Federal Reserve Board Chairman Alan Greenspan says owners who would profit from the success of a depository institution should have "the appropriate amount" of their own capital at risk.
Greenspan, addressing the American Bankers Association convention this week, said requiring owners to have a large stake in their enterprise would discourage "excessive risk-taking.""There must be a symmetry of risk for owners of depository institutions; those who stand to gain substantially if the institution is successful must also stand to lose substantially if outcomes are not so favorable," he said.
"Surely one lesson from the experience with some troubled depository institutions in recent years is that unbalanced incentives to assume risk, arising when the federal insuror absorbs losses while the owners reap profits, can lead to destablizing behavior," he said.
Greenspan said capital and liquidity, which he called the natural "shock absorbers" of the financial system, should be strengthened to respond to economic conditions now and in the future.
At the same time, he said, better use should be made of "market and market-like incentives" to discourage excessive risk-taking by individual institutions.
"There is no better way to ensure that owners exert discipline on the behavior of their firm than to require that the owners have a large stake in that enterprise," he said.
Greenspan drew applause when he called for timely closing of insolvent firms to avoid the "misallocations of credit, the distorted competitive incentives, and the increased costs to deposit insurance funds that result when a failed institution is allowed to operate with the public's money."
He said the Federal Reserve supports efforts to limit deposit insurance protection to depositors in the insured intermediary and not extend the protection to the creditors of the parent holding company.
Greenspan said some might argue that raising capital standards would put banks at a competitive disadvantage, but he said that was short-sighted.
"Well-capitalized firms can be counted on to be around in the future, and thus worthy of customers' willingness to establish long-term relationships," he said.
Capital ratios of bank holding companies have been rising but still tend to be far below those at non-depository financial firms, Greenspan said. He said that probably reflects real or imagined federal protection.
"This tendency toward over-reliance on the safety net by both owners and depositors has inhibited, and in some cases may have eliminated, the private market signals that would have made much less likely many of the portfolio problems now facing numerous depository institutions," he said.
Greenspan said higher standards may mean increased capital requirements for many banks, and some may consider that burdensome since they do not feel market pressures to raise capital ratios.