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Thanks to Washington’s growing regulatory mood, the Federal Reserve is about to be handed unprecedented controls over the market functions of the American economy.
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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.
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 the American Enterprise Institute. Karen Dubas assisted him in the preparation of this article.
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