The Road Ahead for the Fed

Reviewed by Thomas D. Simpson
Department of Economics and Finance at the University of North Carolina, Wilmington and formerly a senior official of the Board of Governors of the Federal Reserve System.

The financial crisis that developed in 2008, permeating nearly every segment of our financial system and pulling our economy into a major recession, has imposed massive costs on the public and has altered significantly the political agenda.  Clearly, this is something we do not wish to repeat. 

To better ensure that nothing like this happens again will require that a number of questions be addressed.  How much of the underlying causes can be attributed to behavior in the private sector and how much to misguided public policy?  Will the costs incurred by private agents be sufficient to prompt them to make self-correcting adaptations?  Or will it be necessary to make changes in public policy—and if so, just tweaks or wholesale reforms?

Important to achieving the most constructive outcome are high-level postmortems performed by very experienced and knowledgeable persons. This book represents such a contribution and is based on papers prepared for a conference held at the Hoover Institution in March 2009.  The authors represent a rich mixture of current and former public policy makers, high-level financial market participants, and prominent academics: George P. Shultz (Hoover and formerly Secretary of State, Treasury, and Labor); Allan H. Meltzer (Carnegie Mellon and the American Enterprise Institute); Peter R. Fisher (Blackrock and formerly Under Secretary of the Treasury and Desk Manager at the New York Fed); Donald L. Kohn (Vice Chairman, Federal Reserve Board); James D. Hamilton (San Diego); John B. Taylor (Hoover and Stanford and formerly Under Secretary of the Treasury); Myron S. Scholes (Platinum Grove Asset Management, Stanford, and Nobel Prize winner), Darrell Duffie (Stanford); Andrew Crockett (J.P. Morgan Chase and formerly general director of the BIS); Michael J. Halloran (Kilpatrick Stockton, LLP and formerly senior staff of the SEC); Richard J. Herring (Wharton); and John D. Ciorciari (Michigan).

It is worth noting that the crisis has its origins in the residential real estate sector where generous financing—most notably aggressively offered and priced subprime and other nonconforming loans—contributed to a price bubble and construction boom.  For some time, mortgage and other financing had been shifting from traditional institutional lending to the capital markets where whole loans were transformed into securities.  There, investors appeared to have an ever-growing appetite for more product—and more complex and opaque product.  This securitization process was thought to have desirable consequences for the soundness and stability of the financial system by moving credit risk from the balance sheets of regulated financial institutions, including commercial banks, to markets where the risk could be more effectively borne and managed.  In the end, ironically, major commercial banks and investment banks took much of the blow coming from the bursting of the bubble as they retained exposures in complicated and nontransparent ways.  This led to a seizing up of essential parts of the financial system and an adverse feedback loop that pushed both the financial system and the economy into mutually reinforcing tailspins.   

As the title implies, much of the attention of the book is devoted to the role of the Federal Reserve (Fed) in contributing to the financial crisis, managing it, and possibly being given more responsibility for regulating the financial system.  All of the contributors agree that an independent Fed is critical for achieving price stability and desirable long-term macroeconomic performance.  Shultz and Meltzer emphasize that this independence was achieved by the Treasury-Fed Accord of 1951 and by Paul Volker’s hard-fought struggle to achieve low inflation in the early 1980s.  Taylor and Meltzer argue that the Fed compromised its price stability goal by departing from a well-established rule (Taylor rule) in the earlier part of the decade by holding its monetary policy rate (the federal funds rate) too low for too long.  This was seen as also contributing to the easy financial conditions behind the real estate bubble (Meltzer and Fisher).  Meltzer argues further that the absence of a policy—or rules—regarding access to the Fed’s discount window compounded the crisis, especially once it unfolded, and added unnecessarily to uncertainty in financial markets.  Several voiced fear that, for these and other reasons, the Fed’s independence could be curbed going forward.  For some, the numerous actions taken jointly by the Fed and Treasury to address the crisis are risking the loss of Fed independence.

Various other federal policies were also seen to be contributors.  Among these were federal housing policies encouraging home purchases, especially those fostered by loans that were excessively risky.  Securitization activities by financial institutions outside the regulated entity were also viewed as contributors, as was moral hazard caused by market participants’ perceptions that major private financial institutions were too-big-to-fail (primarily Fannie Mae, Freddie Mac, major commercial and investment banks, and a behemoth insurer).  Fisher also points to a 2005 revision to the bankruptcy code that encouraged a concentration of risk in a number of large financial institutions.

Once the crisis unfolded in August 2008 the Fed initiated a variety of measures to address the problem.  As noted by Kohn, these took the form of monetary easing (slashing the policy rate) and expanding financing through the discount window and through open market purchases of certain securities that had not been used much—so- called credit easing.  To some extent, these actions were undertaken to address slippage that had developed between the Fed’s policy rate and the financial conditions that influence business and household spending decisions; conditions facing borrowers were getting progressively tighter than suggested by the setting of the policy rate.  Taylor and Hamilton emphasize the unprecedented nature of many of these measures and how close they come to credit allocation.  They voice concern about the implications for how the Fed will be implementing monetary policy in the future and how the independence of the Fed could be compromised by its involvement in decisions  that are more appropriately left to the political sector.  Both emphasize the importance of returning to traditional methods for conducting monetary policy and the need for a sound, well-articulated exit strategy from current practices.

On the matter of regulatory reform, Scholes lays out a useful framework based on the well-known Modigliani-Miller principle establishing that leverage, raising the volatility of returns, does not add to shareholder value.  Shocks can push volatility above financial institutions’ targets, often simultaneously, and attempts to lower volatility through the unwinding of that leverage imposes large dead-weight costs on the financial system—and perhaps the economy more broadly— because of the high degree of interconnectedness of financial institutions. This implies a regulatory emphasis on capital regulation to keep leverage ratios low and thereby hold down risks posed to the system.  Policy should discourage implicitly subsidized leverage, such as implicit guarantees of debt, or improperly priced explicit provisions of credit or guarantees.  Scholes proposes that greater leverage only be permitted through mandatory convertible debt that would be required to be converted to equity in the event of a systemic event.

Elsewhere on the regulatory front, Duffie argues that the regulation of credit default swaps should be outside the insurance industry—à la AIG—where current fragmented state-level regulation is ill-equipped for the task.  In addition, Halloran argues that the SEC is ill-equipped to be the systemic risk regulator.  Crockett suggests that the regulator of systemic risk not be the Fed.  He argues that giving it to the Fed would divert the Fed from its principal monetary policy responsibilities; pose risks to its credibility when problems occur in the regulatory area; create conflicts of interest between monetary policy and systemic risk goals; and add to concerns about the Fed becoming too powerful.

Herring proposes applying a pre-insolvency trigger to a broader range of financial institutions than commercial banks, where such a trigger has worked fairly well.  This would help regulators avoid falling behind the curve in dealing with failing institutions as routinely occurs owing to reporting lags and efforts by managers to hide losses.  Herring also proposes that each large institution posing systemic risk concerns be required to file a winding down plan to better highlight the risks it poses to the system and to serve as a guide for those involved in managing the resolution process in the event it fails.

Looking ahead, the pain of the financial crisis is prompting private agents to take actions that, at least for a while, will lower the chances of a recurrence.  Market discipline will ensure that leverage is held down and risk managers will be more cautious with new, untested financial products.  But it would be foolish to believe that these adaptations, by themselves, will be sufficient.  National regulatory policy will need to change.  This is because of the genuine presence of systemic risk and the associated practice of treating some institutions as too-complicated-to-fail—that is, to avoid unwinding them in ways that disrupt the functioning of broader markets and, ultimately, the economy.  A wider array of financial entities—those deemed to pose or to be parts of institutions that pose systemic risk—will come under this regulation.  And it seems likely that much of the attention will be focused on capital regulation and other ways to align the interests of private financial institutions with those of safety and soundness of the system.  The papers in this volume reinforce the arguments for stronger and more comprehensive capital regulation.  Although powerful arguments can be made for the systemic risk regulator not being the Fed, at the end of the day the Fed alone controls the discount window and is accountable for credit decisions made at the window.  To make the most informed credit decisions, often with little or no lead time, the Fed will want to be able to understand and influence the behavior of its counterparties.  A most vexing dilemma centers on whether giving such power to the Fed will compel lawmakers to curtail the independence of the Fed to conduct monetary policy.