As the United States Senate resumes debate on financial regulatory reform, I want to share some of my concerns with several aspects of the bill passed by the Senate Banking Committee. The financial crisis has clearly demonstrated the need for reform. It is important, however, that reform does not mistake symptoms for root causes or overreach in ways that could lead to unintended consequences. If we don’t enact the right reform, we may end up sowing the seeds of another, unintended crisis.
I believe that the most important challenge that reform must address is the too-big-to-fail problem. If equity investors and creditors do not seriously believe that their money is at risk and that any financial firm can fail, regardless of size, then they will remain inclined to take on too much risk. More importantly, creditors, if they perceive any possibility of a government backstop, will have less incentive to monitor the risk-taking of the owners. Under the current system, when stock and bondholders of TBTF firms win, they profit, but when they lose, they become eligible for a government bailout. Such an arrangement clearly leads to moral hazard. We only need to look at Fannie and Freddie for the outcome. Reform must end the belief that some firms are TBTF.
In order to end TBTF, we must have a way that credibly convinces large financial firms and the markets that firms on the verge of failure will, in fact, be allowed to fail. If the resolution mechanism is either too vague or allows for too much discretion by regulators or Congress to rescue firms through subsidies or bailouts, then troubled firms will surely argue that the risks of failure are so severe and systemic that they must be bailed out. This is what we saw in the recent crisis. A credible commitment by government not to intervene or bail out firms must be the centerpiece of the resolution mechanism.
I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court. I recognize that the current bankruptcy code does not adequately address the inherent challenges in liquidating large financial institutions without risks to the market, but I believe a modified bankruptcy process would eliminate discretion and strengthen market discipline, by permitting creditors as well as regulators to place the firm into bankruptcy when it is unable to meet its financial obligations.
The Senate bill’s proposal to restrict the Federal Reserve’s supervisory authority to about 35 of the largest financial firms with $50 billion or more in assets further undermines the effort to end TBTF. The markets will likely interpret this provision as signaling that these firms are unique and will continue to be treated as TBTF. Many would assume that the language in the resolution section that emphasizes bankruptcy would not apply to these firms. This provision would, de facto, make the Federal Reserve supervisor of the firms deemed TBTF.
In addition, restricting the Federal Reserve’s supervisory authority to these large firms would focus the Federal Reserve’s attention more toward Wall Street and less on Main Street. Nearly a century ago, Congress established the Federal Reserve as a decentralized central bank, by chartering 12 regional Reserve Banks, overseen by the Board of Governors in Washington, D.C. The structure provides checks and balances – between centralization and decentralization, between the public and private sectors, and between Wall Street and Main Street – all to ensure that policy decisions are balanced and independent.
Today, the Federal Reserve supervises about 5,000 bank holding companies and 850 state-chartered banks. These responsibilities help give the Fed direct contact and knowledge of banks and communities on Main Streets across America. In the Third District, the Philadelphia Fed supervises over 100 bank holding companies and 23 state-chartered member banks. These supervisory responsibilities support and complement the central bank's ability to meet its congressional mandates for financial stability and monetary policy. Losing direct supervision of all but the largest bank holding companies would dramatically reduce the Federal Reserve’s abilities to monitor the economy and financial market developments, to act as an effective lender of last resort, and to identify risks to the financial system. That is why I believe the Fed must retain supervision of bank holding companies of all sizes and state member banks.
Finally, I am concerned that the bill contains provisions that seek to politicize the governance of the Federal Reserve, including making the New York Fed president a political appointee with a five-year term. This proposal would gravely dilute governance structures that have sheltered the central bank from short-term political influences. Fed Governors are appointed by the President and confirmed by the Senate, but serve 14-year terms to encourage a long-term perspective and shelter them from partisan politics. Federal Reserve Bank presidents are selected in a nonpolitical process by their boards of directors, subject to the approval of the Board of Governors in Washington.
There are two important reasons for protecting monetary policymakers from direct political pressures. First, monetary policy affects the economy with sometimes long and variable lags. Monetary policy actions will not have their full effect on the economy for several quarters and perhaps as long as several years. Congress recognized that delegating monetary policy decision-making to an independent central bank with a long-term perspective would limit the temptation to pursue short-term gains at the expense of future outcomes.
The second important reason to give monetary policy decision-making to an independent central bank is to separate the authority of those in government responsible for making the decisions to spend and tax from those responsible for printing the money. This lessens the temptation for the fiscal authority to use the printing press to fund its public spending, thereby substituting a hidden tax of inflation in the future for taxes or spending cuts.
The Senate bill would create a new political appointee based at the New York Fed. The rationale for this change was that the New York Fed president has a permanent vote on the Federal Open Market Committee and traditionally serves as vice chairman of the FOMC, the main monetary policymaking body within the Fed. Congress gave votes on the FOMC to the seven Governors, to the New York Fed president, and to four other Reserve Bank presidents on a rotating basis. Changing the New York position to a Presidential appointee would greatly skew the center of power and influence to New York and Washington and further reduce critical input to monetary policy from the rest of our country. There would be a powerful temptation to mitigate the effects of a crisis using the Federal Reserve’s power to print money, rather than through fiscal action. Even in normal times, added political pressure might keep interest rates lower in order to stimulate short-term growth, at the expense of long-term inflation. This is not a partisan issue. Political influence over monetary policy is dangerous no matter which party is in control.
I also stress that I do not raise these objections simply to maintain the status quo. The Federal Reserve should and will change to improve the strength and effectiveness of our nation’s regulatory system. As I have outlined, I am for changes in bankruptcy laws to create a credible way to fail troubled nonbank financial firms, so we never again need to bail out individual firms. In recent months, I have also called for the following reforms:
- Eliminate or curtail the Fed's 13(3) lending authority, which allows lending to corporations, individuals, and partnerships under "unusual and exigent circumstances." I believe the fiscal authorities should do emergency lending and that the Fed should be involved only upon the written request of the Treasury. With an appropriate bankruptcy process that protects the financial system from the failure of one firm, the need for 13(3) type lending is vastly reduced.
- Enhance market discipline by requiring financial firms to hold contingent capital in the form of convertible debt that could be converted into equity in periods of financial stress. Contingent capital would be less costly than simply raising capital requirements. Perhaps most important, it would provide a means of recapitalizing these firms in a crisis without the necessity of government rescues and bailouts. Moreover, the market price of such debt would provide regulators with a signal about the health of the firm and the market's perception of risk.
- Support greater transparency by requiring the Fed to deliver a semi-annual Financial Stability Report to Congress and the public. Similar to the Fed’s requirement to submit its Monetary Policy Report, this requirement would improve the transparency and accountability of the Fed's financial oversight responsibilities, which would help ensure public trust and credibility.
- Have the Federal Reserve conduct monetary policy using a portfolio that contains only Treasury securities, which would promote a clearer distinction between monetary policy and fiscal policy, help uphold the Fed's independence, and assign fiscal decisions to the Congress where they belong.
Here in Philadelphia, just blocks from the Philadelphia Fed, you can find the vestiges of the First and Second Banks of the United States, two earlier attempts at a central bank, which both failed because they became embroiled in politics. I ask you to keep this historical perspective in mind as you weigh the decisions on financial reform in the weeks ahead. Above all, we should avoid any changes that would impede the Fed’s ability to meet its congressionally mandated objectives for sound monetary policy to ensure price stability and maximum sustainable economic growth.
Charles I. Plosser is President and CEO of the Federal Reserve Bank of Philadelphia. This originally appeared on the Philadelphia Fed's website on April 20. It is reprinted here with permission.