Regulatory quakes and tremors
If there were a regulatory Richter scale that measured the shaking of the financial system, the 2010 Dodd-Frank Act would register about 8, while the 2011 Basel III framework might be a bit above 7. (For reference, the 1906 San Francisco earthquake was a 7.8). Fortunately, this shaking is mostly for the better – helping to make the financial system more resilient in the long run.
The new “Bailout Prevention Act” of Senators Vitter and Warren also might be an 8 on the shaking scale, but it would be a true disaster, because it undermines the Fed’s role as crisis lender of last resort. In contrast, the Senate Banking Committee’s new discussion draft of a “Financial Regulatory Improvement Act of 2015” is probably a 2 or a 3. If enacted, it will be “felt slightly by some people” but probably won't do much damage.
If you’re looking for good legislative news on the regulatory front, it’s that neither draft includes the most populist proposals that would threaten the monetary policy independence of the Federal Reserve (see here regarding “Audit the Fed”). But with the Vitter-Warren quake, otherwise known as S.1320, we fear that the good news stops there.
Former Fed Chair Ben Bernanke makes clear that Vitter-Warren requires immediate release of information in a crisis about who is borrowing from the Fed (unfortunately, the text of the bill is not available to us as of this post, so our analysis is based on Senator Vitter’s summary and Bernanke’s post). At the extraordinary 500-basis-point penalty lending spread that the bill requires, any borrower would be admitting publicly that it cannot fund itself in the market. We call that “stigma,” and its impact in a crisis is predictable: no borrowers and no lender of last resort; just fire sales and a collapse of credit.
We know this from painful experience. At the start of 1932, following thousands of bank failures, the new Reconstruction Finance Corporation (RFC) began lending to distressed banks, and failures temporarily slowed. But, the loans were controversial, so a July 1932 law required reporting of the borrowers by name – information that Congress quickly released. What followed was an even bigger wave of bank runs and failures.
Why, after 101 years of the Federal Reserve, and the experience of the Great Depression, is the lender of last resort still so controversial? The political problem is that the borrowers are often big and powerful, and occasionally foreign, making them obvious targets for populist retribution. From an economic perspective, the issue is whether a potential borrower is just illiquid or truly insolvent. Lending to an insolvent bank is a no-no: it creates poor incentives and actually adds to stigma (see here). But, in a crisis, when trading in markets is rare or nonexistent, prices of assets aren’t readily available. The resulting inability to value bank assets haunts central bankers. Unfortunately, this problem cannot be legislated out of existence. You might as well try to outlaw inflation.
Keep in mind that Vitter-Warren is not about transparency: the Fed already releases full information about all its loans about two years after the fact (see here). Sadly, the issue is whether the Fed should lend at all.
Turning to the Senate Banking Committee proposal, despite ambitious claims, the draft bill makes little progress in “fixing” Dodd-Frank: all its major faults remain (see here and here). These include the failure to address systemically important markets (like repurchase agreements and money market mutual funds) and the government-sponsored enterprises (GSEs); the tendency to regulate by legal form rather than economic function (see our discussion here); the mispricing of (implicit) government guarantees; and the reliance on an ex post tax on intermediaries to fund the resolution of a failed behemoth, rather than on an ex ante risk-adjusted fee.
Before we continue, we should admit that we have only read a 9-page summary, not the 216-page draft bill. That said, and given our interest, we will make a few comments on how the draft bill affects the Financial Stability Oversight Council (FSOC) – the umbrella committee of U.S. regulators created by Dodd-Frank – and the Federal Reserve.
On the FSOC: Congress seems uncomfortable with its new regulator, but sensitive to the anxieties of those big nonbanks that fear designation by the FSOC as “systemically important financial intermediaries” (SIFIs). Since it began operations, the FSOC has designated a total of four nonbank SIFIs (AIG, GE Capital, MetLife, and Prudential), making them subject to supervision by the Federal Reserve and to the imposition of capital and liquidity requirements designed to reduce systemic risk. [Note that MetLife and Prudential are ranked numbers 4 and 5, respectively, in NYU Stern Volatility Lab’s latest rankings of systemic risk contributors in the United States. AIG is number 57 and GE Capital is unranked because its stock does not trade separately from that of the parent firm.]
The draft bill would make the FSOC slightly more transparent in its governance and gives potential and actual SIFI-designees greater opportunity to influence their regulatory fate. On the governance side, greater access helps address (largely turf-motivated) criticism of the FSOC by the members of some agencies who complained that their views were not considered. They still may not get their way, but their views should be heard.
Achieving the proper role for the big intermediaries themselves in the SIFI designation process requires a delicate balance. On the one hand, like any legal or regulatory procedure, SIFI designation should be fair, open and predictable, not least so that nonbanks can choose intelligently whether to take on or to shed systemic risks that might cause them to be designated. On the other hand, providing intermediaries too many avenues to influence regulators invites gaming of the system and, in the extreme, regulatory capture.
The new draft bill clearly tilts the field toward greater risk of such gaming. We think it would be more effective (and less risky) to promote transparency about the methodology of assessment, rather than the procedures of specific assessments, which require confidentiality. Behemoths don’t change spots overnight – or even over a year – so the economic rationale for frequent review of a SIFI designation and for its automatic expiration after five years – as called for in the bill – is unclear. Gaming of the regulatory system is a serious problem in finance. These changes could easily make it worse.
What’s missing from the bill regarding FSOC? Dodd-Frank also contemplated the FSOC as a means to coordinate U.S. regulators. On that front, FSOC appears to lack the enforcement powers needed for success – witness the SEC’s continued resistance to an effective reform of MMMFs – but the draft bill provides no remedy.
On the Fed: The draft bill tinkers – mostly in a positive way – with Fed communications. It calls for quarterly, rather than semi-annual, reports from the Fed. It asks for more details about the Fed’s assessment of the economy, and requires the central bank to disclose “rules or strategies used or considered to determine monetary policy.” Less benignly, it shortens the lag for releasing FOMC transcripts to three from five years. These changes may add little to Fed disclosure, which is already extensive, but they shouldn’t do much damage. One unintended outcome may be a proliferation of rules that the Fed could “consider” in assessing its policy stance (including multiple versions of the Taylor Rule in addition to rules for targeting nominal GDP or the price level).
Perhaps the most constructive proposal in the area of monetary policy is to shift authority for setting the interest rate paid on reserves (IOER) from the Federal Reserve Board to the FOMC. In coming years, we see monetary policy as largely embodied in this rate, not the federal funds rate used in the past. As a result, this transfer ensures that monetary policy remains the province of the FOMC, both de facto and de jure.
Less constructive and much more worrisome is the proposal for a commission to “make a recommendation to Congress on the optimal organization of the Federal Reserve System.” No one thinks the current structure is optimal: it remains a reflection of 1913 U.S. demographics and the personalities who controlled the pre-World War I Congress. Yet, for all its faults, the system functions reasonably (especially by comparison to other agencies of government). So, while we would welcome a rationalization (including, say, a more reasonable geographic balance among the districts), the draft bill’s broad mandate for the commission opens the door to those whose real goal is to weaken the Fed, rather than make it more effective.
Finally, the draft bill calls for the President of the Federal Reserve Bank of New York (FRBNY) to be nominated by the President and confirmed by the Senate. This would further politicize the Fed without necessarily solving any problems. For those who consider the FRBNY too powerful, this further elevates the status of the FRBNY President relative to that of the other Reserve Bank Presidents. If, instead, the goal is to make the 12 Reserve Bank Presidents more alike in authority, then Congress could require that the current FOMC voting rotation rules apply equally and that the role of Vice Chair rotate (currently, the FRBNY President always votes and serves as Vice Chair).
So, what’s missing with regard to reform of the Fed? We think that financial stability and monetary policy are now so closely linked that making good monetary policy requires thorough knowledge of the state of prudential regulation and supervision. However, many FOMC members – especially those from Reserve Banks with no SIFIs in their districts – lack access to critical information. If Congress wishes the FOMC to remain the key authority for setting monetary policy, all FOMC members will need timely access to the full range of information used to formulate and evaluate financial stability policy.
Our bottom line: Vitter-Warren would be a disaster, perhaps no less so than “Audit the Fed.” But the “Financial Regulatory Improvement Act of 2015” is just a minor tremor. Even so, we plan to watch carefully, because tremors can be omens of bigger things to come.