Regulatory Failures at the Federal Reserve

Most of this weekend’s discussions focus on monetary policy, and rightly so, as that’s the Federal Reserve’s primary powers. But that is not all the Fed does.

Even before its regulatory powers were expanded in Dodd-Frank, the Fed stood as the lead banking regulator, responsible for the safety of our largest banks.

As I will detail in just a moment, a number of regulatory decisions by the Fed were important contributors to the recent financial crisis.

More troubling is that the Fed is currently making a number of regulatory moves that I believe will help drive the next crisis, along with another round of bailouts.

Let’s go back first and look at the last crisis. One often hears repeated the claim that regulators lacked sufficient tools to reign-in risk-taking, especially outside the banking system.

Perhaps the most commonly used example is that of AIG. We are told that if only the Fed had sufficient powers over non-banks like AIG, the crisis could have been avoided.

Left out of this narrative is that the interconnection between banks and AIG was one that actually blessed by the Fed. JP Morgan came to the NY Fed and requested permission to use AIG CDS to reduce its capital.

The assumption was that if JP Morgan off-loaded some of its risk to AIG, it wouldn’t need as much of its own money on the line. The NY Fed approved and encouraged other banks to do the same. AIG’s own financial reports reveal as much.

Sadly after having given such approval, the NY Fed felt the need to rescue AIG in order to cover up its own mistakes.

Something similar happen with Citibank’s large off-balance sheet holdings. In order for Citi to hide significant risk off its books, it needed the approval of the NY Fed, which it received.

When Citi was forced to take back this risk onto its balance sheet, it lacked the capital to do so. Luckily for Citi, the NY Fed was ready to create a variety of assistance programs under its 13-3 powers that allowed Citi to off-load this risk.

These regulatory failures were nothing compared to the Fed’s advocacy and embrace of the Basel capital accords. The Fed for years led the charge to “risk-base” bank capital standards.

In theory such almost sounds attractive. Different assets do have different risks after all. Yet in practice risk-based capital standards were a direct contributor to the crisis.

Under Basel II, as negotiated by the Fed, zero risk weights were assigned to such high-risk assets as Greek sovereign debt. The Fed also concluded that the debt of Fannie Mae and Freddie Mac were low-risk, and accordingly encouraged banks to load-up on their debt. These Fed driven standards left our banking system highly leveraged and loaded with risky assets.

The reason for this perverse outcome is that the Fed’s capital risk weights were ultimately driven by politics and the fiscal needs of government than by solid economics. Regulation by the Fed will always be political regulation.

It is also worth remembering that the Fed is also the primary enforcer of the CRA, leading the charge towards lower quality mortgages. In fact an infamous study by the Boston Fed in the early 1990s provided the ammunition for the expansion of CRA in 1995. The Fed also conditioned its approval of banks mergers on a promise of more CRA lending.

To take a moment to summarize. The Fed incentivized banks to increase their leverage by herding into mortgages, mortgage backed securities and government debt, while pushing banks to reduce the quality of those mortgages.

Even without the reckless monetary policy we witnessed, a Fed driven crisis was guaranteed.

You would think we all these failures, the Fed would be punished or at least have its regulatory powers stripped. But then if you thought so, you’d be unfamiliar with how Washington rewards failure rather than punishes it.

One reason the Fed has been able to avoid responsibility for its role in the crisis was its influence over the Financial Crisis Inquiry Commission; whose executive director was on loan from the Fed. Talk about an inside job.

Burrowing inside the Commission was not the Fed’s only avenue. The key staff at Treasury negotiating Dodd-Frank was also on loan from the Fed. It is as if we let executives at Fannie Mae write the bill. But then having Dodd and Frank do so comes pretty close.

Much of what I have discussed was conducted by the NY Fed. Despite these failures, what did we do to the head of the NY Fed during this time? Did we fire him? No, he got a promotion to Treasury Secretary.

From there he led the Administration’s efforts at financial regulatory reform. Given Geithner’s role in helping create the crisis, it should be no surprise that one of his objectives in reform was to not only protect the Fed but to expand its authorities.

Most troubling of the Fed’s new powers is its expansion of supervision over large non-banks. So far this has only included insurance companies, but may potentially extend to any non-bank financial company, such as hedge funds, asset managers, pension funds or mutual funds.

Given the Fed’s track record, we should of course be concerned about how well it will perform as a supervisor of non-banks. To some extent the theory behind Dodd-Frank is that if only non-banks had been as well regulated as Citibank was, the crisis would have been avoided. We, of course, know how well Citibank worked out.

So competency is certainly an issue, both in monetary and regulatory policy.

More troubling is the Fed’s tendency to view non-banks as just some version of a bank, and to therefore apply bank-like standards.

But of course non-banks are not banks. To regulate them like banks may well make them less stable, even potentially making the system overall less stable.

First by forcing non-banks into a system of bank regulation, one will push non-banks and banks to have more similar balance sheets and funding strategies. One downside of such will be to reduce liquidity. In a vibrant, robust and diverse financial system, one sector might want to buy certain assets as another sector wants to sell those assets. Uniform regulation makes this difficult.

Unfortunately uniform regulation can also make fire-sales more likely. The Fed, for instance, seems to be moving in the direction of making insurance companies look more like banks. This is despite the fact that insurance companies do not have deposits that could run, and nor are they as highly leveraged.

The Fed’s solution to runs is to require everyone to hold lots of government debt. The logic being that the only way to protect the taxpayer from bailouts is to make sure financial companies hold lots of assets that are directly backed by the taxpayer. That’s Fed logic for you.

Such is not solely the result of new capital standards, but also the Fed’s new liquidity standards, which are estimated to require US banks to purchase an additional trillion dollars in US treasuries. I suspect the Treasury Department will be happy to provide them.

The essence of liquidity is to be able to find buyers when you want to sell. But if everyone is pushed to hold the same assets, as the Fed seems to desire, then finding interested buyers during a crisis will be all that harder.

Of course such assumes the Fed cares about market-wide liquidity. What the new liquidity rules are ultimately about is loading up banks and non-bank financials with assets which the Fed is willing to lend against.

The Fed’s current regulatory push will ultimately dry up market liquidity, leaving the Fed not as a lender of last resort, but as a rescuer of first resort. The Fed’s extensive assistance facilities used in the crisis, created under its 13-3 powers, will over time become normal operating procedure.

While I would prefer a full repeal of the Fed’s 13-3 powers, at a minimum we should restrict these assistance programs to solvent firms and require the assistance to be provided at a penalty rate.

I should note that not only do the Fed’s current regulatory actions lay the foundation for another crisis, they also undermine its ability to conduct monetary policy. We have repeatedly seen the Fed inject selective liquidity into the market as an avenue for assisting firms that find themselves in trouble due to regulatory mistakes by the Fed.

This isn’t simply my observation. Economics profession Barry Eichengreen at UC Berkeley has found that countries with central banks that engage in both monetary policy and bank regulation end up with both more inflation and more financial crises.

Dodd-Frank has also given the Fed responsibility for the clearinghouses that settle trading in derivatives. For the first time ever, these clearinghouses will have access to the Fed’s lending facilities. We saw with Fannie and Freddie what happens when politicians concentrate risk in a small number of baskets. The taxpayer ends up rescuing those baskets. Sadly the Fed’s supervision and backing of derivatives clearinghouses will result in future bailout of those facilities.

Another manner in which the Fed will contribute to future crises is its obsession with mathematical modeling, especially in the case of its bank stress tests.

The Fed’s models are based upon poor assumptions and inadequate data that will ultimately lead banks to take more risk, not less. It were be bad enough if the Fed’s models were simply wrong, but the Fed is also forcing banks to all mimic the it’s model. The outcome will be that the largest banks will all be exactly wrong in the same manner at the same time.

That is of course a recipe for a crisis. Unfortunately the Fed has lead the charge for one-size-fits-all financial regulation. When what we need for a robust financial system is diversity.

One of the strengths of the American financial system is our diversity. Europe, for instance, has had a much worse crisis, in part, due to its extensive reliance on commercial banks. Most European corporations rely on commercial banks for external finance. In the US, you can go to banks or you can go directly to the capital and commercial paper markets.

The Fed has repeatedly attempted to push the United States toward a European financial system. One that is heavily dependent upon large, concentrated banking markets, with little role of small banks or other forms of alternative finance.

The Fed, along with the Treasury, have served as America’s representatives at international meetings on financial regulation. I believe they have continued to represent the views of large NY banks, while ignoring the concerns for the rest of our financial sector.

The Fed’s conduct of monetary policy has brought us here today. I hope I have impressed upon you the need to reform the Fed’s role in bank regulation as well.

While we badly need to change the substance of bank regulation, moving towards greater reliance on market discipline and less reliance on guarantees and bailouts, if we do not make these changes, we should at a minimum remove banking regulation from the Fed and transfer it to another agency, such as the FDIC.

Thank you. I welcome any questions or comments.

Mark A. Calabria is director of financial regulation studies at the Cato Institute.