Rocking the Fed’s Boat

Sunday, October 12, 2008

Freddie, Fannie, the Bear, the Brothers Lehman . . . they sound like characters plucked from a cautionary fairytale. But this is no fairytale. The global credit and housing crisis is a complex story of suspense and danger— bubbles, bankruptcies, and continuing financial risks are only the beginning; the concluding chapters will be about regulatory reform. If policy makers are not careful, the story will conclude with the same, worn moral of other economic tales of woe: “Beware the unintended consequences.”

Financial regulation has always represented a unique set of challenges, both in principle and in practice. Those challenges have only increased with the pace of financial innovation. Even before the Wall Street crisis emerged, the Treasury Department had proposed to modernize the nation’s financial regulatory system in response to advances in financial services. Perhaps most important, that proposal set up a debate over the bounds of authority for our financial regulators, a debate only intensified by the financial storm that began last year.

The independent Federal Reserve System (the Fed) is sure to remain a desired feature of our financial regulatory landscape. The past several decades witnessed a marked increase in economic stability in the United States. Indeed, both the frequency and the magnitude of economic fluctuations exhibited such a pronounced decrease that many characterized this period as the “great moderation.” Authoritative accounts credit the moderation not only to a better understanding of how monetary policy affects real economic activity but also to the Fed’s power to act outside politics.

Because the Fed’s political autonomy is considered central to effective monetary policy, some are tempted to assume that financial regulation could be improved if the bank’s powers were expanded. However, any such broadening of the Fed’s authority and responsibilities could bring significant political pressure. Imagine, for example, that the Fed was responsible for regulating mortgage backers Fannie Mae and Freddie Mac. Our independent central bank would have been the target of Freddie and Fannie’s widely cited lobbying for favorable regulation. While the impact of such lobbying would be unclear, the mere fact that pressure was being directed at the Fed would put at risk the bank’s credibility and its role as lender of last resort—not to mention price stability.


The financial sector has grown immensely in both scope and magnitude of services. Lenders and borrowers have access to many new, and now notorious, credit derivative instruments. Credit default swaps (CDS) allow the transfer of third-party default risk. More general credit derivative indexes allow investors to gain exposure to narrower dimensions of borrowers’ demand for capital, through “tranches” representing specific maturities and levels of risk. According to Federal Reserve governor Randall Kroszner, the notional value of these indexes had doubled each year beginning in 2001. By 2006, credit derivative indexes constituted an alphabet soup of investment instruments valued at $20 trillion.

Amid the rapid change in financial services, the Treasury Department initiated a yearlong study of capital market competitiveness. The study, the Blueprint for a Modernized Financial Regulatory Structure, was released March 31, 2008. It outlined a financial regulatory system that would “attract capital based on its effectiveness in promoting innovation, managing systemwide risks, and fostering consumer and investor confidence.” Among the host of recommendations was the designation of three objectives- based regulators. Here is how it would work:

  • A new business-conduct regulator would ensure consumer protection;

  • A new prudential regulator would ensure the safety and soundness of institutions with financial guarantees;

  • The Federal Reserve would ensure overall financial market stability.

Even as the Treasury study group worked, economic and financial market conditions worsened. The Fed’s interest-rate-setting committee first acknowledged slowing economic activity in a statement released May 9, 2007. Monetary policy interventions began in August 2007, with the U.S., Japanese, and European central banks injecting more than $350 billion in liquidity to stave off a credit market freeze. The Fed continued its economic and financial stimulus moves during the next several months.

Reforms that broaden the Fed’s powers and responsibilities would bring heavier political pressures.

Ironically, financial regulatory reform has been pushed off the front page even as the crisis has unfolded. In March, with growing creditor demands but little cash, Bear Stearns was facing the prospect of a bank run. And because (as the Depression proved) bank runs can be contagious, the Fed arranged a marriage between JPMorgan Chase and the Bear. A procession of interventions would follow, from Freddie and Fannie to Washington Mutual to a systemwide program being developed as this article goes to press. Amid the public and political clamor to “do something,” however, it remains important to look ahead to the debate over financial regulatory reform that is sure to resume.


The Treasury plan is only a starting point for thinking about regulating the emerging financial landscape. Some may also see recent interventions as a justification for a greater Fed role in financial regulation. Expanding the Fed’s regulatory responsibilities appears attractive in at least two ways. First, the Fed’s stock of scientific expertise and experience in how policy affects economic stability is impressive. Second, entrusting these responsibilities to what is perhaps the most independent government bureaucracy may help limit political interference during election cycles. The Fed’s traditional policy objectives are facilitated by independence, so wouldn’t newly awarded policy obligations work well under the same model?

Maybe not. A central bank becomes a target of special interests once it moves beyond monetary policy.

Many government policies result in either benefits or costs to narrowly defined constituencies—ethanol subsidies, for example, that raise the value of feed stocks or tax policies that raise the cost of cigarettes. In those cases, all corn farmers or cigarette smokers will have common interests. And members of a group with strong enough common interests will band together to lobby for regulatory accommodation.

In contrast, monetary policies result in diffuse costs and benefits. Lower interest rates, for instance, benefit debtors in general—a group that may range from a company financing its receivables to a borrower at a payday loan store. Individuals in this group have a much more varied set of interests and are correspondingly less likely to organize to lobby the monetary authority. The diffuse nature of monetary policy consequences may help insulate the Fed from lobbyists and political pressure.

But were the Fed to assume a broader scope of financial regulatory duties, this healthy distance might be reduced. For example, former Fed chair Paul Volcker has testified that efforts to boost liquidity in mortgagebacked securities have made central banks “supporters of the mortgage market.” Any reorganization of the Fed that formalizes these responsibilities would bring new political pressures, undercutting its primary job: to produce sound monetary policy.


It’s tempting to wish for an easy fix that restores confidence in our financial regulatory system. How comforting it would be to know that we could avoid a repeat of the subprime-lending meltdown by assigning responsibility to one agency or another. Unfortunately, there is no alternative to the hard work of getting policy right.

Wholesale reforms are appealing, but the debate also has to consider the many seemingly smaller opportunities to address policies that increase financial risk across the system. Anticipating financial crises is extremely difficult, but many reforms to improve private incentives that enhance stability are closer at hand.

A reorganization that adds to the Fed’s policy obligations may endanger its ability to produce sound monetary policy.

Dividend tax policy is a good example. Double taxation of dividends encourages firms to take on too much debt, which increases systemic risk. If taxes on dividends were reduced, the incentive for firms to borrow too much would lessen, and the resulting reduction in leverage thus would move toward the Treasury’s goal of “stable and resilient markets.”

Let’s look at an illustration. The potential for a large, Bear Stearns-like fiasco grows with the leverage that firms take on. Equity-funded firms, for example, can adjust to economic shocks without creating much pain to others. Debt-heavy organizations must sell assets in response to shocks. But when shocks affect many firms at the same time (during a deterioration of assets that are backed by subprime mortgages, for instance), this selling takes place in a less-than-orderly manner—and what began as a localized lack of liquidity can turn into a systemwide lack of solvency. Indeed, Hoover senior fellow and Stanford economist Robert E. Hall observes that the current financial turmoil dealt a greater blow to the East Coast, where firms rely more on debt, than to the West Coast, where high-tech firms tend to be financed by equity.

To mitigate systemic risks up front, then, reforms might try to remove distortions in how firms finance their operations. Dividend tax rates were lowered to 15 percent in 2003, but this decrease must be revisited in 2010. Maintaining or even furthering this cut would weaken the incentive to take on too much leverage and thus reduce the potential for systemic risks in the first place.

To be sure, debt financing maintains some advantages of corporate governance. It constrains the cash flows with which management might opportunistically indulge its own preferences, and it can lead to more careful monitoring through restrictive covenants and capital requirements. But in the current credit crisis, such benefits may not have compensated for the parallel increase in the potential for systemic distress. Instead, by continuing to treat dividends as taxable distributions and interest payments as deductible expenses, the tax code may have biased firms to take on too much debt, not only from the narrow perspective of risks for the firm but from the broader perspective of systemic risks. Lower taxes on dividends better align the actions of private firms with the objectives of prudent regulation.

It would be comforting to know that we could avoid a repeat of the subprime lending crisis by assigning responsibility to one agency or another. But we can’t.

Dividends tax policy represents just one opportunity to contribute to financial stability. Meanwhile, the debate over a new financial regulatory structure, and the future of the Federal Reserve System, has just begun. Determining the Fed’s ultimate scope of policy obligations must be done with great care. Expanding policy objectives is likely to increase pressure from narrow interests, jeopardizing central bank independence.

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