The ad hoc Investors' Working Group composed of former financial regulators and high investment firm officials last week released a report on reforming U.S. financial regulation.
This report strongly disagrees with the Obama administration's proposal to designate the Federal Reserve Board as the uber-regulator for systemically important firms.
The report notes that the Fed's "easy credit policies and lax regulatory oversight let institutions ratchet higher their balance sheet leverage and amass huge concentrations of risky, complex securitized products." Adding to this financial conflagration was the Fed's "refusal to police mortgage underwriting or to impose suitability standards on mortgage lenders."
The IWG report echoed the doubts of Senate Banking Committee Chairman Christopher Dodd. Last month he quoted an academic who likened giving more regulatory power to the Fed to "a parent giving his son a bigger, faster car right after he crashed the family station wagon."
The Fed has richly earned this skepticism.
In three ways the Fed not only failed to use its existing authority to curb financial excesses, but actually may have added to them:
Low interest rates and easy money: Early in this century the Fed responded to the bursting of the technology bubble and the Sept. 11 attacks with injections of liquidity and low interest rates. In 2003-04 short-term rates were at 1% a 50-year historic low.
As a result, mortgage rates also dropped to historic lows, which fueled the housing bubble, and investors were looking for higher returns, thus creating a seemingly insatiable demand for mortgaged-backed securities, particularly those secured by subprime mortgages with their higher yields and cash flows.
One need not heap scorn on the Fed's performance to point out what now is obvious: The Fed was no more prescient than most others at realizing the danger embedded in its monetary policy.
Ineffective safety and soundness regulations: Congress in 1991 directed the Fed and the other bank regulatory agencies to issue uniform guidelines, regulations or standards governing a number of banking practices, including real estate lending.
The agencies chose not to issue regulations. Instead, the Fed and others merely cautioned the banking industry about various aspects of real estate lending, such as "prudent underwriting standards , including loan-to-value ratios," "capacity of the borrower to cover the debt," "undue concentrations of credit" and "market conditions."
One aspect of these interagency real estate lending standards deserves particular mention: They exclude "Loans that are to be sold promptly after origination, without recourse, to a financially responsible third party." In other words insofar as the banking agencies were concerned loans to be fully sold into the secondary market were standardless.
Why did the Fed not use its already ample authority to compel banking institutions and their holding companies to follow more prudent real estate lending standards? Roger Cole, the Fed's director of bank supervision, answered that question on March 18 in testimony to a Senate subcommittee: "When bankers are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, we must have even firmer resolve to hold firms accountable for prudent risk management practices."
Here again, one need not be overly critical of the Fed in pointing out that like most others it failed to foresee and forestall the coming train wreck.
Untimely consumer protection enhancements: Almost by definition, the subprime loans at the heart of the financial meltdown generate for lenders more fees and higher interest rates. Congress in 1994 directed the Fed to add to its Truth-in-Lending regulations some special protections for these so-called high-cost mortgages.
Since the early 2000s consumer groups, some congressional leaders and others have criticized the Fed's original regulations as inadequate, and urged the Fed to act against many of the kinds of lending practices that led to the subprime mortgage meltdown.
Not until July 2008 did the Fed finally act to ban many of the practices that underlay the growth of the subprime mortgage market. When those regulations actually become effective in October 2009 they will:
- Prohibit a lender from making a loan without regard to borrowers' ability to repay the loan from income and assets other than the home's value. A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan.
- Require creditors to verify the income and assets they rely upon to determine repayment ability.
- Ban any prepayment penalty if the payment can change in the initial four years.
Had the Fed acted years sooner, it might have severely limited the amount of poison that flowed into the world's financial system.
But these three lapses are not the only reasons the IWG report favors a completely independent systemic risk oversight board instead of investing the Fed with greater authority.
The IWG's proposed board would recommend to "the appropriate regulators how to address potential systemic threats." Regulators then must respond by either adopting the board's recommendation or justifying an alternative course of action.
Giving the Fed this responsibility would put it in the largely useless position of overseeing itself.
Finally, making the Fed an overall systemic regulator will imperil its independence in exercising monetary policy.
Effective systemic regulation will greatly impact both individual firms and the overall U.S. economy. Experience with the Tarp funds demonstrate the political pressures that inevitably will be brought to bear on whoever exercises these extraordinary systemic powers.
The media have reported on individual senators and congressmen intervening on behalf of individual Tarp applicants. On a broader scale, Congress created both an oversight board and a special inspector general to monitor Tarp.
And Congress' watchdog, the General Accountability Office, is salivating at the chance to realize its long-held dream of expanding its ability to investigate the Federal Reserve.
Two hundred thirty four representatives a majority of the U.S. House are co-sponsors of HR 2424, Rep. Dennis Kucinich's bill to expand GAO oversight of the Fed, including on-site examination of any credit facility extended by the Fed or any reserve bank.
Were the Fed to become the systemic regulator, in no way could it avoid greatly expanded political oversight of its monetary functions.
For all of these reasons, empowering the Fed as a systemic regulator is a bad idea whose time has not come.