In response to the financial crisis of 2007-2009, Congress created the Financial Stability Oversight Council (FSOC), a committee of the chiefs of the U.S. regulatory agencies, chaired by the Treasury Secretary, to monitor and secure the stability of the financial system. Critical to this task is the FSOC’s authority to designate nonbanks as “systemically important financial institutions” (SIFIs).
On November 17, the U.S. Treasury issued a report assessing the FSOC’s designation process. Treasury calls on the FSOC to adopt a strategy that prioritizes the regulation of activities or functions—affecting whole sectors of the financial industry—over regulation based on entity or legal form (such as the designation authority). For the most part, we find this sensible, as this focus reduces the scope for regulatory arbitrage that an entities-only approach may foster (see here).
However, we doubt that activities-based regulation alone will be sufficient to limit systemic risk. Our overall conclusion is that the Treasury’s approach sets the bar for FSOC designation too high, diminishing its deterrence effect on undesignated nonbanks. In the end, a sensible focus on both entities and activities is needed to fulfill one of FSOC’s key objectives—to restore market discipline. Adopting the Treasury’s proposed framework will not meet the goal, set out in the President’s Core Principles for Regulating the U.S. Financial system (see Executive Order 13772), of preventing taxpayer-funded bailouts.... Read More
The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).
A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.
But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust.... Read More
Dear Vice Chair McHenry,
We find your January 31 letter to Federal Reserve Board Chair Janet Yellen both misleading and misguided.
It is in the best interest of U.S. citizens and our financial system that the Federal Reserve (and all the other U.S. regulators) continue to participate actively in international financial-standard-setting bodies. The Congress has many opportunities to hold the Fed accountable for its regulatory actions, which are very transparent. We hope that the new U.S. Administration will support the Fed’s efforts to promote a safe and efficient global financial system.
Your letter is filled with false assumptions and assertions.... Read More
The median FOMC participant forecasts that the Committee will raise the target range for the federal funds rate three times this year. That is, by the end of 2017, the range will be 1.25 to 1.50 percent. Assuming the FOMC follows through, this will be the first time in a decade that the policy rate has risen by 75 basis points in a year. It is natural to ask what sort of criticism the central bank will face and whether its independence will be threatened.
Our concerns arise from statements made by President-elect Trump during the campaign, as well as from legislative proposals made by various Republican members of Congress and from Fed criticism from those likely to influence the incoming Administration’s policies.... Read More
China’s rapid credit expansion is worrying. Will Chinese policymakers be able to contain the growth of credit without undermining economic growth and without triggering a banking or currency crisis? Aside from the consequences of Brexit, this is probably the most important issue facing global policymakers and investors today.
As it turns out, there are powerful arguments on both sides. The positives—high national savings and returns to investment, combined with the government’s broad tools for intervention—must be measured against a set of negatives—growing loan losses, the spread of shadow banking, large capital outflows, falling investment returns, and declining confidence in the government’s financial policy management. Against this complex background, it is no wonder that concerns and uncertainty are both high. What one can say confidently remains conditional: things are very likely to end badly if the credit buildup continues amid slowing economic growth... Read More
If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]
But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....
Central bank independence is controversial. It requires the delegation of powerful authority to a group of unelected officials. In a democracy, this anomaly naturally raises questions of legitimacy. It also raises fears of the concentration of power in the hands of a select few.
An independent central bank is a device to overcome the problem of time consistency: the concern that policymakers will renege in the future on a policy promise made today .... Read More
We read with interest your August 21 Bloomberg View that calls for “a thoughtful congressional discussion of the pros and cons of a more thorough audit” of the Federal Reserve. While we share your desire for effective congressional oversight of the Federal Reserve, we strongly disagree on the best way to do it... Read More
What would you think if you were to open your morning newspaper to find the following headline?
“Congress Closes Down Fed, Takes Over Monetary Policy”
If you’re like us, you’d panic. In short order, you’d think that long-term inflation expectations would rise, pushing bond yields higher. You’d anticipate an increase in the volatility of growth, employment and inflation. That more volatile environment would drive up the risk premium required on new investments, hindering long-term economic growth. Finally, you'd be very worried about how these Congressional policymakers would manage the next financial crisis.
This is not a pretty picture. Why would anyone want it to become a reality? Well, these are surely not the intended goals, but they are the likely outcomes should lawmakers ever replace the Federal Reserve Board with what we would call a Congressional Reserve Board... Read More
In a recent speech, Federal Reserve Governor Daniel Tarullo criticized the use of banks’ internal models for determining capital adequacy. There are several reasons to be dissatisfied with the internal ratings-based (IRB) approach, starting with the complexity and opacity that Governor Tarullo highlights. Our uppermost concern is the lack of consistent results across banks. That is, given the same portfolio of assets, different banks’ models yield very different estimates of required capital. These model-driven differences undermine both the trust in banks’ reported capital ratios and their usefulness. Read More
Central bank communication is a work in progress everywhere, but particularly so in the euro area.
Unlike the Fed, the Bank of England, and the Bank of Japan, which all publish minutes of their policy meetings with a lag of a few weeks, current ECB rules anticipate releasing summary records of Governing Council meetings only 30 years after they occur. Read More