Monetary Policy and Systemic Risk Regulation

featuring John B. Taylor
Thursday, July 9, 2009
John B. Taylor

The Obama administration’s plan for financial regulatory reform would grant the Federal Reserve significant new powers—more powers than ever before in American history—including the power to determine “whether an individual financial firm poses a threat to financial stability” considering such issues as size or interconnectedness. All such Fed-designated firms would then be placed in a special group called Tier I FHCs (financial holding companies) that the Federal Reserve would then have the power to supervise and regulate. Such Tier I FHCs would also become subject to a proposed “resolution regime” that would expand the existing resolution regime for insured deposit institutions under the Federal Deposit Insurance Act. The Fed would also have the power to collect “periodic and other reports” from all U.S. financial firms that meet certain minimum (as yet unspecified) size standards. The power of the Federal Reserve under Section 13(3) of the Federal Reserve Act—the unusual and exigent circumstances clause that has been used frequently to intervene during the past year—would not be circumscribed in any specific way, though it would “be subject to prior written approval of the Secretary of the Treasury.’’

Taken as a whole, these new powers proposed by the administration would transform the Fed into a systemic risk regulator, though the term “systemic risk” has not been operationally defined. The important question is whether these new powers—the systemic risk powers—will affect the Fed’s traditional role as the independent authority on monetary policy. In my view, these new powers will have a significant negative effect on this role to the potential detriment of the conduct of good monetary policy. I have four main concerns:

First, the additional powers and responsibilities would dilute the key mission of the Federal Reserve, which is to maintain overall economic and price stability by controlling the growth of the money supply and thereby influencing the overall level of interest rates. My experience in government and elsewhere is that institutions work best when they focus on a limited set of understandable goals and are held accountable by the public for achieving those goals. As the number of goals and the lack of clarity increase, effectiveness and performance generally decline. By giving the Federal Reserve the responsibility for determining which firms should be classified as Tier I FHCs and then giving it broad responsibility for their stability and impact on the economy, the proposed plan would greatly expand the goals of the Federal Reserve and thereby have negative consequences.

Second, responsibility for Tier I FHCs would reduce the credibility of the Federal Reserve by involving it directly in potentially controversial decisions. We have already seen this tendency in the recent criticism of the Fed’s alleged involvement in the Bank of America merger with Merrill Lynch as well as in the backlash against the large bailouts of financial institutions and questions about the collateral involved. Academic research and practical experience show that the Fed’s credibility is an extraordinarily valuable asset that would be terrible to lose.

Third, the plan would create a conflict of interest. With firms in the Tier I FHC category being perceived as too big to fail, or perhaps even too big to resolve, there will be a temptation to adjust the instruments of monetary policy to protect those institutions, perhaps by not increasing short-term interest rates, even though such an increase would be warranted under the goals of price stability or overall economic stability. Or the Fed could mistakenly recommend an inappropriate start of the resolution regime for one or more Tier I FHCs, thus making it easier to raise interest rates to achieve its price stability goals.

Fourth, by giving so much power to the Federal Reserve, the plan would threaten the Fed’s independence regarding monetary policy. There is a good rationale for an independent monetary authority: it helps prevent giving too great a focus to the short run at the expense of the long run, and international comparisons have shown that independent monetary authorities deliver better economic performance. Why would giving more power to the Fed in the area of regulation and supervision of Tier I FHCs of its choosing result in less independence in the monetary sphere? Because sooner or later the increased power will result in checks and limits on it, perhaps through micromanaged political interference or even through legislative changes. It would also be impossible to prevent such interference from spreading from the new regulatory and supervisory function to the traditional monetary function, via the executive or legislative branch of government.

The Fed’s credibility is an extraordinarily valuable asset that would be terrible to lose.

Loss of Federal Reserve independence is a serious issue, especially at this time of rapidly increasing federal debt and a greatly expanded Federal Reserve balance sheet. Indeed, after reviewing recent events, George Shultz (who has served as secretary of state and the Treasury) writes, in The Road ahead for the Fed: “Observing this process, the question comes forcefully at you: Has the Accord gone down the drain? And remember how difficult it was for the Fed to disentangle itself from the Treasury in the post–World War II period.” (Secretary Shultz is referring to the 1951 Accord by which the Federal Reserve regained its independence following the World War II peg of Treasury borrowing rates.) Requiring the secretary of the Treasury to approve using Section 13 (3) raises additional independence concerns; better to carve out specific Section 13(3) actions in specific ways in legislation and perhaps assign those to the Treasury.

Given the above disadvantages, what are the alternatives for systemic risk regulation? In general, I would define systemic risk in the financial sector as a risk that affects the entire financial system and economy, through cascading, contagion, and chain-reaction effects. The triggering event for such a macroimpact can come from the public sector, as when the central bank suddenly contracts liquidity; from the financial markets, as when a large private firm fails; and from the outside, as when a natural disaster or terrorist attack shuts down the payment system.

Examples of systemic events before the current crisis were the default by the Russian government in 1998, which affected markets around the world and led the Federal Reserve to cut interest rates, and the September 11, 2001, terrorist attacks, which affected the payment system in the United States by severely damaging financial firms intimately engaged in that system. It is important to emphasize that contagion or chain reactions are not automatic; they can be altered by changes in the rules of the game established by public policy. When Argentina defaulted on its debt in 2001, three years after the Russian default, there was no global contagion, even though the world economy was in worse shape than it is now, primarily because the rules of International Monetary Fund support were explicit and anticipated.

What were the systemic events in the current crisis? Fortunately, there was no terrorist attack or natural disaster, so was it government forces or market forces? In my view, government actions—from monetary policy being too easy to government-sponsored agencies encouraging too much risk—were the primary causes. The failure to regulate adequately entities that were supposed to be—and thought to be—regulated encouraged the excesses. Risky transactions connected to regulated banks were allowed by regulators. The Securities and Exchange Commission was supposed to regulate broker-dealers, but its skill base was investor protection rather than prudential regulation. Similarly, the Office of Thrift Supervision was not up to the job of regulating the complex financial products division of the insurance company AIG. These regulatory gaps and overlapping responsibilities added to the problem and need to be addressed in regulatory reform.

So efforts to reform the regulatory system are in order. But what are reasonable objectives and tasks for systemic risk regulation? Based on recent experience, closing present and future regulatory gaps and untangling overlapping and ambiguous responsibilities would help reduce systemic risk, especially as new instruments and institutions evolve. In addition, systemic risk might be reduced if disaggregated information were aggregated and passed back to the private sector, as suggested by Nobel Prize–winning economist Myron Scholes.

But none of these tasks and objectives requires a new systemic risk regulator, whether at the Fed or elsewhere. Indeed, such a regulator might serve as an excuse for existing regulatory agencies to pass off responsibilities for past and future regulatory failures.

I have suggested that these tasks be done within the existing President’s Working Group on Financial Markets, suitably expanded with the additional regulatory agencies and with funding to support sufficient staff at the Treasury to take on the tasks. This recommendation is very close to replacing the President’s Working Group with the Financial Services Oversight Council as proposed by the Obama administration. In my view, this would be a sufficient reform in the systemic risk area and would not require giving the additional powers to the Federal Reserve.