Greg Ip

Articles by The Economist’s U.S. Economics Editor

Financial regulation: Top watchdog

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The original story is linked here.

Mar 19th 2009 | WASHINGTON, DC
From Economist.com

Should the Fed take up the cudgel as America’s regulator-in-chief?

AFP

frank

 

BARACK OBAMA’S government is using the firestorm over American International Group to press a priority of its own: new authority to take over any big, troubled financial institution and a watchdog to look for risk in the entire financial system. But the controversy has also created a new obstacle for those plans. The most logical agency to fill those roles had been the Federal Reserve, but political support for that idea may have been hurt by its role in the bail-out of AIG.

That is the view of Barney Frank, the powerful chairman of the House Financial Services Committee, who suggested in an interview on Thursday March 19th that “The Fed has taken a bit of a hit over this AIG issue.” He argues that the “political case for the Fed as systemic risk regulator is going to have be rebuilt, re-examined. It has not changed my personal view of the Fed as the best possible [candidate] but it has substantially weakened their political position.”

 

As president of the Federal Reserve Bank of New York last autumn, Tim Geithner helped to oversee the initial Fed loan that kept AIG from collapsing as mounting losses in its massive derivatives book triggered crippling calls for collateral from its counterparties. It still oversees the firm as it closes down those positions and seeks to divest more mundane operating units. Now the treasury secretary, Mr Geithner is under fire for not having taken more steps, in either his past or current jobs, to limit the company’s payment of bonuses to staff. The Fed also underestimated the company’s problems and the money needed to keep it afloat.

American regulators have long had the ability to take over a bank, repay its depositors, impose losses on creditors and wipe out shareholders. On Tuesday Mr Geithner told Congress that the AIG mess underlines the need for an expanded resolution authority so that regulators could have the same authority over any systemically important financial institution that is not technically a bank, as was the case with Bear Stearns, Lehman Brothers and AIG. He also wants to set up a “systemic risk regulator”, empowered to snoop into the secretive areas of finance, such as hedge funds, imposing safety measures, such as capital requirements, where necessary.

The government is expected to provide details of its proposal in the coming weeks, and Mr Frank has made legislation on the issue a priority. It had been assumed the same agency would both be systemic risk regulator and wield the new resolution authority. The Fed has always been ambivalent about accepting the role, although its chairman, Ben Bernanke, has expressed openness to the idea. Mr Frank said the Fed would almost certainly have some role in whatever is created, but it may be necessary to create the resolution authority first, and endow it on a group of agencies, and decide later who the systemic risk regulator will be.

The Fed for its part, frustrated with the lack of alternatives to bailing out AIG, has been emphatic about the need for some kind of resolution authority but open minded about who wields it.

Many questions exist over the merits of a systemic-risk regulator. First, could it hope to forestall a crisis? None of the banks foresaw today’s mess, even though their survival was at stake. Regulators, meanwhile, looked the wrong way: they were far more worried by hedge funds than subprime mortgages. That tends to be typical.

Second, which institutions would be covered by the new regime, how would they pay for the privilege (if at all), and would they then be viewed as too big to fail? Peter Wallison of the American Enterprise Institute, a think-tank, worries that those most closely scrutinised could borrow more cheaply, squeeze out competitors, and eventually become as risky as Fannie Mae and Freddie Mac, the two giant mortgage agencies.

Third, is the Fed right for the job? Its own regulatory record is unimpressive: it was Citigroup’s principal regulator. Its new duties could draw it into political fights that could compromise its independence. They may also conflict with monetary policy; it may keep interest rates low to prevent a firm from failing, though that could risk stoking higher inflation.

On the other hand, as the lender of last resort only the Fed can inject money into almost any type of firm; it might be good to give it corresponding authority to prevent abuse, too. Moreover, the Fed’s regulatory record is not the worst. AIG, for example, owned a tiny thrift which meant that the parent and the unit that produced its derivatives book were overseen by the Office of Thrift Supervision. The OTS also supervised the two biggest banks to fail so far: IndyMac and Washington Mutual. Such cases suggest that banks shop for the friendliest regulator. (The OTS notes numerous firms have stumbled, regardless of regulator. Mr Frank points out that systemic risk is not the OTS’s mandate.) Adding one more—even an overarching one—may do little good unless the whole regime is streamlined.

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Written by gregip

March 19, 2009 at 4:50 pm

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