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Will Regulatory Reform Prevent Future Crises? James Bullard President and CEO CFA Virginia Society February 23, 2010 Richmond, Virginia. Any opinions expressed here are my own and do not necessarily reflect those of the Federal Open Market Committee participants. O VERVIEW O RIGINS OF THE C RISIS T OPICS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS FOR TODAY Main idea: Try to assess the state of the regulatory reform debate. Consider some of the origins of the financial crisis. Ask two questions of current financial regulatory reform proposals: Could these proposals have prevented the current financial crisis? Would they prevent future crises? O VERVIEW O RIGINS OF THE C RISIS P REVIEW OF W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS M AIN CONCLUSIONS Only a few of the current financial regulatory reform proposals are likely to help prevent future crises. As the nation’s lender of last resort, the Fed will be at the center of any future financial crisis. This argues for the Fed playing the lead role in the new regulatory structure. A Fed with appropriately broad regulatory authority provides the nation with the best chance of avoiding a future crisis. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS Origins of the Crisis C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS O RIGINS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS OF THE CRISIS Fundamentally, the crisis was caused by a failure of financial engineering. First, a securitization boom. Second, a housing boom followed by a dramatic decline in housing prices. Securitized products did not take the possibility of a decline in housing prices into account appropriately. Securitized paper was worth much less than most anticipated, and it was held by financial entities worldwide, who had to accept large losses. The crisis caused runs in the shadow banking sector ... ... institutions that did not take deposits and so were not thought to be susceptible to a run ... ... and because of this were not regulated as tightly as banks. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE F INANCIAL SECTOR ASSETS R EFORM P ROPOSALS BOOM C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE H OUSING BOOM AND BUST R EFORM P ROPOSALS C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS IT’S W HAT N EEDS TO BE D ONE MOSTLY SHADOW BANKING R EFORM P ROPOSALS C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS IT’S W HAT N EEDS TO BE D ONE MOSTLY SHADOW BANKING R EFORM P ROPOSALS C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS S UMMARY OF THE TABLE As the crisis started, 20 firms accounted for about 80 percent of financial sector assets in the U.S. About 1/3 of this total was in banks. About 2/3 was non-bank financials: Government sponsored enterprises, investment banks, insurance companies, and thrifts. A large fraction of financial assets in the U.S. were not in the bank regulatory system. All of these firms faced severe stress during the crisis, regardless of the type of firm or the nature of regulation. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS T HE FINANCIAL LANDSCAPE The crisis encompassed a far larger segment than just commercial banking. Many non-bank financial firms, outside the banking sector, were at the heart of the crisis. These firms were not regulated by the Fed or other banking regulators. The crisis showed that large financial institutions worldwide were “too big to fail.” (TBTF) We can let large financial firms fail suddenly, but then global panic ensues. Reform proposals have to face this fact. O VERVIEW O RIGINS OF THE C RISIS S MALLER W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS BANKS ARE NOT THE PROBLEM Regulation works well for the thousands of smaller banks in the U.S. The system features deposit insurance plus prudential regulation. The system allows failure, but prevents bank runs and the associated panic. Smaller banks did not cause the crisis and do not need to be re-regulated. Changing this part of the regulatory environment as we are trying to cope with high stress makes no sense. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS What Needs to Be Done C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS T HE F ED W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS AND BANKING SUPERVISION The U.S. has a primary regulator system for the nation’s 8,000+ commercial banks and thrifts. The primary regulator has the key authority for the regulation of the bank. As of January 2007: The Fed had primary regulatory responsibility for about 12 percent of the banks. About 14 percent by assets. More than 85 percent of banks and assets had non-Fed primary regulators. O VERVIEW O RIGINS OF THE C RISIS T HE F ED W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS AND THE FINANCIAL LANDSCAPE Banks are only one part of the financial landscape. Non-bank financial firms turned out to be the most troublesome entities in this crisis. The Fed had no supervisory authority over these entities: Investment banks like Goldman Sachs and Bear Stearns. Insurance companies like Prudential and AIG. Financial hybrids like GE Capital and GMAC. Bottom line: The Fed had access to a limited view of the financial landscape as the crisis began. O VERVIEW O RIGINS OF THE C RISIS T HE CRISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS UNFOLDS As the crisis began, all eyes turned to the Fed as the lender of last resort. This always happens in a crisis—only the central bank can play the lender-of-last-resort role. But the Fed had detailed knowledge only of part of the financial landscape: that for which it had supervisory authority. The Fed had limited access to information on institutions outside its supervisory authority, especially non-bank financial firms. Many of the critical lending decisions involved the controversial non-bank financials like Bear Stearns. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS T HE REFORM RESPONSE The clear lesson is that the Fed had insufficient access to information about the financial landscape going into the crisis. The Fed did not fully understand the potential for feedback between the financial sector and the rest of the economy. Yet, the Fed will also be at the center of all future crises because of its lender of last resort role. The reform response should be to provide the Fed direct access to detailed information across the entire financial landscape, not less as is the focus of current policy discussions. A Fed with appropriately broad regulatory authority provides the nation with the best chance of avoiding a future crisis. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS Reform Proposals C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS R EGULATORY REFORM PROPOSALS The House Bill (H.R. 4173; passed December 11, 2009). The Senate Banking Committee draft legislation. General debate. C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS S YSTEMIC W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS RISK The House bill creates an interagency Financial Services Oversight Council (FSOC) to monitor systemic risks posed to the financial system. In the House bill, the Federal Reserve would serve as the “agent” to the Council and not as the systemic risk regulator. Other debate has suggested investing the Council with more direct authority. Would this prevent a future crisis? I think the evidence is far from clear. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS M ORE ON SYSTEMIC RISK It seems like it would be difficult for an interagency Council to come to agreement on a specific risk and an associated action when times are good. In crises, decisions need to be made quickly, not subjected to long committee debates. It is also possible to overreact, shutting down a particular practice which in reality does not pose a systemic risk. The Fed would be better at navigating this type of decision-making, which occurs commonly in monetary policy. The Fed is also more politically independent than a Council. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS A RESOLUTION REGIME In the House bill, the FDIC is granted expanded authority to put systemically important firms into receivership. Other debate has suggested a special bankruptcy court for large financial firms. Would this prevent a future crisis? It might. This reform goes in the direction of strengthening market incentives. A resolution regime is a way of putting market discipline on very large financial firms—we really could allow failure without creating panic. The fear of failure would then prevent firms from taking excessive risks and from being able to borrow at low rates. O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE A RESOLUTION REGIME : K EY R EFORM P ROPOSALS C ONCLUSIONS CONCERNS Key concern: How credible will the regime be? If it is not credible and the government is going to come in after all, then it is useless. “Funeral plans” for the firm in the event of failure do not strike me as credible. Key concern: How much global cooperation can be expected? O VERVIEW O RIGINS OF THE C RISIS R ESTRICTIONS W HAT N EEDS TO BE D ONE ON R EFORM P ROPOSALS C ONCLUSIONS 13(3) LENDING In the House bill, significant restrictions are placed on Fed lending to non-banks under the “unusual and exigent circumstances” clause. Would this prevent a future crisis? No. This will probably exacerbate a future crisis. A future Fed facing a crisis will be more likely to say that it does not have the authority to act, letting the crisis roll on. O VERVIEW O RIGINS OF THE C RISIS C ONSUMER W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS PROTECTION The House bill creates a separate Consumer Financial Protection Agency (CFPA) with rule-writing authority for all banks and non-banks that extend consumer credit. This has been very controversial in the Congress. Other debate has suggested putting this in other agencies or not including it in the bill. Would this prevent a future crisis? I don’t think so. A fair playing field is certainly desirable in all consumer products. But the housing boom was a classic gold rush: most people bought the houses because they thought the prices would keep rising. A CFPA would not have changed the gold rush dynamic. O VERVIEW O RIGINS OF THE C RISIS S ECURED W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS CREDITORS In the House bill, secured creditors may be required to take a 10% haircut if the government has to step in and take over a failing firm. Would this prevent a future crisis? Probably not. But, this provision does go in the direction of enhancing market discipline. Creditors would have greater incentives to understand and analyze risk at large financial firms. Why limit creditor exposure to 10%? Lots of evidence that money-at-risk is available. Problem is "moral hazard" created by implicit or explicit government credit insurance. O VERVIEW O RIGINS OF THE C RISIS S INS OF W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS O MISSION GSE reform not addressed in current legislative proposals. C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE Conclusions R EFORM P ROPOSALS C ONCLUSIONS O VERVIEW O RIGINS OF THE C RISIS W HAT N EEDS TO BE D ONE R EFORM P ROPOSALS C ONCLUSIONS C ONCLUSIONS Only a few of the current financial regulatory reform proposals are likely to help prevent future crises. As the nation’s lender of last resort, the Fed will be at the center of any future financial crisis. This argues for the Fed playing the lead role in the new regulatory structure. A Fed with appropriately broad regulatory authority provides the nation with the best chance of avoiding a future crisis. Federal Reserve Bank of St. Louis stlouisfed.org Federal Reserve Economic Data (FRED) research.stlouisfed.org/fred2/ James Bullard research.stlouisfed.org/econ/bullard/
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