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

The establishment of a clear and credible GSE receivership process, the second element, is needed to create market discipline for these companies.  Reform legislation should establish (1) a well-defined and mandatory process for placing a GSE in receivership and (2) a method for resolving a GSE once it is placed in receivership.  Both parts are necessary for the receivership process to be meaningful and credible.  Market participants should clearly understand that, once certain conditions arise, regulatory forbearance will be impermissible and a GSE receivership will be established.  Importantly, the GSE receivership process should include a mechanism for ensuring that both the shareholders and creditors of a failed GSE will bear financial losses.  Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline.

As I testified before the Congress both this year and in 2004, the GSEs need a regulator with authority on par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear.