By Steven K. Beckner

NEW YORK CITY (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser said Wednesday that the first priority of financial
regulatory reform should be ending the government practice of treating
the largest banking organizations as “too big to fail.”

Plosser, speaking at a conference sponsored by the Squam Lake Group
of academic economists and former policymakers, said the government
should strive to make sure that financial firms have enough capital to
avoid insolvency.

But if they nevertheless get into trouble, he said a “credible” way
must be found to allow them to fail without disrupting the entire
financial system. His preferred method was a specialized bankruptcy
court, as opposed to a “resolution mechanism” run by government
regulators.

Plosser, speaking as the House and Senate continue to try to hammer
out a compromise financial reform bill, said the emphasis should be on
imposing “market discipline,” including the use of convertible debt —
bonds that would convert to equity in a crisis. And he said systemically
important firms should be required to write a “living will” — a plan
for their own bankruptcy should them become insolvent.

He expressed distrust of government agencies determining systemic
risk, opining that “regulators are prone to see systemic risks under
every rock.”

“In my view, the most important element in fixing our financial
system is that we must end the notion that some financial firms are too
big or too interconnected to fail,” said Plosser. “If a firm’s creditors
believe that the government will rescue them in times of trouble, they
will have little incentive to exert market discipline and discourage a
firm from taking excessive risk.”

“Eliminating too big to fail should be the first priority of any
regulatory reform,” he added.

He recommended two broad approaches: “First, we must seek ways to
ensure that a financial firm that is susceptible to creditor runs has a
capital structure that reduces the likelihood of insolvency. The second
is to ensure that if such firms do become insolvent, there is a credible
way to allow them to fail without disrupting the entire financial
system.”

Although regulators are already empowered to take “prompt
corrective action” to prevent banks from failing, Plosser said “there
will be times when failure is the only option.” So he said a “resolution
mechanism” is needed “that will close failing financial firms when early
intervention has not led to the firm’s recovery.”

Contrary to the approach being taken in Congress, Plosser said “the
best model for this mechanism should be bankruptcy, which imposes an
orderly resolution of counterparty claims according to predetermined
rules.”

To aid the process, he said “a regulatory requirement that
financial institutions develop living wills will help make it easier to
unwind these firms in an orderly fashion, consistent with their complex
corporate structures, and at lower costs.”

Plosser opposed “heavy-handed regulation” limiting banks’
activities, because that “runs the risk of firms devising ways of
getting around the rules, forcing activities into the unregulated sector
and creating risks elsewhere.”

A better idea, he said is to use “reverse convertible securities”
which “would function as debt in normal times but would convert to
equity in times of stress.”

A report produced by the Squam Lake Group proposes that
convertible debt convert to equity only if both the firm’s financial
condition deteriorates and the regulators declare that the whole banking
system is in crisis. But Plosser objected to that approach.

First, he said, “regulators will find it very hard to pull this
second trigger until very late in the game.” He said he would prefer
reverse convertibles that could be “triggered at an earlier stage, when
market participants may not agree that the system is in crisis.”

Plosser warned that “waiting for regulators to declare a crisis
before debt could convert would be a mistake, since regulators may be
too concerned that the announcement itself will worsen the crisis.”

What’s more, Plosser said structuring reverse convertibles with a
double trigger “may limit the demand for these securities.”

Plosser advocated triggering conversion “when the market value of a
firm’s equity falls below some specified value” for two reasons:

* “First, book values tend to lag economic realities, yet as I just
argued, there are benefits in having conversion occur at an early stage
when the economic value of capital is still significantly positive, as
this will keep the firm bounded away from insolvency.”

* “Second, relying on an equity price means that recapitalization
becomes a market-driven event that does not depend on the regulators’
evaluation of the firm’s books.”

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