Yesterday, the House Financial Services Committee’s Subcommittee on Domestic Monetary Policy and Technology held a hearing entitled “Balancing the Independence of the Federal Reserve in Monetary Policy with Systemic Risk Regulation.” The following witnesses testified at the hearing:
- Donald L. Kohn, Vice Chairman, Board of Governors of the Federal Reserve System
- Frederic Mishkin, Alfred Lerner Professor of Banking and Financial Institutions, Graduate School of Business, Columbia University
- Laurence Meyer, Vice President, Macroeconomic Advisers
- James K. Galbraith, Lloyd M. Bentsen Jr. Chair in Government/ Business Relations and Professor of Government, LBJ School of Public Affairs, University of Texas
- Richard Berner, Chief Economist, Morgan Stanley
- John B. Taylor, Mary and Robert Raymond Professor of Economics, Stanford University
- Allan Meltzer, The Allan H. Meltzer University Professor of Political Economy, Tepper School of Business, Carnegie Mellon University
Subcommittee Chairman Melvin Watt (D-NC) began yesterday’s hearing by calling the current U.S. regulatory system “ineffective and outdated.” Discussing the Obama Administration’s proposal to vest the Federal Reserve with broad authority over systemic risk, Mr. Watt noted that “the Fed’s independence has long been viewed as necessary to allow the Fed to meet the long-term monetary policy goals of low inflation, price stability, maximum sustainable employment and economic growth,” and that “most central banks around the world have a strong tradition of independence in executing monetary policy.” Watt continued, stating that “for our economy to function effectively, the Fed’s monetary activities … must be independent and free from political influence.”
Mr. Kohn suggested that any proper framework for monetary policy should include “a careful balance between independence and accountability.” He warned against the federal government’s use of the central bank to finance large deficits. “Such episodes invariably lead to high inflation,” said Kohn. Kohn also argued that “any substantial erosion of the Federal Reserve’s monetary independence would likely lead to higher long-term interest rates” and a lowering of the U.S. Treasury’s debt rating by rating agencies, thereby increasing its cost of borrowing. “Statistical studies have confirmed that countries with more independent central banks experience more stable rates of inflation with no sacrifice of jobs or income,” noted Kohn. Despite his expressed concerns, Kohn ultimately advocated an expanded role for the Federal Reserve, calling monetary policy independence and supervisory regulatory authority “mutually compatible” with “beneficial synergies.” Kohn pointed to the Federal Reserve’s existing supervisory authority over critical payment, clearing and settlement systems as an example. He argued that “the Federal Reserve … has always been involved in issues of systemic risk, most notably because central banks act as lenders of last resort.” When questioned by Spencer Baucus (R-AL) about the challenges an expanded Federal Reserve role might present for combating inflation, Kohn dismissed the concern, countering that the increase in the Federal Reserve’s power would only be “incremental.” Kohn highlighted the supervisory role of the Government Accountability Office (GAO) over the Federal Reserve, and stated that “the GAO, under existing law, has full authority to audit” the Federal Reserve’s supervision and regulation of “systemically important firms,” and he cautioned against removing any statutory limitations on GAO audits of monetary policy, as such a move might “undermine public and investor confidence.”
Professor Mishkin agreed that the Federal Reserve should be the primary systemic risk regulator. He argued that, as a consequence of the Federal Reserve’s “daily trading relationships with market participants,” it is uniquely positioned, and has strong “insight and access to the broad flows in the financial system.” Mishkin pointed to the Federal Reserve’s mandate to promote macroeconomic stability, stating that “macroeconomic downturns are often tightly connected to the financial system.” He also noted the considerable independence of the Federal Reserve. While advocating expanding the authority of the Federal Reserve to include systemic risk regulation, Mishkin also proposed the Federal Reserve relinquish its role as a consumer protection regulator, calling the skills required for the role “fundamentally different from those required by a systemic risk regulator.”
Mr. Meyer concurred that there was no major inherent risk in the Federal Reserve’s proposed role as systemic risk regulator. He also argued that the Federal Reserve’s role in executing monetary policy and the role of systemic risk regulator need not be insulated more than they are at present. Meyer called the Federal Reserve “the best choice for consolidated systemically institutions,” and stated that a role as systemic risk regulator “is a natural fit” with its role as an independent authority on monetary policy.
Professor Galbraith argued that “there are ways in which the macroeconomic role of the Federal Reserve could come into perceived or actual conflict with its capacity to regulate systemic risk effectively.” Galbraith pointed to the Federal Reserve’s record of “regulatory capture” and its “institutional identifications with the interests of the regulated sector.” He suggested that the FDIC is better equipped to play such a role, as combating systemic risk is that agency’s “first priority.” Galbraith also argued that large financial institutions that pose systemic risk should shrink, divest and “otherwise reduce concentration of power.”
Mr. Berner disagreed, concluding that the Federal Reserve “is best equipped to lead on risk regulation and oversight. He identified three major faults with the present regulatory framework:
- The regulatory structure focuses on institutions other than financial activities;
- The present system creates institutions which are “too big to fail”; and
- The regulatory infrastructure promotes procyclical swings in investor behavior which magnify financial market volatility.
As a solution, Berner suggested building a “system of capital regulation that builds reserves and limits leverage in good times,” the simplification of securities themselves and greater use of central counterparties for OTC derivatives. To encourage the Federal Reserve’s independence in its role a systemic risk regulator, Berner also suggested that “the resolution of troubled financial institutions” should be delegated to the FDIC.
Professor Taylor warned of a “significant negative impact” on the Federal Reserve’s role as the independent authority on monetary policy presented by a new role as systemic risk regulator. “The additional powers and responsibilities will dilute the key mission of the Federal Reserve to maintain overall economic and price stability by controlling the growth of the money supply,” said Taylor. He argued that “institutions work best when they have a limited set of understandable roles. He also argued that decisions made in connections with institutions that are “too big to fail” could reduce the Federal Reserve’s credibility and present potential conflicts of interest. Taylor feared that an expansion of the Federal Reserve’s power will “result in checks and limits,” thereby decreasing the central bank’s independence. Alternatively, Taylor suggested “closing present and future regulatory gaps” and clarifying ambiguous responsibilities in the regulatory system, but insisted that a new systemic risk regulator is unnecessary.
Finally, Professor Meltzer criticized the Federal Reserve’s record, stating that there are no “clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures.” He also question’s the Federal Reserve’s role as a “lender of last resort,” noting that the central bank has never officially announced such a policy. As an alternative to the Federal Reserve acting as a systemic risk regulator, Meltzer suggested ending “too big to fail” by requiring all financial institutions “to increase capital more than in proportion to their increase in size of assets.” He also advocated the creation of a concrete rule for “lender of last resort” that gives banks the “incentive to hold collateral to be used in a crisis period.” Meltzer also argued that regulation is an “ineffective way to change behavior,” stating that “incentives for fraud, evasion and circumvention of regulation have often been far more powerful than incentives to enforce regulation that protects the public.