WASHINGTON — Current and former leaders of the Federal Reserve Board expressed concern Tuesday about establishing a regulator to supervise the firms considered critical to the financial system's proper functioning.
Though no one said Congress should abandon its efforts to ordain a systemic risk regulator, they cautioned that simply focusing on tougher supervision will not prevent a financial crisis.
Former Fed Chairman Alan Greenspan said regulators cannot identify systemic risk well in advance. "What regulators cannot do is anticipate things," Greenspan said during a panel discussion at the Brookings Institution. "If we are to put a regulator out there who is supposed to fend off systemic risks, I will tell you that system will fail. … Knowing when a crisis will happen is not possible."
House and Senate Democrats are weighing how systemically important institutions should be regulated. House Financial Services Committee Chairman Barney Frank, D-Mass., has said those powers should go to the Fed, but Senate Banking Committee Chairman Chris Dodd, D-Conn., is reluctant to give them to the central bank, citing its regulatory failures in the buildup to the financial crisis.
Fed officials did not address whether the central bank should take the role. Instead, they seemed more concerned about whether such a system will work.
"I'm not persuaded that if we devote more resources to traditional … [supervision and regulation] and we raise capital standards and we limit activities, that all of that at the end of the day is going to get us where we want to go," Gary Stern, the president of the Federal Reserve Bank of Minneapolis, told reporters after speaking on the Brookings panel.
Speaking in Chicago, Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, said a "battery of new regulatory restrictions" would be a "wrong-headed approach."
That approach "would generate large supervisory costs, stifle innovation and result in regulatory arbitrage as markets worked to evade the regulations," he said. "Such regulatory arbitrage was a contributor to the current financial crisis."
Despite criticism in some circles that uninhibited market forces helped spawn the crisis, Plosser argued that regulators can still rely on the market to provide discipline. "Regulators cannot hope to foresee and control all events," he said. "It is important that we design a regulatory structure that enhances the effectiveness of market discipline and doesn't try to replace it. The regulatory structure must recognize the central role of markets in pricing and controlling risks and in allocating credit."
Stern argued that once the market turmoil ends, regulators can revive market discipline by letting creditors of large firms know they could lose money in the event of a failure. "Our approach does not simply seek to limit systemic risk, but takes the next step of … putting creditors at risk of loss."
Exactly who should absorb that loss remained up for debate.
Greenspan argued that losses should not be imposed on debtholders of firms that have been bailed out, at least as long as the crisis continues. Most bailouts have protected debtholders while wiping out shareholders. "You have to be very careful about senior debt," he said. "There has to be a fixed pillar somewhere in the system which seemingly is infallible."
But Vincent Reinhart, the former director of the Fed's division of monetary affairs, disagreed during the Brookings panel discussion. "I would argue that last year the government's playbook of fully protecting all debtholders and wiping out shareholders creates an incentive for speculation," he said. "When we finally get to closure in this — that is, when we resolve a few large financial institutions and get past this — I would hope those resolutions involve taking haircuts across all the liabilities."
Reinhart also took issue with plans announced by the Obama administration last week that would govern the winding down of major institutions. Rep. Frank could move this week on the plan, which would give the Federal Deposit Insurance Crop. resolution powers over systemically significant firms.
He argued such a solution makes the process more complicated. "Their solution is to add another layer on top of an already complicated system," he said.
