trigger increased redemptions. Market forces thereby exerted
discipline on banks' activities and the types of assets they held.
Similarly, later in the nineteenth century, when demand deposits became the primary form of bank
liability, bankers recognized that any loss of confidence by depositors might provoke a run - panicky
withdrawals - that could force the bank to close its doors. Presumably the potential for deposit runs
led banks to take fewer risks than they might have otherwise - another instance of market discipline
(Calomiris and Gorton, 1991).
Although the actions of note-holders and depositors constrained banks' risk-taking, they had some
undesirable side effects. Throughout the nineteenth century and in the early decades of the twentieth,
bank runs often helped to precipitate general financial panics that shut down large parts of the
financial system and constricted economic activity. Bank runs, by extinguishing deposits, also tended
to sharply reduce the nation's money supply. And they sometimes wreaked considerable hardship on
the depositors themselves. Certainly, from a modern perspective, putting the burden of monitoring
banks on small depositors seems inappropriate. Most retail depositors don't have the time and
resources to gather information on bank assets and investments, and typically they cannot absorb
losses when a bank fails.
In response to this series of financial panics, the Congress in 1913 founded the Federal Reserve to
provide the nation with a safer, more flexible, and more stable monetary and financial system.
Specifically, the Fed was established "to furnish an elastic currency, to afford means of rediscounting
commercial paper, [and] to establish a more effective supervision of banking in the United States."1
Such powers can be used to provide liquidity when an otherwise solvent bank experiences
unexpected and widespread withdrawals during a financial panic. Today, the Federal Reserve's
discount window and its oversight of the payment system are core components of the so-called federal
"safety net" provided to banks.
However, the Federal Reserve failed to avert the banking panics of the Great Depression of the
1930s, the longest and most severe series of banking panics in U.S. history. Thousands of banks
failed, many after suffering runs on their deposits. As a consequence, the Congress added another
element to the safety net when it established government-backed deposit insurance. Deposit
insurance both protects depositors (subject to limits on the size and type of account) and reduces the
liquidity risks faced by banks. It has achieved its objective in that runs on insured institutions have
virtually disappeared.
However, despite its evident benefits, deposit insurance created a new type of problem. Unlike the
note-holders and depositors of earlier years, insured bank depositors, who know that their funds are
protected even if their bank fails, have little or no incentive to evaluate the risk-taking activities of their
bank. In the absence of other measures, this safety net reduces the restraint that creditors would
otherwise place on unsound lending because the insurance reduces the amount of money they have
at stake. The tendency of banks to take on excessive risks when they face little economic penalty for
doing so is an example of what economists call a moral hazard problem.
To help counter the moral hazard created by deposit insurance, and to try to ensure that banks
operate safely and soundly, the United States has developed an extensive system of banking
supervision and regulation. In effect, regulators assumed the role of monitor, the role that insured
depositors no longer have any incentive to play. Somewhat ironically, however, this system of
government supervision may itself exacerbate moral hazard if the banks' uninsured creditors assume
that the government's oversight obviates any need for them to monitor banks. Market discipline may
erode further if market participants believe that, to avoid the risk of a financial crisis, the government
will step in to prevent the failure of any very large institution - the "too big to fail" problem. With little or
no help from market forces, the burden of ensuring banks' soundness falls entirely on the supervisory
agencies. But as we saw in the savings and loans crisis of the 1980s, regulatory oversight may also
fail if the regulators are not sufficiently vigilant or lack the political will or financial resources to promptly
close insolvent institutions.
The lesson of history appears to be that neither market discipline nor regulatory oversight alone is
completely adequate for keeping the banking system safe and sound. However, regulators have
increasingly come to appreciate the value of a hybrid system that supplements direct regulation with a
substantial amount of market discipline. Fortunately, regulators have a variety of ways to restore and
strengthen market discipline for banks, notwithstanding the existence of the federal safety net.
Minimum capital requirements are one method. A bank's capital provides a buffer that can absorb
losses before they fall on the deposit insurance fund (and, ultimately, the taxpayers). In addition,
however, capital requirements enhance market discipline; they do so by ensuring that the bank will
have shareholders (and possibly other types of creditors as well) who have a significant amount of
money at risk. These shareholders have a substantial financial incentive to monitor the bank's
activities and to insist on changes if they are dissatisfied. Bank managers are also quite aware that a
low share price could invite a hostile takeover, an outcome they usually want to avoid.
The incentives for a bank to control risk are even stronger if regulations link the amount of regulatory
capital to the risks taken by banks. (Tying capital requirements to risk is a primary objective of the
Basel II capital accord, currently in the process of review and implementation.) Risk-based capital
regulations, if properly designed, require banks that take more risks to hold more capital. Because
equity capital is the most expensive form of funding, this linkage gives banks an incentive to better
measure and control risks.
Credible receivership provisions for insolvent banks are another method of enhancing market
discipline. Effective market discipline requires that uninsured investors believe they could lose some,
or all, of their stake. This belief is especially important in the case of very large banks, which investors
may otherwise perceive to be too big to fail. Receivership rules that make clear that investors will take
losses when a bank becomes insolvent should increase the perceived risk of loss and thus also
increase market discipline.
In the United States, the banking authorities have ensured that, in virtually all cases, shareholders
bear losses when a bank fails. Historically, however, bondholders and uninsured depositors have at
times doubted that regulators would impose significant losses on them in the event of a bank's failure.
To address this issue, the Congress has reduced regulators' discretion when dealing with troubled
banks. For example, the requirement for prompt corrective action prohibits regulatory forbearance
when a bank's capital falls to a predetermined level; and the least-cost-resolution requirement compels
regulators to resolve a troubled bank at the lowest cost to the deposit insurance fund.2
Improving and broadening the requirements for disclosing information are yet another method of
strengthening the invisible hand. For example, the part of the Basel II capital initiative called Pillar 3
requires banks to release additional information to the public about their risk-taking. Pillar 3 should
thus help investors, creditors, and other counterparties better assess banks' risk profiles.
Transparency about risk has become all the more important because modern financial assets
increasingly entail greatly different degrees of economic leverage per dollar invested.
When pursuing regulatory objectives through the application of market discipline, regulators must
consider the nature of the incentives faced by different types of stakeholders in varying circumstances
as well as the ways each type of stakeholder affects the bank's risk-taking. For example, as I
mentioned, bank capital usually gives equity investors an incentive to monitor and control risk. But
when a bank falls into financial distress, its capital may be all but depleted, and its equity investors
may thus have little left to lose. Consequently, equity holders may "gamble for resurrection" by
encouraging rather than discouraging excessive risk-taking. Thus, as was evident in the savings and
loan crisis of the 1980s, market discipline by equity holders may break down when it is most needed.
This example suggests that the mix of instruments a bank uses to raise funds can matter. For
instance, holders of uninsured debt (such as large certificates of deposits or corporate debt issues)
care mostly about the risk of bankruptcy. They don't benefit if the bank's stock price rises when undue
risk-taking pays off. Consequently, they focus on what bank managers are doing to avoid default. The
incentive to monitor risk-taking is particularly keen for holders of subordinated debt, as they are last in
line in the event of failure. Because debt holders are sensitive to changes in the probability of financial
distress, risk-taking by a bank raises its cost of funding in credit markets, and that connection creates
an incentive for banks to control risks. Moreover, the price of a bank's debt provides useful information
about the bank's riskiness. With that information, the bank's counterparties and supervisors can take
steps of their own to ensure that the bank is operating safely.3
Hedge funds
Hedge funds provide a second illustration of how the invisible hand can be used to support regulatory
objectives. Their rapid growth is one of the most important developments in U.S. financial markets in
the past decade or so. Hedge funds vary widely in their investment strategies and in the types of risks
they take. Overall, however, most economists agree that the rise of hedge funds has been a positive
development for investors and for financial markets. They have stimulated an extraordinary amount of
financial innovation in recent years; and, using many of these new financial tools, they have greatly
enhanced the liquidity, efficiency, and risk-sharing capabilities of our financial system.
Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly
sophisticated counterparties and investors, and because they have no claims on the federal safety
net, the light regulatory touch seems largely justified. However, the growing market share of hedge
funds has raised concerns about possible systemic risk. The complexity and rapid change inherent in
the strategies of many funds make them relatively opaque to outsiders, and so the concern arises that
the collapse of a hedge fund might come with little warning. In addition, many hedge funds are either
highly leveraged or hold positions in derivatives or other assets that make their net asset positions
very sensitive to changes in asset prices (the functional equivalent of high leverage). Highly leveraged
investors are intrinsically more vulnerable to market shocks, of course, but leverage also increases the
risks to the broader financial system. The failure of a highly leveraged fund holding large, concentrated
positions could involve the forced liquidation of those positions, possibly at fire-sale prices, thereby
imposing heavy losses on counterparties. In the worst scenarios, these counterparty losses could lead
to further defaults or threaten systemically important institutions. In addition, market participants that
were not creditors or counterparties of the defaulting firm might be harmed indirectly through changes
in asset prices, liquidity strains, and increased market uncertainty.
As I have noted, the market discipline provided by creditors and investors is potentially a powerful
mechanism for controlling leverage and other aspects of risk-taking. But market discipline can fail, as
is illustrated by one notable case - the hedge fund Long-Term Capital Management (LTCM), which
was at the center of an episode of severe financial stress in 1998. Perhaps because of the stellar
reputations of LTCM's principals, banks and broker-dealers provided credit on generous terms, even
though LTCM took exceptional risks. LTCM's investors and counterparties simply did not ask the
tough questions necessary to understand the risks they were taking. Together with the admittedly
extraordinary market conditions of August 1998, these risk-management lapses were a major source
of the LTCM crisis.
In response to the LTCM episode, the Congress might have imposed a much more intrusive regulatory
regime on private pools of capital. However, doing so would have been costly and technically difficult,
would have increased moral hazard by relieving investors and counterparties of the responsibility for
monitoring the funds, and likely would have reduced the social benefits of hedge funds by hampering
the ability of their managers to respond quickly and flexibly to changing market conditions. Instead, the
regulatory approach taken in the United States has followed recommendations set forth in 1998 by the
President's Working Group on Financial Markets and recently reaffirmed in a set of principles by the
same group.4
The market-discipline approach to regulating hedge funds imposes responsibilities on four sets of
actors: hedge fund investors, creditors and other counterparties, the regulatory agencies, and the
hedge funds themselves.
In discussing the regulation of commercial banks, I noted that most small retail investors are
illequipped to provide effective market discipline because monitoring complex financial activities
demands considerable time, effort, and sophistication. In the case of hedge funds, securities laws
effectively allow only institutions and high-wealth individuals to invest in them. These investors
generally have the resources and sophistication, as well as the incentive, to monitor the activities of
the hedge funds. Large investors are not only well equipped to assess the management, strategies,
performance, risk-management practices, and fee structures of individual hedge funds but they also
have the clout to demand the information they need to make their evaluations. Although regulations
limit the direct access of retail investors to hedge funds, small investors may obtain indirect exposure,
through pension funds for example. However, managers of pension funds and similar institutions
generally have a fiduciary duty to their investors to research and understand their investments and to
ensure that their overall risk profile is appropriate for their clientele. In practice, most pension funds
have only a small exposure to hedge funds.
Counterparties are another important source of market discipline. The principal counterparties of most
hedge funds are large commercial and investment banks, which provide the funds with credit and a
range of other services. As creditors, counterparties have a clear economic incentive to monitor and
perhaps impose limits on hedge funds' risk-taking, as well as an incentive to protect themselves from
large losses should one or more of their hedge-fund customers fail. Counterparties seek to protect
themselves against large losses through risk management and risk mitigation. Risk management
includes the use of stress tests to estimate potential exposure under adverse market conditions;
riskmitigation techniques include collateral agreements under which hedge funds must daily mark to
market and fully collateralize their current exposures.
The incentives of hedge fund counterparties line up well with regulators' objectives, which include not
only constraining excess risk-taking by hedge funds but also preventing losses that would threaten the
stability of other major financial market participants. However, for various reasons, including
competitive pressures and the existence of the safety net for some counterparties, private
counterparties may not fully account for risks to general financial stability. Thus, supervisors seek to
ensure that hedge-fund counterparties - primarily very large commercial and investment banks -
protect themselves and, in so doing, protect the broader financial system. Supervisors also monitor
markets and key institutions, coordinate with their domestic and foreign counterparts, and work with
the private sector to strengthen market infrastructures. For example, the Federal Reserve Bank of
New York has been leading joint public-private efforts to improve the clearing and settlement of credit
derivatives. Coordination of this type can improve market functioning and reduce risks to financial
stability without harming market discipline.
Finally, in a system of market-based discipline, hedge-fund managers themselves have both the
incentive and the responsibility to manage risk effectively, to develop consistent methods for valuing
assets and liabilities, and to provide timely and accurate information to their investors, creditors, and
counterparties.
Thus far, the market-based approach to the regulation of hedge funds seems to have worked well,
although many improvements can still be made (Bernanke, 2006). In particular, risk-management
techniques have become considerably more sophisticated and comprehensive over the past decade.
To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or
even failing - nor should it. If hedge funds did not take risks, their social benefits - the provision of
market liquidity, improved risk-sharing, and support for financial and economic innovation, among
others - would largely disappear.
Conclusion
I have argued today that, in many situations, regulation that relies on the invisible hand of
marketbased incentives can complement direct government regulation. For market-based regulation to work,
the incentives of investors and other private actors must align with the objectives of the government
regulator. In particular, private investors must be sophisticated enough to understand and monitor the
financial condition of the firm and be persuaded that they will experience significant losses in the event
of a failure. When these conditions are met, market discipline is a powerful and proven tool for
constraining excessive risk-taking.
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