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.

Beijing Plays Hedge Ball - A contract should be a contract

Beijing Plays Hedge Ball. WSJ Editorial
A contract should be a contract.
WSJ, Sep 09, 2009

Beijing needs to clarify whether a contract is a contract, and fast. Recent suggestions that the government might allow or even encourage companies to challenge derivatives contracts that went against them send a bad signal to foreign companies and countries doing business with China.

The controversy stems from commodities hedges gone wrong. When fuel prices were high, airlines like China Eastern, Air China and Shanghai Airlines and shippers like China Ocean Shipping crafted derivatives contracts with foreign banks to protect the companies from even higher fuel prices. Instead the price of oil has fallen, leaving the companies on the hook for the downside risk of their hedge—a total of about $2 billion for the airlines alone, by some counts.

The companies are crying foul, and several reportedly sent a letter to the banks that sold them the derivatives suggesting they may be "void, invalid or unenforceable." Worse, the government is getting into the act. The state-owned Assets Supervision and Administration Commission, which oversees these companies, on Monday posted a statement on its Web site suggesting that Beijing might countenance efforts to sue to nullify the contracts.

China has been down this road before, pushing foreign counterparties several times over the past decade to back down from derivatives contracts that had turned against a Chinese company. In those cases, the companies or the government variously argued that the firms had been illegally speculating or had not understood the risks they were taking—or even that the people signing the papers on behalf of the Chinese companies hadn't been authorized to do so. It's hard to see how such arguments could apply to the kind of bread-and-butter fuel hedging at issue here.

Policy makers might think the government holds a lot of cards in this case, and in some respects it does. While the derivatives contracts would be tough to wriggle out of legally since they're enforceable through courts in Hong Kong, Singapore or Britain, it would be hard for the banks to collect on any judgment unless they're willing to seize planes at Heathrow or Changi airports.

The banks would have strong incentives not to try, too. Regulators in Beijing decide whether the foreign banks receive various business licenses, for instance, and state-owned enterprises constitute some of the biggest bank clients. Especially since the goal could only be to renegotiate the contracts instead of canceling them, policy makers and executives might think the banks will be willing to pay that price to continue doing business in China.

But this kind of bullying is not free. Most immediately, hedging is a risk-management tool that many Chinese companies can't afford to live without. It works on trust between counterparties that each side will hold up its end of the bargain. Already banks reportedly are demanding higher collateral for derivatives contracts like those at issue here to compensate for the loss of trust. That's an added cost of doing business not faced by other airlines that take their lumps when hedges go wrong. like Hong Kong's Cathay Pacific or America's United.

This incident will leave foreign investors wondering where China stands on its road to commercial rule of law. Following the arrests of Rio Tinto executives in a dispute over ore prices, foreign businesses already have to wonder about their physical safety if they run afoul of Chinese companies in contract negotiations. Now it appears foreign companies can be in financial danger simply for ending up on the "wrong" side of a standard off-the-shelf derivatives transaction.

Beijing officials may not realize the potential effects of this controversy on Chinese companies investing abroad. Chinese mergers and acquisitions in countries like America or Australia have been controversial in large part because politicians in those countries have worried about a lack of transparency within Chinese companies, and whether those companies would play by the rules once they hit foreign shores. Politicians already predisposed to oppose Chinese investment—and perhaps some who'd otherwise support allowing such investments—will hardly take comfort from a sign that Chinese companies won't play by the rules if it doesn't suit them. If Beijing is actively trying to dissuade foreign investment, it's on the right track.

Beijing might be responding to a political storm over the notion Chinese companies have been exploited by Western banks (one wag has called derivatives "financial opium," a charged phrase in China). Or it could be trying to bail out a few companies that made bad fuel-price bets. Or some other political motivation could be at work. Whatever the cause, though, Beijing's only smart way forward is to state clearly that a contract is a contract and that Chinese companies must abide by theirs.