WHY ALL REGULATORY ROADS LEAD TO THE FED / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Why all regulatory roads lead to the Fed

By Frederic Mishkin

Published: June 22 2009 19:45


The US Treasury has just taken the historic step of proposing a new regulatory regime in which the Federal Reserve would become a systemic regulator. The plan raises three questions. Do we need a systemic regulator? Should the Fed be the systemic regulator? Are there dangers from this proposal for the Fed and its core mission of conducting monetary policy to control inflation and promote maximum sustainable employment? The answer to all three is yes.

Do we need a systemic regulator? Before the current crisis, financial regulation in almost all countries was designed to ensure the soundness of individual institutions, principally commercial banks, against the risk of loss on their assets. This focus ignores critical interactions, when attempts by individual financial institutions to remain solvent in a crisis can undermine the stability of the system as a whole. As we have seen in this crisis, the failure of one financial institution can inflict severe losses that threaten the viability of many others. In addition, the focus on individual institutions can also cause regulators to overlook important changes in the overall financial system. For example, although the markets for securitised assets and the shadow banking system of lightly regulated financial institutions grew dramatically in the years before the current crisis, the existing regulatory structures did not evolve with them.

The need for a systemic regulator to oversee the health and stability of the overall financial system has never been greater. Its role should include gathering, analysing and reporting information about significant interactions and risks among financial institutions; deciding on which institutions expose the financial system to systemic risk; designing and implementing regulations such as higher and countercyclical capital requirements for systemically important institutions; and co-ordinating with other regulatory agencies and the fiscal authorities to manage systemic crises.

Should the Fed be the systemic regulator? There are four reasons why it makes sense to have the central bank as a systemic regulator. First, the central bank has daily trading relationships with market participants as part of its core function of implementing monetary policy and is well placed to monitor market events and to flag looming problems in the financial system. No other public institution in the US (and in other countries) has comparable insight and access to the broad flows in the financial system.

Second, the central bank’s mandate to preserve macroeconomic stability is well matched to the role of ensuring the stability of the financial system. The worst economic contractions are always associated with financial crises, so the Fed has naturally had to think about the interaction of finance and monetary policy in carrying out its core mission.

Third, successful systemic regulation requires a focus on the long term, so the respect and independence that central banks such as the Fed enjoy makes them natural candidates to be the systemic regulator.

Fourth, a central bank is the only entity that can function as a lender of last resort, that is, it can use its balance sheet to provide emergency funding in times of crisis. As a systemic regulator, the Fed will be able to get first-hand information gathered from direct on-site examinations of systemically important institutions, which it will need to make the right decision as to whether it should lend money to save an institution.

Are there dangers from the Treasury proposal to make the Fed the systemic regulator? There are three dangers from handing this new responsibility to the Fed. First, the clear focus on achieving output and price stability might become blurred once the central bank also takes account of financial stability objectives. Second, there is a danger of increased political pressure on the Fed that could subject it to attacks on its independence when it takes action to rein in risk-taking by systemically important institutions. Third, the Fed does not currently have sufficient resources to take on this new role. Without sufficient resources, the systemic regulator will not be able to identify systemic risks and craft the needed regulations. As I learnt when I was a governor of the Fed during the current crisis, its staff have been stretched to the limit. Asking it to become a systemic regulator will stretch already thin resources, perhaps even compromising its ability to conduct monetary policy.

Despite these dangers, given the importance of the financial stability goal and the fact that some institution must play the role of the systemic regulator, I strongly believe that the Fed should take on this new task in spite of the difficulties this will pose. Some safeguards can mitigate the difficulties. For example, some central banks have used explicit, numerical long-run inflation objectives to keep the price stability goal firmly in view. As I have argued before on this page, the Fed should head in this direction. Congress also needs to support the Fed’s independence and funding.

An important lesson from the current crisis is that we desperately need a systemic regulator and the Fed is the only logical choice.

The writer is a professor of finance and economics at the Graduate School of Business, Columbia University, and a former member of the Board of Governors of the Federal Reserve. This article draws from a working paper of the Squam Lake Working Group on Financial Regulation


Copyright The Financial Times Limited 2009