Interview: Jeremy Stein

Moise Y. Safra Professor of Economics at Harvard University; former member of the Board of Governors of the Federal Reserve System; former senior advisor to the Treasury Secretary.

Has the experience of the crisis changed your view of the central bank policy toolkit?

Governor Stein: Yes, on two dimensions. First, on the toolkit insofar as it has to do with crisis prevention; and second, insofar as it has to do with what you do in the aftermath, when the economy is very weak and you are stuck at the zero lower bound.

Let me focus on the first of these two—what we’ve learned about crisis prevention. Speaking broadly, the tools of central banks can be classified into monetary policy, lender of last resort, and regulation. You might argue that – since we’ve learned that financial crises are more damaging then we had previously thought – we should use each of these tools to do more in the way of either crisis prevention or crisis mitigation. To the extent that there exists a consensus, this is surely true with respect to regulation. That is to say, I think that everyone basically believes that regulation in the period leading up to the crisis was inadequate and that we need to do better.

The other two are a little more interesting. You might have thought that one lesson from the crisis is that central banks acting as a lender of last resort was an important and powerful part of the response. Yet, the general thrust of Dodd-Frank is to make it harder to use the lender of last resort function for nonbanks like broker-dealer firms – namely, to make it more difficult to invoke Federal Reserve Act Section 13(3) powers in “unusual and exigent circumstances” for a specific firm. I think it’s an open question whether that’s a useful direction to go. I might lean against that a little bit: if you have the ability to regulate broker-dealers effectively, and you can regulate them as stringently as a bank, then you might want to have the ability to make the Federal Reserve’s lender of last resort capabilities available to them as well.

And the second is with respect to monetary policy. If you take the view that we should be working with all of our tools to mitigate crises, should monetary policy be drawn into trying to reduce the odds of a crisis, or more generally, should it concern itself with buildups of risk in financial markets ex ante? I don’t know if there’s a consensus lesson there, but clearly the question has come more to the fore.

Where should we be looking for financial stability risks?

Governor Stein: Everywhere! By which I mean that one of the things to be most aware of is the shape-shifting nature of financial-market activity. So one doesn’t want to be overly focused on just those areas that were a source of problems last time around. With that in mind, let’s consider three areas of the financial system: banking, leveraged shadow banking, and everywhere else.

To the extent that changes in regulation have done a good job, it’s probably been most effective in the areas where we already had, not so much good regulation, but a regulatory infrastructure and the dials to turn. That would be in the banking system. Here, there has clearly been some progress. There is substantially more capital. There has been movement towards improved resolution. All of that is good and leads you to be a little less worried about a large banking institution being in the middle of the next big problem. This is not to say that it’s not still an issue, but I think at least there there’s been some meaningful mitigation.

The second area is leveraged shadow banking. The classic notion of shadow banking is maturity transformation that takes place outside the banking sector. Think of firms funding assets with repo; repo that eventually winds up in a money market mutual fund or something like it. I think there has been a very clear appreciation that that is potentially problematic. And there have been policy efforts to address it, with the Financial Stability Board and others quite engaged. But, it’s been harder to make progress, in part because we just didn’t have a preexisting set of tools. So, with bank capital, it was inadequate before, but at least there were capital requirements and we could raise them. We had a good infrastructure and well-delineated responsibilities.

With shadow banking, it’s much tougher. The efforts of the Financial Stability Oversight Council (FSOC) around money market mutual funds (MMMFs) are a good example. Oversight of MMMFs falls into the domain of the Securities and Exchange Commission (SEC), but there was more interest in aggressive reform coming from parties other than the SEC. All that had to get litigated. As a result – even in a case where the imperative to do something was very, very strong – progress has been slow and not entirely satisfying. I think that’s a place where risks still remain, and there’s quite a lot of urgency to address them.

And then the third area regards intermediaries that were not directly implicated in the crisis. Here, I’m thinking of developments like the very rapid growth of open-end bond funds. These don’t have leverage in the usual sense, but nevertheless have demandable liabilities. That is, an open-end bond fund doesn’t issue debt per se, but has claims that can be pulled the next day and are increasingly backed by relatively illiquid assets. So, as Hyun Shin (Economic Adviser and Head of Research at the Bank for International Settlements) and others have argued, I think there is potentially some risk here. I don’t think we have much evidence to go on, but that’s one of the areas where I worry. And, again, I worry that not much has been done to address it and that there’s not a great process in place. One would hope that this is the kind of thing that the FSOC is paying close attention to, but jurisdictionally it’s complicated and intellectually it’s also complicated.

What do we need to do to preserve the benefits of global finance?

Governor Stein: That’s a broad question. You can take it in different directions.
With regard to finance generally, one direction to take it is a political economy direction. Painting with a very broad brush, finance surely does quite a lot of good in the world and there are aspects of finance that are worth preserving and worth fighting to preserve. On the other hand, finance has also done quite a bit of damage. And some of the things that it’s done, even when they haven’t caused major systemic damage, have nevertheless been pretty off-putting, to put it mildly.

In a democratic system, that raises the question of what is the political support for the financial system, or for financial institutions. Can we have a political system that regulates the financial system intelligently? A technocrat might say (and this is my view) that we want to regulate in a very muscular way in those places where it makes sense to do so, but with some nuance. In other words, one shouldn’t do dumb populist things just for the sake of bashing bankers. For example, I’m all in favor of quite aggressively higher capital requirements within the broad risk-weighted framework that we have. If you ask me would I like a few percentage points more of capital surcharges on systemic intermediaries, I think that is quite likely to be a good thing. On the other hand, there have been calls from some quarters for large increases in the un-weighted leverage ratio, above and beyond what we have now. While this sounds superficially appealing, and makes a good rallying cry, I believe it makes less sense and could do some harm. But this distinction is fairly subtle relative to what a political system that doesn’t do subtlety very well may be able to achieve.

In that world, events like the never-ending procession of LIBOR and other scandals are extremely damaging. I don’t think there were large systemic implications associated with the LIBOR manipulations thus far. But these sorts of things undermine the confidence and trust in these institutions. They change the political calculus and make it very hard to preserve in the most intelligent way the benefits of finance. So I think we should explore what can be done to shut down this sort of behavior, possibly including further reform to compensation practices. Federal Reserve Bank of New York President William Dudley recently gave a talk about bank culture. These are very difficult things to deal with, but if they don’t get addressed, policy is going to end up being made in a very blunt way.

With regard to the global aspects of finance, one tension that we dealt with at the Federal Reserve is how do we, as a host country, regulate the behavior of foreign banks. There’s a balance that needs to be struck. The United States is in a distinctive situation because of the very wide-scale use of wholesale dollar funding by foreign banking organizations that have broker-dealer subsidiaries and/or bank branches in the United States. To what extent do we want to regulate that?

There have been some people saying you should regulate foreign banks operating in the United States with a very light touch. Yet, precisely to preserve the benefits of cross-border finance, we needed to do things in a more harmonized fashion. Previously, we had a situation that supported maximum activity in the United States by foreign banks, but they were operating with a relatively unstable wholesale funding model, and in some cases with less capital. That allowed them to become an aggressive presence, but made it somewhat unstable. In the longer run, having a stronger domestic regulatory framework for the foreign banks is probably a good step.