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Wednesday, June 17, 2009

Can the Federal Reserve Regulate Systemic Risk?

The latest “bright” idea that the Obama Administration has proposed is to have the Federal Reserve (Fed) regulate the largest financial players in the market (those that are “too big to fail”) in an effort to prevent a future financial meltdown. This decision begs the following questions. 1) How can the Fed ensure future financial security when it not only already has regulatory authority, but its monetary policy played a role in the housing debacle that ignited the meltdown? 2) Is it wise to expand the Fed’s regulatory authority when it has no accountability? 3) Is it possible to regulate systemic risk? If so, one can argue that the Fed itself poses systemic risk.

It is interesting how the Obama Administration proposes giving the Fed this regulatory authority when it already has general authority to regulate all banks in the United States. The Fed controls the nation’s monetary system. Its influential powers over money supply, interest rates and the availability of credit have a direct effect on the overall stability of the economy. The Fed’s effort to maintain economic stability is essentially the attempt to manage systemic risk.

One of the core responsibilities of the Federal Reserve is to supervise and regulate banking institutions to ensure consumer protection. The Fed has done a wonderful job protecting consumers and managing systemic risk in the past…why not have confidence in the future?! While it is true that Congressional policies (i.e. the Community Reinvestment Act and the vast expansion of Fannie Mae and Freddie Mac) played a role in the housing crash, the Fed helped to provide financing by keeping interest rates at questionably low levels between 2002 and 2005. The Fed could have brought to light the damage the regulatory quest for “affordable housing” caused. However, it chose to finance it instead.

The Federal Reserve is accountable to no one. It is an independent entity within the government that is quasi-public. The Fed’s decisions do not have to be ratified by Congress. The Fed does not have a budget, and it is not subject to audits. In addition, no governmental body including the President can supervise its operations. Therefore, how can the Obama Administration propose expanding the Fed’s powers when it not only failed to prevent the housing crash, but its regulators cannot be held accountable? Unfortunately, this is politics at its finest. Obama is providing nothing more than an illusion that he is taking serious action to prevent a future crisis. If the President was serious about preventing a future crisis, he would propose a legislative overhaul of the regulations and policies that created the sub-prime mortgage market in the name of “affordable housing” that lead to the crash.

Systemic risk is defined as overall market risk that cannot be diversified. The economy is cyclical – it always has been and always will be. Just as there are four seasons in a year, there will always be four parts to the economic cycle – 1) Expansion, 2) Recession, 3) Trough, and 4) Recovery. The degree of systemic risk depends on the economic cycle, which means it is impossible to avoid.

If systemic risk is impossible to avoid, then how can the Fed regulate it? The answer is obvious - it cannot. What the Fed can do is continue to prop up large financial institutions due to the fact that they are “too big to fail.” This will come at the expense of future opportunity, and it will be extremely difficult for smaller financial branches to be competitive when the larger institutions are being subsidized by the government. What should have taken place and what should take place in the future is to let the Federal Deposit Insurance Corporation (FDIC) step in, as it would make way for more viable players in the market without causing major market turmoil.

Furthermore, the Federal Reserve can CAUSE systemic risk through its policies. Just as low interest rates helped fuel the housing bubble, monetary policy in the future can contribute to more artificial bubbles and busts. The Fed has unchecked power as well as the power to negatively influence the economy. Its decisions can cause inflation, deflation, weaken currency and other factors which sharpen the impact of economic downturns and give way to future problems.

Rather than expand the powers of institutions that already have too much power, the Obama Administration should have the courage to repeal the laws and regulations that caused the housing crisis. It is fact that major banks were required to comply with the provisions of the “Community Reinvestment Act,” which forced them to loan money to people who were not worthy of such credit. Instead, lawmakers have blamed what happened in the aftermath of such a proposal: foreclosures, speculation, derivatives and the bundling of mortgage-backed securities instead of admitting that the negative consequences that ensued were the direct result of interfering with the free market. Going forward, the best way to regulate systemic risk is for the government to get out and stay of the private sector.

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