The Fed Can't Monitor 'Systemic Risk'

The Fed Can't Monitor 'Systemic Risk'. By PETER J. WALLISON
That's like asking a thief to police himself.
WSJ, Sep 09, 2009

Using the financial crisis as a pretext, the Obama administration is determined to enact massive financial regulatory reforms this year. But the centerpiece of its proposal—putting the Fed in charge of regulating or monitoring systemic risk—is a serious error.

The problem is the Fed itself can create systemic risk. Many scholars, for example, have argued that by keeping interest rates too low for too long the Fed created the housing bubble that gave us the current mortgage meltdown, financial crisis and recession.

Regardless of whether one believes this analysis, it is not difficult to see that a Fed focused on preventing deflation in the wake of the dot-com bubble's collapse in the early 2000s might ignore the sharp rise in housing prices that later gave us a bubble.

There is also the so-called Greenspan put. That's a term that refers to investors taking greater risks than they otherwise would because they believed the Fed would protect them by flooding the financial system with liquidity in the event of a downturn. If there really was a Greenspan put, it has now been supplanted by a "Bernanke put."

These puts may or may not be real, but there is no doubt that the Fed has the power to create incentives for greater risk taking. In other words, simply by doing its job to stabilize the economy, the Fed can create the risk-taking mindset that many blame for the current crisis.

And finally, there are those—including some at the Fed itself—who argue that the Fed does not have, and will never have, sufficient information to recognize a real bubble. As a result, the Fed is just as likely to stifle economic growth as it is to sit idly by while a serious asset bubble develops.

All of this means just one thing: If we are to have a mechanism to prevent systemic risk it should be independent of the Fed. That is probably one reason why creating a systemic-risk council made up of all of the federal government's financial regulatory agencies, including the Fed, has the support of Senate Banking Committee Chairman Christ Dodd (D., Conn.) and others on the committee.

The current administration isn't the only one that has been willing to hand too much power to the Fed. The idea that the Fed should have some responsibility to detect systemic risk originated with the Bush Treasury Department's "Blueprint for a Modern Financial Regulatory Structure," issued in March 2008. In that plan, the regulation of bank holding companies would be transferred from the Fed to the comptroller of the currency and the Federal Deposit Insurance Corporation. The Fed would be charged with detecting the development of systemic risk in the economy.

The idea was that the Fed's authority would be pared back in those areas where it is actually supervising specific financial institutions but expanded where its responsibilities dealt with the economy as a whole. This is a plausible idea. There is every reason to remove from the Fed's plate the supervision of specific financial institutions as well as the regulation of businesses such as mortgage brokers. As a matter of government organization, it makes a tidy package for the Fed to handle issues that affect the economy as a whole.

But piling yet more responsibilities on the Fed raises the question of whether we are serious about discovering incipient systemic risk. If we are, then an agency outside of the Fed should be tasked with that responsibility. Tasking the Fed with that responsibility would bury it among many other inconsistent roles and give the agency incentives to ignore warning signals that an independent body would be likely to spot.

Unlike balancing its current competing assignments—price stability and promoting full employment—detecting systemic risk would require the Fed to see the subtle flaws in its own policies. Errors that are small at first could grow into major problems. It is simply too much to expect any human institution to step outside of itself and see the error of its ways when it can plausibly ignore those errors in the short run. If we are going to have a systemic-risk monitor, it should be an independent council of regulators.

It is one thing to set a thief to catch a thief—as President Franklin Delano Roosevelt is said to have done when he put Joe Kennedy in charge of the newly created Securities and Exchange Commission in the 1930s. But to set a thief to catch himself is quite a different matter.

Mr. Wallison is a senior fellow at the American Enterprise Institute.