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Saturday, July 25, 2009

The Fed as Systemic Risk Regulator?

Alan Blinder favors making the Fed the systemic risk regulator for the U.S.:

An Early-Warning System, Run by the Fed, by Alan Blinder, Commentary, NY Times: ...[T]wo contradictory crosscurrents are swirling in Washington — one that would enhance the Fed’s powers and one that would curtail them.

The Treasury’s recent white paper on financial regulatory reform would have the Fed “supervise all firms that could pose a threat to financial stability,” even if they are not banks, turning the Fed into what some people are calling the nation’s “systemic-risk regulator.” Doing so would expand the Fed’s reach...

On the other hand, some members of Congress are grumbling that the Fed has already overreached, usurping Congressional authority. Others contend that it has performed so poorly as a regulator that it hardly deserves more power. Representative Ron Paul, the Texas Republican, has even introduced a bill that would have the Government Accountability Office audit the Fed’s monetary policy — a truly terrible idea that could quickly undermine the Fed’s independence. ...

The main task of a systemic-risk regulator is to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Can this job be done perfectly? No. Is it worth trying? I think so. ...

Some people would end the systemic-risk regulator’s role there, making it an investigative body and whistle-blower whose job is to alert other agencies to mounting hazards. But if systemic problems are uncovered, someone must take steps to remedy or ameliorate them.

Under one model, the regulator would be like the family doctor ... making a general diagnosis and then referring the patient to appropriate specialists for treatment: to the Securities and Exchange Commission for securities problems, to the banking agencies for safety and soundness issues... But if multiple agencies are involved, their actions would need coordination. Would a systemic-risk regulator ... find itself herding cats?

An alternative model would work more like a full-service H.M.O., where an internist refers patients to in-house specialists as necessary. To make that work, the systemic-risk regulator would need more power — not just to diagnose problems, but also to fix them. And it would need a huge range of in-house expertise.

Crucially, when truly systemic problems arise, a lender of last resort is almost certain to be part of the solution — and that means the central bank. So if there is to be a systemic-risk regulator in the United States, it should be the Fed.

Furthermore, unlike any other agency, the Fed would not be starting from scratch... The Fed already has the eyes and ears (though not enough of them) to do this job, and has the broad view (though, again, not broad enough) over the entire financial landscape. It must have such a view to handle monetary policy properly.

I am also deeply skeptical that a consortium or a committee would succeed at systemic-risk regulation. Creating a hydra-headed regulator, as some have proposed, invites delays, disagreements and turf wars — and dilutes accountability. So the Treasury plan sensibly puts the Fed in the driver’s seat, with the others playing advisory roles.

Now to the final question. Critics who worry about the Fed accumulating too much power have a point. But the Treasury proposal already clips the Fed’s wings by stripping away its authority over consumer protection, and further wing-clippings are possible. But when it comes to dealing with systemic risk, Treasury Secretary Timothy F. Geithner said last month, “I do not believe there is a plausible alternative.” Neither do I.

Here's Alice Rivlin with a more space to write and hence a more nuanced view of the issues. This is from her testimony before the House Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs. I agree with most of what she says, but not point three where she argues that "it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed." One of her arguments is that we can't necessarily identify systemically risky institutions until problems actually develop, but I believe it is possible to do this. It may require that we develop some new measures of connectedness, size isn't the only determining factor, but it seems quite feasible and desirable to develop ways of characterizing risk from interconnectedness. And once the risk is identified, it needs to be controlled and I see the Fed as the best agency to do this for the reasons Blinder outlines (point three is the main focal point in the extracts below, but there's quite a bit more in the original, e.g. sections on the need for regulation to fix the perverse incentives in the mortgage and financial industries, and a discussion of controlling leverage):

Reducing Systemic Risk in the Financial Sector, by Alice M. Rivlin:  July 21, 2009 — Mr. Chairman and members of the Committee:

I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. ...

It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world’s economic wellbeing.

Approaches to Reducing Systemic Risk

The crisis was a financial “perfect storm” with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.

  • The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system... The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
  • The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
  • The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms... Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.

The Case for a Macro System Stabilizer

One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. ...

Systemically Important Institutions

The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.

It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the federal government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk-taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late.

Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks.

Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ‘Too Big to Fail’ and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures.

Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the UK’s FSA, but structured to be more effective than the FSA proved in the current crisis. In the US one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.

I don’t pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier One Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy.

Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macro economists—Paul Volcker, Alan Greenspan, Ben Bernanke—who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort—including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed’s control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown—and the Fed has been more transparent about its objectives. Although respect for the Fed’s monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives.

If the Fed were to take on the role of consolidated prudential regulator of Tier One Financial Holding Companies, it would need strong, committed leadership with regulatory skills—lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed’s budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed’s effectiveness and credibility in containing inflation.

In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system—again in coordination with the Council. I would not create a special regulator for Tier One Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank.

Thank you, Mr. Chairman and members of the Committee.

    Posted by on Saturday, July 25, 2009 at 04:09 PM in Economics, Financial System, Regulation | Permalink  Comments (15)


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