Feature

The Fed Fails Upward

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.

By From the May 2009 issue

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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 2002 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 “something, anything,” to address the financial crisis. That urge, combined with pressure from the Democratic left to gain greater control over the financial 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 “systemically significant” 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: “Never waste a good crisis.” 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 the American Enterprise Institute. Karen Dubas assisted him in the preparation of this article.

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Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.