Fed's Follies & Systemic Risk Regulation

The administration’s proposal sets out to restore the shadow banking system and all the various securities markets that have arisen in the past fifteen years or so, including credit default swaps. The underlying presumption is that these markets serve public purpose, that they can be restored, and that they should, in fact, be restored.

The presumption is not correct. - James K. Galbraith

Against the backdrop of blocking a Federal Reserve audit by the Senate, we have additional questions being raised on the Federal Reserve as Systemic Risk Regulator.

War of the Audit

 

A recent House Financial Services Committee hearing: Regulatory Restructuring: Balancing the Independence of the Federal Reserve in Monetary Policy with Systemic Risk Regulation, gives damning testimony.

Professor James K. Galbraith, addresses the history, the question of constitutionality and a possible solution of the Federal Reserve. I suggest reading the entire testimony but here is one structural change recommendation:

One way forward would be to eliminate the boards of directors of regional Federal Reserve banks – as should have been done anyway long ago. They could be converted, without loss, into broadly-based advisory boards. Another approach would be to remove the voting power of the regional bank presidents on the FOMC, while locating the systemic risk examiners at the Board rather than within the regional banks. Either measure would eliminate the constitutional anomaly, while also resolving the perception of conflict.

A key point of the Treasury plan is to identify institutions which pose systemic risk. While Galbraith recommends assigning that power to the FDIC, I must wonder why any institution is allowed to become so large and powerful it can bring down a global economy? I am not alone in this fundamental question, Credit Write Downs also wonders how to regulate without breaking up some of these too big to fail institutions. (later on Galbraith implies the same thing, too big to fail means break up these institutions.)

Other points of Galbraith, paraphrased to blogger lingo, the Federal Reserve is a boys club with strong ties to other banks, Wall Street, and the obvious: The Federal Reserve did nothing to stop the lead up to the financial crisis. Greenspan in fact encouraged adjustable mortgages which became a primary financial vehicle to travel the road of ruin. As Galbraith says:

The Fed’s failure to use the regulatory tools it has – including margin requirements in the 1990s information technology boom and the bully pulpit as well as its examination authority in the housing bubble of the past few years, are precisely failures to take account of systemic risk in the work of monetary policy.

A principal public policy consideration is the actual track record of the agency in predicting and averting systemic risk. By any standard, the record of the Federal Reserve in this area, from Greenspan’s “New Paradigm” in advance of the 2000 technology crash to Bernanke’s “predominant risk of inflation” in advance of the Great Crisis, is poor.

No kidding! Why give an institution more power when it repeatedly fails?

This is also not just one expert railing on the Federal Reserve or the U.S. Treasury. AEI Economist Allan H. Meltzer's testimonyis a laundry list of major Federal Reserve failures. Meltzer even gives us a mnemonic, TBTF - too big to fail.

End TBTF. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF is perverse. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur.

In other words, end corporate welfare, stop socializing the risk and privatizing the reward. I recommend reading Meltzer's entire testimony. Viewing the history of the Federal Reserve, with failure after failure after failure in one document....suddenly one shudders at the idea this institution would be the global economic collapse watchdog.

Hoover Institute Economist John B. Taylor outlines four reasons the Federal Reserve should not be granted more powers.

  1. dilute the key mission
  2. reduce credibility
  3. create a conflict of interest
  4. threaten the Fed’s independence regarding monetary policy

Taylor recommends the role of systemic risk regulator be given to the President's working group on Financial markets.

Morgan Stanley, no surprise there, is all for the Federal Reserve being granted more power, and in reading the rest of the testimony, the argument, again summed in blogger speak, seems to be, the Fed needs even more power in order to be more powerful than the institutions under regulation. What?

For example, Columbia Professor Frederic S. Mishkin lists the incredible knowledge of the Federal Reserve with market flows. Yet if this is true, why did the Federal Reserve not tip off the SEC long before Bear Sterns became a toxic wasteland?

Some more interesting quotes from the New York Times:

A broader warning came from John B. Taylor, a top Treasury official under President George W. Bush who was considered a potential candidate to succeed Alan Greenspan as Fed chairman.

Mr. Taylor said that expanding the Fed’s power would dilute its main mission of steering the economy, create conflicts of interest, reduce its credibility and jeopardize its independence.

“The administration proposal would grant to the Fed significant new powers, more powers than it has ever had before,” he told lawmakers. “My experience in government and elsewhere is that institutions work best when they focus on a limited set of understandable goals.”

Here is the entire hearing, with a searchable transcript.

Independence of the Federal Reserve

 

Considering we cannot get an audit of the Federal Reserve passed, it's highly questionable to give the Federal Reserve even more power, out of government oversight.

Meta: 

Comments

If we break up TBTF then we don't

need a systemic risk regulator. A systemic risk regulator, particularly the Fed fulfilling that role, will only be as good those leading the function. For instance, the Fed under Greenspan had an opportunity to prevent many of the subprime lending abuses that were occurring but did nothing because Greenspan was a free market fundamentalist.

The only way it works is if we create an separate entity that is relatively independent (nearly impossible) such as the Fed. But that adds another regulatory to already congested web of regulators. Does TBTF serve any public purpose?

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Besides, Wall Street likes the Fed.

I like what William Greider said:

Giving more power to the Federal Reserve to be the uber-regulator of banking and finance is a terrible idea (I examine the dangers in a forthcoming Nation article). Asking the cloistered central bank to resolve all the explosive questions about the over-reaching power of financial institutions is like throwing the problem into a black box and closing the lid, so people will be unable to see what happens next. That is the idea, after all, the reason Wall Street's leading firms first proposed the Fed as super-cop, then sold it to George W. Bush and now Barack Obama. Give the mess to the Wizard of Oz, the guy behind the curtain. He can do miracles with money, but don't watch too closely. This constitutes the high politics of evasion.

Obama Administration is giving the financial oligarchy exactly what it wants.

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