PrefBlog

Bernanke made an important speech today on the future of financial regulation:

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States. The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets. In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad.

I’ll buy it … but he’s skating around the responsibility of the Fed. If, in fact, there was a lack of prudence in the investment of capital, the implication is that monetary policy was too loose. It also implies fiscal policy was too loose.

Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.

Achieving more effective supervision of large and complex financial firms will require a number of actions. First, supervisors need to move vigorously–as we are already doing–to address the weaknesses at major financial institutions in capital adequacy, liquidity management, and risk management that have been revealed by the crisis. In particular, policymakers must insist that the large financial firms that they supervise be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis. In that regard, the Federal Reserve has been looking carefully at risk-management practices at systemically important institutions to identify best practices, assess firms’ performance, and require improvement where deficiencies are identified. Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards.[footnote]

Footnote:Such an approach would also help offset the incentives for financial firms to become too big to fail.

This is good, and I am particularly encourage by the reference to high capital standards and offsetting the incentives for financial firms to become too big to fail. I have argued before – and I will argue again – that there should be a sliding scale of regulatory charges to capital based on size; and to prevent games-playing this should be calculated as an increment to Risk-Weighted-Assets. If, for example, a factor of (Lesser of (a) 1.0, or (b) pre-increment RWA / $250-billion) were to be applied to RWA, then any firm growing beyond $250-billion in RWA will find itself needing more and more capital to operate; smaller, regional, banks will be in the sweet spot.

Second, we must ensure a robust framework–both in law and practice–for consolidated supervision of all systemically important financial firms organized as holding companies. The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.

He’s still angry about AIG, as mentioned on March 3.

Third, looking beyond the current crisis, the United States also needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm, including a mechanism to cover the costs of the resolution.

I’m not such a big fan of this point. With all the best intentions, it will create a Regulator of Everything. His primary example is the jawboning by the New York Fed – led by his former underling and current boss – on CDS clearinghouses, which may well be a good solution, but should not be a mandated solution. The mandated solution should be realistic capital charges for exposure and concentration; let the private sector determine whether the overhead of a central clearinghouse is worthwhile.

In light of the importance of money market mutual funds–and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses–policymakers should consider how to increase the resiliency of those funds that are susceptible to runs. One approach would be to impose tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity. A second approach would be to develop a limited system of insurance for money market mutual funds that seek to maintain a stable net asset value. For either of these approaches or others, it would be important to consider the implications not only for the money market mutual fund industry itself, but also for the distribution of liquidity and risk in the financial system as a whole.

“Money Market Fund” is a term defined in Ontario securities law and I’ll assume the situation is similar in the states. It should be a simple matter to bring MMFs under the supervision of bank regulators so that they are regulated as banks, and required to have (and to disclose regularly) the usual amounts of Tier 1 and Total Capital.

Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. We should review capital regulations to ensure that they are appropriately forward-looking, and that capital is allowed to serve its intended role as a buffer–one built up during good times and drawn down during bad times in a manner consistent with safety and soundness.

I couldn’t agree more. Higher capital charges for new – or expanded – relationships should be implemented. Or, perhaps, just apply a surcharge for year-over-year increases in (Risk Weighted) assets.

How could macroprudential policies be better integrated into the regulatory and supervisory system? One way would be for the Congress to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system. The elements of such an authority’s mission could include, for example, (1) monitoring large or rapidly increasing exposures–such as to subprime mortgages–across firms and markets, rather than only at the level of individual firms or sectors; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, such as the mutual exposures of highly interconnected firms; and (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole. Two areas of natural focus for a systemic risk authority would be the stability of systemically critical financial institutions and the systemically relevant aspects of the financial infrastructure that I discussed earlier.

I wonder if at this point in the speech he was coughing theatrically and pointing at himself?

Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority; others have expressed concern that adding this responsibility would overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, as well as on how the necessary resources and expertise complement those employed by the Federal Reserve in the pursuit of its long-established core missions.

It seems to me that we should keep our minds open on these questions. We have been discussing them a good deal within the Federal Reserve System, and their importance warrants careful consideration by legislators and other policymakers. As a practical matter, however, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role.

* cough, cough *

Financial crises will continue to occur, as they have around the world for literally hundreds of years. Even with the sorts of actions I have outlined here today, it is unrealistic to hope that financial crises can be entirely eliminated, especially while maintaining a dynamic and innovative financial system. Nonetheless, these steps should help make crises less frequent and less virulent, and so contribute to a better functioning national and global economy.

Thank you, Mr. Bernanke! Expectations of a New Millennium of Bank Regulation are far too high at the moment. Shit happens. Get used to it.