The Fed Fails Upward

Federal Reserve Bank, Washington D.C. spakattacks/Flickr/Creative Commons

Let’s understand something. Increasing regulation, and spreading it over the
rest of the financial economy, only solves Congress’s problem; it makes
everything else worse. We’ve seen this before. The Sarbanes-Oxley Act in 2 002
imposed immense costs on U.S. companies and drove foreign companies out of our
markets. Now we are seeing members of Congress prepare to adopt legislation that
will impair innovation, raise costs, and destroy competition because–once
again–they have to be seen doing quot;something, anything,quot; to address the
financial crisis. That urge, combined with pressure from the Democratic left to
gain greater control over the fi nancial system, could produce an outcome second
only to the Card Check legislation in its adverse effect on the U.S.
economy.

Although there is no draft legislation yet available, the broad outlines of
what congressional leaders are likely to propose in the wake of the financial
crisis are becoming clear. Statements by Barney Frank, the influential chairman
of the House Financial Services Committee, indicate that he would like to
regulate all quot;systemically significantquot; financial institutions in
addition to banks, and thus would extend safety and soundness regulation to the
largest hedge funds, securities firms, insurance companies, finance companies,
private equity firms, and possibly other financial intermediaries. There is also
seemingly widespread agreement in Washington that the agency to perform this
role is the Federal Reserve. Both proposals are deeply troubling and reflect
little serious thought to their unintended consequences.

Defining Systemically Significant Institutions

One of the most difficult problems confronting a Congress determined to allay
systemic risk is to decide what it is. The traditional conception of systemic
risk is that it arises from contagion–a cascade of losses coming from the
failure of one large institution; as it goes down, its failure damages many
others and eventually the economy as a whole. But if we look at the current
financial crisis, that didn’t happen. Instead, its origin can be found in the
combination of a deflating housing bubble, an unprecedented number of sub-prime
and other non-prime mortgages, and a mark-to-market accounting system that
caused asset values (and hence bank capital) to spiral down as distress sales
drove down market prices. The failure of Lehman Brothers and the rescue of Bear
Stearns, AIG, and many of the largest banks came many months after the market
for asset-backed securities had completely dried up, forcing banks to write down
their assets to values far below what those assets were actually worth based on
their cash flows. In other words, there was no single institutional failure that
caused the current crisis, simply the fact that large numbers of the world’s
major financial institutions purchased and held low-quality U.S. mortgages that
are now failing in unprecedented numbers.

So why, if the current financial crisis was not started by the failure of any
systemically significant company, are Barney Frank, others in Congress, and–if
one believes the media–the Obama administration looking to regulate
systemically significant companies in the future? Good question. The best answer
comes from Obama chief of staff Rahm Emanuel: quot;Never waste a good
crisis.quot; The left has always wanted to get the government’s fingers more
deeply into the private economy, and this financial crisis may provide the
momentum for more–and more intrusive–regulation. Even though the current
crisis was not started by a systemically significant firm’s failure, perhaps no
one will notice as the administration and a compliant Congress seek greater
regulatory authority over systemically significant companies.

The Effect of Designating Systemically Significant Firms

The plan to regulate systemically significant firms is by far the most
dangerous of the regulatory ideas currently circulating on Capitol Hill and
within the administration. In terms of its potential impact on competition in
the financial services industry, it may be the most dangerous regulatory idea
ever to have been advanced in Congress. Yet it has been endorsed by top
international financial specialists led by Obama adviser Paul Volcker, and by
such unlikely private sector (and supposedly free market) groups as the U.S.
Chamber of Commerce and the Securities Indus try and Financial Markets
Association (known as SIFMA). The reason is simple: firms that are designated as
systemically significant will be seen by the market as too big to fail–that’s
why they’re considered systemically significant. Once it becomes clear that they
will not be allowed to fail, these firms will in effect have the implicit
backing of the government. As we have seen with Fannie Mae and Freddie Mac, when
a private firm has the implicit backing of the government–especially if the
backing comes from an agency like the Fed, with the power to extend
financing–it has easier and less costly access to credit and capital, and can
usually grow faster and become more profitable than its competitors. Eventually,
every financial sector will come to look like the housing market, with giant
government-backed companies that drive out or gobble up smaller competitors. It
is astonishing, after our experience with Fannie Mae and Freddie Mac, that so
many Washington groups can be backing this idea, and equally astonishing that
smaller companies around the country have not been protesting an idea that has
gained so much momentum in the capital.

The Federal Reserve as Systemic Risk Regulator

It is not surprising, however, that when new regulation is in the offing all
eyes on Capitol Hill turn to the Fed. For reasons that are far from clear, the
Fed’s monumental errors in monetary policy and regulation of banks and bank
holding companies (BHCs) never seem to tarnish its support in Congress. An
example is right in front of our eyes.

Somehow, the Fed Survives Its Failures

Since 1970, the Fed has had authority under the Bank Holding Company Act to
supervise and regulate companies that control banks. It has sweeping powers
under the act–in every way the equal of the powers that might be given to a
systemic regulator. The act allows the Fed to regulate BHCs in the same way that
a bank supervisor can regulate a bank–by regulating their capital and their
non-banking activities and influencing the lending policies of the underlying
bank. If the Fed had wanted to control the risk-taking of the largest banks–the
institutions most likely to be declared systemically significant–it could have
done so through its control over their holding companies.

However, the Fed has not exercised this authority, as we can tell from the
fact that the government has had to rescue Citibank, the principal subsidiary of
BHC Citigroup and an institution that everyone would define as systemically
significant. Nor did it prevent the failure of Wachovia and many other smaller
institutions that were controlled by BHCs operating under the Fed’s supervision.
Despite these failures, Chairman Frank and many others see the Fed as the right
agency to take on the role of systemic regulator. Strange, but as I say, not
surprising.

Threats to the Independence of Monetary Policy

The Federal Reserve System was designed to be independent of both Congress
and the executive branch. Its members are appointed for 14-year terms, and its
chair cannot be changed by a newly elected president for two years after his
inauguration. This extraordinary insulation gives the Fed credibility with the
financial markets, which are justifiably concerned that policies on price
stability will eventually start to follow election returns, allowing the dollar
to devalue for political rather than economic reasons. Long-term interest rates,
which are essential for investment planning by business, remain stable only as
long as the credit markets believe that the Fed will continue to follow a stable
price policy in the future. The credit markets understand that the political
pressures in a democracy favor inflation–there are simply many more borrowers
than lenders–and so they watch carefully to determine if the Fed is buckling
under pressure from Congress and the president. Thus, while the Fed’s
independence is inconsistent with democracy, it reflects a practical judgment
that the nation’s economy will be better off if its monetary policy is
determined by economic rather than political considerations.

It is through this lens that the Fed’s power over systemically significant
companies should be viewed. Giving the Fed the power to regulate all the key
financial firms in the U.S. economy would involve the agency in major decisions
about how business is carried out by whole industries. Unlike monetary
policy–which depends for its success on the financial markets’ belief that the
Fed is making its decisions on the basis of economic rather than political
factors–in a democracy the president and Congress should be able to influence
how regulatory authority is pursued. There is a serious danger that the Fed’s
involvement in these political and policy issues will compromise its monetary
role and cast doubt on the objectivity of its decisions. The result could be a
loss of faith in the dollar itself as a store of value.

The Fed’s Expertise

The Fed is a bank regulator; it has no expertise in regulating or
understanding the details of businesses like hedge funds, securities firms, or
insurance companies. Yet, as the regulator of systemically significant
companies, the Fed would be required to make important decisions about such
things as appropriate capital levels, leverage, products, and risk management
that require deep understanding of any industry in which a systemically
significant firm is located. In order to decide these issues the Fed would have
to have a detailed knowledge of the business practices, accounting standards,
and taxation of each business model.

Accordingly, as the systemic risk regulator for the varied financial
industries and business sectors, the Fed would have to acquire a great deal of
expertise in other fields of finance. In addition, because all these industries
compete with one another, every regulatory change for one sector would have an
effect not only on the competition within the industry in which the particular
systemically significant firm is located, but also on that firm’s ability to
compete with other members of the financial services sector.

Finally, the underlying theory of a systemic risk regulator is that the
agency will not only be able to supervise the systemically significant members
of the financial services industry–no matter what business form they take–but
will also be able to recognize the development of systemic risks before they
place the financial system in jeopardy. So the Fed would not only have to be
able to forecast the effect of new products and business activities on the
future financial health of the economy generally, but also to understand what
particular activities or investments present excessive risks when undertaken by
a particular business model. It is exceedingly doubtful that any single agency
can make these varied judgments, and certainly not more effectively than the
market itself.

Use of the Discount Window

The Fed has one authority that no other regulator possesses: the ability to
create and lend money without an appropriation from Congress. The flexibility of
the Fed’s authority as lender of last resort has been demonstrated in the
current financial crisis by the agency’s willingness to lend on an emergency
basis to companies and organizations that are not banks or BHCs. The continued
availability of this authority raises troubling questions if the Fed is to
become the regulator of all systemically significant financial institutions,
because it will institutionalize a substantial broadening of the Fed’s
lender-of-last-resort functions. Giving the Fed authority to regulate and
supervise systemically significant firms is essentially the same thing as giving
it authority to use its lender-of-last-resort facility to provide them with the
liquidity necessary to prevent their failure, and will confirm for the market
that these companies will be bailed out if they get into financial
difficulty.

Conclusion

The case for creating a systemic risk regulator has not been made. There is
no clear definition of systemic risk, and specially supervising companies
arbitrarily designated as systemically significant would seriously impair
competition in every field in which a systemically significant company
operates.

In addition, even if it were possible to identify systemically significant
companies and to overcome the competitive problems such a policy would entail,
the Federal Reserve would be a very poor choice for the systemic supervisor.
Such an assignment for the Fed would create significant conflicts with its
monetary policy role and impair the independence that the agency needs to carry
out that role effectively. As unintended consequences, impairing competition and
endangering the dollar would be a good day’s work for a financial wrecking crew;
we shouldn’t expect it of the administration and Congress.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy
Studies at AEI. Karen Dubas assisted him in the preparation of this
article.