Doubt over Fed’s ability to limit systemic risk

The Obama administration’s proposals for safeguarding the financial system place the US Federal Reserve at the heart of a new regulatory regime for systemic risk, but some former regulators are sceptical of the Fed’s ability to carry out the job.

The proposals would assign the Federal Reserve direct supervision of systemically important financial firms – to be known as Tier 1 financial holding companies – regardless of whether they are regulated as banks or not. This would be in addition to any supervision they already get from functional regulators.

Since the financial crisis hit, the idea of giving regulators the power to deal with systemic risk has become popular across the globe – a trend underlined by the outcome of the G20 summit in London last April.

“The experience of the last two years does underscore the need for some agencies to focus more on the financial system as a whole, the interrelationships of all these large firms and the potential for contagion when there’s a shock to the system,” said Richard Spillenkothen, former director of banking supervision and regulation at the Fed and a director at Deloitte’s Centre for Banking Solutions in New York.

But while there is agreement about the need to address systemic risk, some former regulators are uncertain about the Fed’s ability to do the job effectively. Robert Clarke, former US comptroller of the currency and a senior partner at Chicago-based law firm Bracewell & Giuliani, said the Fed was not the right organisation to tackle systemic risk. “I’m not a fan of the idea of the Fed being a systemic regulator. I’m much more comfortable with the idea of a committee or a college of regulators, where they all have their own responsibilities but they are also responsible for collaborating on systemic risk,” he said.

Like others, he is concerned about the Fed’s ability to square its responsibility for systemic risk with its role as an independent central bank setting monetary policy. “There’s an inherent conflict of interest between the Fed being a banking regulator and a central bank. It’s at least theoretically possible for the Fed to manipulate the economy by the way it supervises the banks,” he said.

But Spillenkothen argued that the twin roles of a central bank and systemic regulator were unlikely to be in conflict. “It makes a lot of sense to me to place responsibility and authority for systemic risk within a central bank – those missions dovetail, in my opinion. But it’s a lot of additional responsibility and it won’t be easy because these are complex and difficult matters.”

These new responsibilities would require changes to the way the Fed operated, suggested Chris Laursen, a former head of risk policy and guidance at the Fed and senior consultant at Washington, DC-based Nera Economic Consulting. While agreeing the Fed was the right institution to handle systemic risk, he said a “top-down and reactive” approach had hindered its attempts to resolve problems in the past.

“They need to create a new group run out of the Federal Reserve Board, and make sure they have the right types of people running it – people who have the right kind of experience and the fortitude to not over-rely on bankers’ explanations,” he explained.

Previously, one problem was that Fed personnel responsible for compliance were often the same as those trying to gain information from banks about market issues, he said. “One of the key structural problems at the Fed is that the people doing the policing are the same people going around asking for information and colour from the firms on general market conditions or over-the-counter derivatives volumes, for example.” Consequently, the Fed would need to be imbued with proper authority as well as accountability for regulatory failings, he added.

As part of the Obama plan, the Fed is expected to consult with the Treasury and independent experts and come up with recommendations by the beginning of October on how it can better align its structure and governance with its new responsibilities.

In light of the expanded role it has taken on since the financial crisis, the Fed has received growing calls to open itself up to greater scrutiny. On July 9, Fed vice-chairman Donald Kohn responded to such arguments in testimony before a House Financial Services Committee panel, defending the central bank against the suggestion that its monetary policy decisions should be audited by the Government Accountability Office (GAO). He also defended the idea of the Fed taking over broad responsibility for systemic risk: “I believe US and foreign experience shows that monetary policy independence and supervisory and regulatory authority are mutually compatible and even have beneficial synergies,” he said.

The Fed already had responsibility for supervising the nation’s largest bank holding companies – a group that had recently swelled thanks to the conversion of firms including American Express, Goldman Sachs and Morgan Stanley, he noted. Moreover, the Fed’s actions as a regulator were already audited by the GAO and would continue to be if it took responsibility for systemic risk, he added.

See also: US regulatory reforms will target the big players
Merge SEC and CFTC, says former SEC commissioner
G20 fires starting gun on global systemic risk regime