speeches · June 18, 2009

Regional President Speech

James Bullard · President

R R EGULATORY EFORM A F FTER THE ALL OF W S ALL TREET James Bullard President and CEO Financial Regulation Reform Collaborative Washington DC 19 June 2009 Any opinions expressed here are my own and do not necessarily reflect those of the Federal Open Market Committee members. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE THE CLAMOR FOR REGULATORY REFORM ThePanicof1907 = FederalReserve. ) TheDepression = Glass-SteagallandtheFDIC. ) The1980sThriftCrisis = FDICIA. ) Enron/Worldcom = Sarbanes-Oxley. ) Conclude: Reformlegislationunlikelytostallout. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE WHAT CAN REFORM ACCOMPLISH? Betterlong-rungrowthprospects? Betterstabilization? Bubbleavoidance? CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE INTERMEDIATION AND LONG-RUN GROWTH Growththeoriesforindustrializedeconomiestendto de-emphasizeintermediationorthedepthoffinancialmarkets. Instead,theytendtoemphasizeimprovementsintechnologyor humancapital. Conclude: evenperfectregulationprobablywillnotimprove long-rungrowth. Theliteratureonfinanceandgrowthappliestodeveloping countries. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE BETTER STABILIZATION Financialcrisescanbeassociatedwithrecession. Avoidingthismeansavoidingthepanicelementofacrisis. Inthepast,thishasmeantavoiding“bankruns.” Oursystemturnedouttobesusceptibletoanewformofa “bankrun.” Conclude: Itmaybepossibletoaddressthisprobleminareform. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE AVOIDING BUBBLES Bubblehasbecomeanoverusedterm. Thereisalargeliteratureonmultipleequilibriain macroeconomics. Usually,high-volatilityvs. low-volatilityequilibria. Thehighvolatilityequilibriaaredrivenbyself-fulfilling expectations. Thepolicyresponseistoknockoutthemultipleequilibria. Thisleavesaneconomythatrespondsonlytofundamental shocksandhasno“extravolatility.” Conclude: Itmaybepossibletoaddressthistypeofproblemas well. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE PLAN FOR THIS TALK Whatarethecoreproblems? Failureoffinancialengineering. “Bankruns”onnon-bankfinancialinstitutions. Implicitinsuranceofcreditorstofinancialinstitutions,a.k.a.TBTF. Someportionsoftheregulatorysystemworkwell. Why? Whattodoaboutthelargefinancialinstitutions? TheroleoftheFederalReserve. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE A FAILURE OF FINANCIAL ENGINEERING Securitizationmarketsareinprincipleagoodfinancial innovation. Theinitialsuccessofmortgage-backedsecurities(MBS)masked underlyingproblems. Bythetimeoffailure,largequantitiesofMBSandrelatedassets wereheldglobally. Fewmajorplayersescapedunscathed,suggestingfewknewthe dangers. Someparallelswithothertypesofengineeringfailures. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE MORE ON FAILED FINANCIAL ENGINEERING Theresultingshocktotheglobalmacroeconomyislargeand real. Thereisnoescapingtheadjustmentthatmustoccur. Governmentinterventioncannotoffsetthislargeshock completely,onlymitigatesomeoftheeffects. Thedesignofthesecuritieswasacoreproblem: Theydidnot performwellinsomestatesoftheworld. Somereformsbeingdiscusseddoatleastindirectlyaddressthis. Onegoalshouldbetorevivesecuritizationmarkets. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE “BANK RUNS” ON NON-BANKS Bankrunshavebeenamacroeconomichazardforhundredsof years. Conceptualizedassimultaneouswithdrawalofdepositsfroma depositoryinstitution. DiamondandDybvig,1983. Policyintervention: Depositinsurance... ...plusprudentialregulation. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE MORE ON “BANK RUNS” Thiscrisishasinsteadproduced“runs”onnon-bank, non-depositoryinstitutions. Therewasnoregulationinplaceforthishazard ...becauseitwasnotgenerallyviewedasahazard. Bear-Stearns,forinstance,borrowedshort-term,butagainst collateral. Depositinsurancedoesnotsolvethisproblem. Whattodo? Mostreformsuggestionsdonotaddressthisproblemeither. “Keepaclosereyeontheseguys”doesnotwork. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE PORTIONS OF THE REGULATORY SYSTEM WORK WELL Bankregulationoutsidethelargestfinancialinstitutionshas workedwellduringthecrisis. Wedonotseethesmallbankpanicthatcharacterizedthe Depression,eventhoughthisisalargecrisis. Thesystemofdepositinsuranceplusprudentialregulation solvesthatproblem. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE MORE ON SUCCESSFUL REGULATION Therearebankfailuresinthesystem,buttheyhavenotcaused marketdisruption. Whythesuccess? Thefirstcomponentisgoodmonitoring. Afairlyclearratingsystemisinplace. Themonitoringsystemmeansthattheregulatorisawareof whichbanksmayfailandcanprepareaccordingly. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE MORE ON SUCCESSFUL REGULATION Thesecondcomponentisaclearandcredibleresolutionregime. Credibilitymeansthatallpartiesunderstandwhatwillhappen intheeventofbankfailure. TheU.S.hasasystemforclosingbanksinawaythatdoesnot damageothersintheindustry. Conclude: Goodregulationisgoodmonitoringplusaclear, credibleresolutionregime. Wecanlearnfromthesuccessofthissystem. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE WHAT THE SUCCESSFUL REGULATORY STRUCTURE DOES Thesystemisnotdesignedto“keepbanksinbusinessatall costs.” Noristhesystemdesignedtotellownershowtoruntheir business. Itsayslittleaboutinternalincentivesystems. Thesysteminfactallowssomefailuretooccur. Whatitisdesignedtodoistoturnpotentiallydisorderlyfailures intoorderlyfailures. Thesystemsucceedshere. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE LARGE, GLOBAL ENTERPRISES Keyproblemsinvolvelargebanksandlargenon-bankfinancial firms. Theseareoftenglobalenterprises. Cross-borderregulatorycompetitionisapowerfulforce. Itisfarfromclearhowmuchrealprogresscanbemadeon globalregulatorycoordination. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE TWO MISSING PIECES Themonitoringproblemforlargeinstitutionsismuchmore difficult. Asaresult,ithasbeendifficulttodiscernhowthesefirmsare copingwiththefinancialengineeringfailure. Thefirm’sincentiveistosay“alliswell”untilthebitterend. Firmsnearfailuremightalertauthoritiesonlydaysbeforethe event. Sothefirstpartofgoodregulationwasmissing: monitoringwas poor. Inaddition,theresolutionregimeisunclear. Thesecondpartofgoodregulation,aclear,credibleresolution regime,wasalsomissing. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE TOO BIG TO FAIL QUICKLY Largefinancialfirmsareoftenconsidered“toobigtofail” becauseofthemarketdisruptionthatmightbecaused. Thecorrectphraseis“toobigtofail... quickly.” Allfirmsfaileventually. Regulatorsmayencounterfraud—forexample: Enron. Someplanhastobeinplacetoshutdownthefailedinstitution inthatcase. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE RESOLUTION REGIMES Wewantanorderlyresolutionregimethatwillclosedownthe failedfirmwithoutcreatingproblemsfortheremainingfirmsin theindustry. RonaldFeldmanandmycolleagueGarySternemphasizethat thisresolutionregimemustbecredible. Crediblemeansthatallpartiesunderstandwhattheregimeis andthatitwillindeedbeemployedintheeventoffailure. IstheresolutionregimeintheTreasuryproposalcredible? CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE RESOLUTION REGIMES AND PRICING Theresolutionregimeaffectstheentireequilibriumpricing structure. Marketplayersarepricingintheprobabilityoffailurealong withtheirpayoutinthatstateoftheworld. Uncertaintyabouttheresolutionstateinjectsuncertaintyintoall financialmarketprices. Forthisreasontheresolutionregimemaybethemostimportant reform. ChairmanBernankehasrepeatedlyemphasizedtheneedfora resolutionregimetohandlelargefinancialinstitutions. Usedcorrectly,thiswillturndisorderlyfailuresintoorderly failuresandavoidpanic. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE EXISTING RESOLUTION REGIMES Bankruptcycourthasbeenconsideredinadequateforcertain typesoflargenon-bankfinancialfirms. Asimplereformwouldbetorewritethebankruptcycodeto allowforspecialconsiderationsthatapplytofinancialfirms. Thiswouldnothelpuswiththemonitoringquestion: thefiling maystillbe“sudden.” CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE SIZE LIMITATIONS Onesimpleapproachthathasbeensuggestedmightbetolimit thesizeoffirms. Thiswouldbringlargefinancialinstitutionswithinaregulatory frameworkwhichisrobustandisknowntoworkwell,evenina crisis. Still,itisquestionablewhethersizerestrictionscouldbe adequatelyenforced. Theglobalaspectofthesefirmsmightalsomakethisidea difficulttoimplement. Aversionofthiswouldbetoplaceataxonfirmsize. Ataxdoesnotseemtohelpeitherwithmonitoringorwith resolution. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE MONITORING WITHOUT A RESOLUTION REGIME Themostcommonresponsetothesituationhasbeenthatwe needmoremonitoringoflargefinancialfirms. Itisunclearwhatmonitoringbyitselfcanaccomplish. Weneed theresolutionregime. Monitoringcanhelpauthoritiestrackwhichfirmsarelikelyto fail. Itcannotdoverymuchaboutpoorbusinessdecisions. Regulatorsarenotgoingtohaveabetterideathanbusiness leadersastowhichdirectiontheirfirmshouldgoinordertobe profitable. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE THE LENDER OF LAST RESORT TheFedisthenation’slenderoflastresort. IftheFedmaybelendingtoinstitutions,itwillneedtohavea roleinregulatingthoseinstitutions. Otherwise,theFedwillbeunabletomakeajudgementon whethertolendandunderwhatterms. TheroleofFedlendinginmitigatingthecurrentcrisishasbeen substantial. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE THE NATION’S MONETARY AUTHORITY TheFedalsorunsthemonetarypolicyofthenation. Toperformthisfunctioneffectively,theFedneedstoknowthe conditionofthefinancialsystem. ThisalsoarguesforasubstantialFedroleintheregulationof thesefirms. Theneedtoknowthestatusoffinancialmarketshasbeen underscoredbyrecentevents. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE SYSTEMIC RISK REGULATION TheFedhasbeenthedefactosystemicriskregulator. Manyfinancialmarketproblems,whetherundertheofficialFed purviewornot,havecometotheFedduringthiscrisis. TheworldexpectstheFedtofixfinancialmarketproblemsas theyoccur. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE A POORLY DEFINED DEBATE Thedebateonsystemicriskregulationneedstobesharpened substantially. Thedefinitionofsystemicriskregulationisfarfromclear. Amacro-prudentialview: doestheFedalreadydothis? Anarrower,institutionalview: whatnewpowerstoassign? CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE A MACRO-PRUDENTIAL VIEW Amacro-prudentialviewoftenemphasizesaregulatorthat “takeseverythingintoaccount.” Coupledwithmonetarypolicy,itmeanstakingeverythinginto accountwhensettinginterestrates. IthinktheFedalreadydoesthis. Certainly,policydebatesinthelasttwentyyearshavediscussed bubblesintechnologystocksandinhousingprices. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE THE FED AND SYSTEMIC RISK ThreeimportantsystemiccallsbytheFed: WilliamPooleonGSEs.* GarySternon“TooBigtoFail.”** NedGramlichonsubprime.*** *“FinancialStability,”2002;“HousingintheMacroeconomy,”2003;and“ReputationandtheNon-PrimeMortgageMarket,”2007. **GaryH.Stern,RonJ.Feldman,TooBigToFail:TheHazardsofBankBailouts,BrookingsInstitutionPress,2004. ***EdwardM.Gramlich,SubprimeMortgages:America’sLatestBoomandBust,UrbanInstitutePress,2007. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE A NARROWER VIEW Anarrowerviewwouldcontaintheideathatcertainmarket practicesmayneedtobecurtailed. Alternatively,businesspracticesatcertainfirmsmightneedtobe discouraged,shouldtheybeviewedassystemicallyrisky. Whatisuncleariswhatpowersanewregulatorwouldneedto carryoutthesetasks. Howwouldfirmsoperate,knowingthataparticularpractice mightbefound“toorisky”atsomepointinthefuture? Idonotthinktheanswersareclearatthispoint. Thedebateneedsamuchsharperfocus. CLAMOR NATUREOFTHECRISIS SMOOTHREGULATION PROBLEMAREAS CURRENTDEBATES THEFED’SROLE CONCLUSIONS Forsmallerbanks,theU.S.regulatorysystemworkswellandis robustduringacrisis. Thisisimportant: Itsolvedaproblemthatplaguedournation fordecades. Forlargebanksandnon-bankfinancialfirms,monitoringis moredifficultandtheresolutionregimeisunclear. Keyimprovementswouldbetodevelopacredibleresolution regimeforlargefinancialinstitutions,andtoupgrade monitoring. TheFed’slenderoflastresortandmonetarypolicyfunctions meanthatitwillhavetoremaincloselyinvolvedinthe regulatorystructure. Thesystemicriskregulationdebateneedstosharpenup. Federal Reserve Bank of St. Louis stlouisfed.org Federal Reserve Economic Data (FRED) research.stlouisfed.org/fred2/ James Bullard research.stlouisfed.org/econ/bullard/

Cite this document

APA

James Bullard (2009, June 18). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090619_james_bullard

BibTeX

@misc{wtfs_regional_speeche_20090619_james_bullard,
  author = {James Bullard},
  title = {Regional President Speech},
  year = {2009},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20090619_james_bullard},
  note = {Retrieved via When the Fed Speaks corpus}
}