A History of the Federal Reserve, Volume 2 (103 page)

The Federal Reserve acted creatively to establish new lending facilities to accommodate market demands. They put off to the future any consideration of how and when they can reverse these overly expansive actions.

One lesson from the current crisis is that the Federal Reserve should announce a lender-of-last-resort strategy and follow it without exception. A second lesson is that Congress should dispense with “too big to fail.” Banks and financial firms should not have incentives to become so large that they cannot fail. “Too big to fail” encourages excessive risk taking and imposes costs on the taxpayers. If banks considered too big to fail are not reduced in size, they should have substantially higher capital requirements including subordinated debt. The very high leverage ratios at large financial institutions responded to the incentives created by earlier rescues and belief in a Greenspan put.

One of the Treasury’s proposed reforms gives the Federal Reserve responsibility for maintaining financial stability. This is a poor choice. The Federal Reserve did nothing about growing savings and loan failures in the 1980s. Ending that crisis cost the taxpayers about $150 billion. The Federal Reserve worked with the International Monetary Fund to protect lending banks during the Latin American debt crisis. The crisis began to end when Citicorp’s chairman decided to recognize the losses by writing down the debt’s value. Others followed. Soon thereafter, the Treasury began a systematic program to write down the debt. The Federal Reserve did nothing.

Although Alan Greenspan warned publicly in 1996 about irrational exuberance in the equities market, neither the Federal Reserve or the Securities and Exchange Commission tried to prevent rampant stock market speculation. And it followed by doing nothing to prevent the large expansion of subprime, Alt-A, and other mortgage loans and the rise in housing prices. This error will cost taxpayers much more than the savings and loan failures.

Reading transcripts of Federal Open Market Committee meetings, one finds very little discussion of regulatory and supervisory credit problems. The Federal Reserve’s record does not support a proposal to increase its responsibility for financial stability. More important, regulation of this kind can succeed only if the regulator makes better judgments about risk than those whose wealth is at risk. A better change would make risk takers bear the risks they take. Failure should remove management and cost stockholders as in the FDICIA rule. Companies would not disappear. They would get new management and stockholders.

FDICIA

In 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA). A main reason for the act was to reduce Federal Reserve lending to failing banks, thereby reducing losses paid by the FDIC. FDICIA gave regulators authority to intervene in solvent banks when losses reduced capital below required limits and to assume control before a bank’s capital was entirely gone. The bank could then be sold or merged. Stockholders would take the loss and managers would be replaced. The regulators did not apply FDICIA standards to failing financial firms in this crisis. FDICIA should be extended to apply to all financial institutions. It is an explicit rule that, if enforced, is known to all interested parties. Prudent bankers will act to avoid failure and the loss of their jobs.

Regulation

The financial crisis brought many demands for increased regulation. Few recognize that regulation works best if it takes account of the incentives it fosters. The Basel Accords agreed to by developed countries are a timely example. The accords required banks to hold more capital if they acquired more risk. The rationale seems clear and unassailable. The practice was very different.

Instead of increasing capital, banks chartered new entities to hold the risky assets. The intent was to keep the risk off their balance sheets. When the mortgage crisis occurred, the banks had to assume the risk and responsibility for losses. Regulation failed, and so did circumvention. The cost to the public is very large. This experience shows again that lawyers and bureaucrats choose regulations, but markets circumvent costly regulations.

Successful regulation recognizes that it creates incentives for avoidance or circumvention. Successful regulation aligns the interests of the regulated with socially desirable outcomes. Successful regulation induces market action to eliminate externalities. Successful regulation recognizes that market participants respond to regulation by changing their actions to find a new optimum.

Regulators rarely respond to this dynamic process by adopting regulations in response to market outcomes. Because all countries have some type of deposit insurance, either de jure or de facto, regulation must limit risk taking. FDICIA provides an incentive to avoid excessive risk. Capital requirements also help to align incentives and avoid excessive risk taking. Regulations such as the Basel Accords do not meet this standard.

After the Treasury supported General Motors and Chrysler with what will be a growing bailout of automobile companies, the Federal Reserve
accepted General Motors Acceptance Corporation (GMAC) as a bank, enabling GMAC to borrow at the discount window. GMAC at once began to offer zero interest rate loans for up to five years to borrowers with below median credit ratings. This appears to be a response to pressure from prominent members of Congress, a further sacrifice of independence. Many members of Congress want the Federal Reserve to allocate credit to borrowers that they favor. This avoids the legislative and budget process just as Fannie Mae and Freddy Mac did. It subverts the principles of an independent central bank.

Independence is not just important. It is a critical part of the institutionalization of a low-inflation policy. It prevents Congress and the administration from financing deficits by printing money. And it avoids pressures for credit allocation to politically favored groups.

Compensation
and
Incentives

MBAs who graduated from the world’s leading business schools purchased and sold mortgages that carried a high degree of risk. In many cases they accepted the credit ratings supplied by others without investigating accuracy. At many banks, traders were well rewarded for doing the transactions and likely fired if they failed to do so. Compensation systems at many firms rewarded short-term increases in revenue without regard for longterm losses. Compensation systems of this kind encourage excessive risk taking.

Not all firms behaved alike. We know now that J.P. Morgan Chase, Bank of America, and some others limited risk taking much more than Citigroup, Merrill Lynch, Bear Stearns, and other failures.

Setting compensation schedules is management’s responsibility. Congress cannot establish rules that managements cannot circumvent, if they choose to do so. An improved compensation system would spread rewards over time to permit losses to be recognized. This can be done in many ways. Regulators should encourage and monitor the actions that managements take, but should leave the choice of compensation schedule to management.

Rating
Agencies

The mix of incentives facing rating agencies are well-known as a contributor to the credit crisis. The agencies applied a rating system that had worked for decades in rating corporate bonds. This may have misled users. More seriously, rating agencies at times adjusted their ratings to satisfy client demands.

Not all of the fault falls on the rating agencies, but they share the blame. The clients did not look at the underlying securities or question the ratings except to ask for more favorable ratings. They too share the blame.

Rating agencies must develop compensation and incentive programs that reward accuracy of rating achieved over time. The aim is to give the agency and its personnel incentives for diligence and accuracy.

Transparency
and
Risk

More information improves decisions and reduces risk. But transparency and increased information are most useful when interpretation is clear. Better reporting of asset and liability positions is most useful when risk models permit users to interpret the information correctly.

Risk models contributed to the credit crisis. These models use standard distributions. They make no distinction between permanent or persistent and transitory changes. Deciding whether risk spreads had permanently fallen before the crash or would return toward historic averages played a role in the crisis. Similarly, risk models were not useful for deciding whether the increase in house prices, or the decline in 2007, would persist. Improving ability to judge persistence can improve judgments and economic performance. Using rating agencies’ judgments without due diligence is a mistake.

RECOMMENDATIONS OF THE ISSING COMMITTEE

After the November meeting of the international grouping known as the G-20, the German government appointed a committee chaired by Professor Dr. Otmar Issing to recommend changes in policies, regulations, and supervision that would reduce the chance of future crises. The Issing committee identified three major causes of incentive misalignment: structured finance, rating agencies, and management compensation. It found that the crisis was a consequence of “massive liquidity and low interest rates” (Issing, 2008, 2) in an “environment of inadequate regulation and important gaps in supervisory oversight [and] inappropriate incentive structures” (ibid.). Unlike most comments on regulation, the report of the Issing committee emphasized incentives. This section summarizes some of its main proposals.

The committee recommended that the accuracy of rating agencies should be monitored and reported to the public. Rating fees should be linked to the accuracy of past ratings.

Many of the main proposals concern increases in transparency by specifying rules of disclosure that improve incentives by buyers and sellers of
financial instruments. Securitization transactions should disclose the allocation of loss to the tranche that receives the first loss. Disclosure should be mandatory to permit the market to price risk more accurately.

The Issing committee did not propose legal limits on compensation as such rules “are expected to backfire” (ibid., 3). Instead they favored full disclosure and the development by rating agencies and auditors of a metric that reports on management incentives.

The committee also proposed a global credit register to show exposure by lenders and their counterparties. The report recognized that the register would be incomplete in real time.

CONCLUSION

The credit crisis should be used to recognize and correct errors on several sides, not to look for scapegoats and evildoers. This is a first step to market reforms that reduce the risk of repetition. We cannot avoid all risk and should not try. We can reduce risk by better policy choices.

Public and private actions contributed to the crisis. Congress and several administrations encouraged public agencies to accept much greater risk to promote home ownership. The Federal Reserve failed to develop a lender- of-last-resort policy. This failure increased uncertainty. Many banks and financial institutions reward risk taking, thereby increasing incentives for actions that later produced losses. Rating agencies erred.

This epilogue suggests some changes to respond to these failings. Unlike the claim that more regulation is needed, I argue that regulation works well only if it takes account of the incentives it induces. Good regulation aligns public and private interests where there is evidence of market failure. Bad regulation usually requires strong enforcement.

To prevent future crises, Treasury Secretary Geithner proposed creation of a new super-regulator responsible for monitoring risk throughout the financial system. His proposal has major problems. First, there is no evidence that anyone can succeed at that task. The Federal Reserve’s record in the savings and loan, Latin American debt, and recent mortgage and banking crises strongly suggests that they would fail. The Securities and Exchange Commission failed totally to prevent the Madoff scandal despite receiving evidence of Madoff’s fraud. Also, the proposal ignores the pressures from Congress and others to support failing institutions important to the members. Second, the proposal increases regulators’ responsibility with errors being paid for by taxpayers. A much better alternative is to strengthen bankers’ responsibility by ending too big to fail and making managements and stockholders responsible for losses. This encourages bankers to hold collateral, monitor risks, and remain vigilant about the
risks they accept. And it removes the risk of losses falling on taxpayers and the public.

One consequence of the credit and economic crisis is the aggressive response by governments and central banks to restore stability and growth. Eventually the excessive liquidity they created must be eliminated, a task that will not be easily accomplished. The Federal Reserve has not given much thought to how it will avoid inflation after the recovery is under way. And the greatly expanded role of governments and central banks must not become a precedent. A main lesson of this crisis is that societies must reinvent individual responsibility for avoiding excessive risk. This will be neither easy nor popular with many, but the survival and prosperity of a free society requires greater acceptance of individual responsibility for mistakes. We cannot expect a private system to survive if the profits go to the bankers and the losses go to the taxpayers.

We cannot know what the future consequence of the crisis and the policy response will be. We should recognize, however, that despite the severity of the crisis, regulators have not announced a policy or encouraged financial markets to believe that they have abandoned “too big to fail.” In fact, mergers have made the largest firms larger.

The broader lesson of this experience should be that policy misjudgments by Congress and the Federal Reserve helped to bring on the crisis. Discretionary policy failed in 1929–33, in 1965–80, and now. The Federal Reserve should announce and follow a rule for its lender-of-last-resort actions. For monetary policy, the lesson should be less discretion and more rule-like behavior. For several years, I have proposed a multilateral arrangement under which major currencies—the dollar, the euro, and the yen— would agree to maintain a common rate of inflation. That would work to increase both expected price stability and greater nominal exchange rate stability. To implement the policy, the Federal Reserve should commit to the Taylor rule. For the monetary policy to work well, the Congress and the Treasury should agree to limit the budget deficit to a narrow range. A rule of this kind increases stability of both domestic and global economies. And Congress should put its housing subsidies on budget and close Fannie Mae and Freddie Mac. As the Issing committee showed, the route to less risky financial markets starts with stabilizing incentives.

The current crisis calls for reopening long-settled issues about Federal Reserve governance and independence. The 1913 Federal Reserve Act and all subsequent legislation made the Federal Reserve independent but never defined independence. Under the gold standard, that was not much of a problem, but this history shows that Federal Reserve chairs often gave up independence. The Volcker and Greenspan eras restored independence,
but Chairman Bernanke has acted frequently as a financing arm of the Treasury.