Systemic Risk and the Fed

Systemic Risk and the Fed. By ROBERT C. POZEN
It is a mistake to give the central bank vast new regulatory powers.
WSJ, Jul 09, 2009

Congress is currently debating how to cope with the widespread ripple effects when a large financial institution fails or a risky financial product blows up. The U.S. Treasury has proposed that a council of eight regulatory agencies be appointed to monitor the so-called problem of systemic risk. Treasury also wants the Federal Reserve to become the exclusive regulator of all financial institutions deemed systemically risky.

This gets things backward.

If the risk monitoring function is delegated to a council, no single agency will take the lead or likely take responsibility. Moreover, the U.S. needs one contact point to coordinate risk monitoring with other countries.

The most logical choice to monitor systemic risk is the Fed. This function is consistent with the Fed's broad review of economic and market developments, which is part of its traditional role in setting interest rates. In this role, the Fed takes a long-term perspective, which is critical to risk monitoring.

More importantly, the Fed has emergency lending powers to prevent a financial institution from suddenly failing. If the remedial action involves a bank holding company, it already has the power to act. If another type of financial institution is at risk, the Fed should work with the relevant regulatory agency to implement a plan. Disagreements should be settled by the council.

But the Fed should not be the exclusive regulator of all institutions posing a systemic risk. It's not possible to identify in advance such institutions; they'll change as market conditions change. Systemic risks also can arise from new products, like credit derivatives, which are used by institutions of various sizes. The Fed would not be able to develop enough expertise to regulate so many different types of financial firms -- hedge funds, pension plans, money funds and insurance companies, as well as banks.

Instead, large financial institutions should continue to be supervised by their functional regulators, such as the SEC in the case of money market funds. The other great benefit of this approach is that it avoids labeling an institution in advance as systemically risky. Once the government uses this label, investors will assume that the institution will always be bailed out by the government.

Giving the Fed the authority to monitor risk but not new regulatory authority also avoids granting it too much power. A good case can be made that the Fed already has too much power, and should give up its current authority to set customer rules for mortgages and credit cards. The Fed should be focused on macroeconomic issues -- not consumer protection.

To be sure, there are gaps in the current system of regulation that should be closed. For example, Congress should require most managers of hedge funds to register with the SEC under the Investment Advisers Act.

Such registration would subject those managers to periodic inspections without limiting their investment strategies. Furthermore, a handful of very large hedge funds (e.g., with assets over $25 billion) should submit to the SEC and the Fed nonpublic reports that include information, such as their leverage ratios, which are relevant to the monitoring of systemic risk.

Congress also should create a federal charter and agency for a small number of giant life insurers. AIG's collapse shows that a giant insurer can have adverse repercussions for the entire financial system. For that reason, almost all countries have a federal regulator of large insurance companies. The states will no doubt object, but they can continue to regulate property-casualty insurers and most life insurers.

In short, I believe the Treasury's proposal for dealing with systemic risk is misguided. To ensure that a risk monitor is accountable, the function should be located in a single entity. To supervise specific financial institutions and practices, however, Congress should look to the traditional functional regulators that already have the expertise necessary to understand and resolve issues specific to these institutions.

Mr. Pozen, chairman of MFS Investment Management, is the author of "Too Big to Save? How to Fix the U.S. Financial System," forthcoming from John Wiley.