Speech

Responding to Financial Crises: What Role for the Fed? PanelDiscussion CatoInstitute24thAnnualMonetaryConference Washington,D.C. November16,2006 Iam delighted to return to Cato, an organi- themostimportantissueisnotreflectedinthe zation with which I feel a natural affinity, titleofthispanel—whattodointheeventof especially through Bill Niskanen with financialcrisis—butinsteadhowtoavoidfinan- whomIservedasamemberoftheCouncil cialcrisisinthefirstplace. of Economic Advisers a quarter century ago. Beforeproceeding,Iwanttoemphasizethat That sounds like a long time ago, and I guess it theviewsIexpressherearemineanddonot was. However, when it comes to the subject of necessarilyreflectofficialpositionsoftheFederal thispanel,Idonotthinkmuchhaschanged.The ReserveSystem.Ithankmycolleaguesatthe key issue then, as today, is time inconsistency. FederalReserveBankofSt.Louisfortheircom- It seems to make sense in the middle of a finan- ments,especiallyRobertH.Rasche,seniorvice cial crisis for someone to bail out a failing firm presidentanddirectorofResearchandWilliam or firms. However, the inconsistency is that, R.Emmons,senioreconomist.However,Iretain however sensible a bailout seems in the heat of fullresponsibilityforerrors. crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too AVOIDING FINANCIAL CRISIS little capital and take too many risks. As every Depositinsuranceandabroader,fuzzy,safety economist understands, a policy of bailing out netforfinancialfirmscreatesanincentivefor failingfirmswillincreasethenumberoffinancial firmstotaketoomuchriskandholdtoolittle crisesandthenumberofbailouts.Alongtheway, the policy also encourages inefficient risk- capital.Thatisafactoflife.Ibelievethatwe management decisions by firms. shouldcontinuetoseekreformstothedeposit Inwritingthepreviousparagraph,Iatfirst insurancesystem.Iamparticularlyfondofpro- beganbysaying,“Everyoneknowsthatapolicy posalsthatwouldestablishaformalpolicyof ofbailoutswillincreasetheirnumber.”Buthere “haircutting”theinsurancecoverageto,say,90 weareinWashington,andacursoryexamination percentofinsuredliabilitiesand/orrequiringthat offederalpolicyprovesthatnoteveryoneknows. insuredfinancialinstitutionsissueexplicitly FederaldisasterreliefpolicyisexhibitA,but uninsuredlong-termsubordinateddebt.Such everycompany,financialorotherwise,knows reformswouldadministerahealthydoseofmar- thatifitgetsintotroubleitisatleastwortha ketdisciplinetofinancialfirms.Butuntilsuch majorefforttoattempttosecureabailoutbecause reformsareputinplace,Idonotseeanyother thereisalwaysasignificantprobabilityofsuc- optionthanmaintainingsubstantialsupervisory cess.Giventhisstateofaffairs,inplaceformany oversightoflarge,systemicallyimportantfinan- decadesdespiteeconomists’pleadings,Ithink cialinstitutions.Thesupervisorsneedtohave 1 FINANCIALMARKETS theauthoritytorequireadequatecapitaland capitalstandardsappliedtotheGSEsaresimply maintenanceofrobustrisk-managementpolicies inconsistentwiththeinterestraterisksthefirms infinancialfirms. haveassumed.Itdoesnotmakesenseforpublic Ibelievethatsupervisoryoversightisin policytopermitGSEstoholdfarlesscapitalthan prettygoodshape,withoneglaringexception. requiredinlargebanksgiventhatGSEshave Government-sponsoredenterprisesarenotade- substantiallysimilarorevengreaterrisksthan quatelycapitalizedandthesupervisorypowers largebanks. oftheOfficeofFederalHousingEnterprise Finally,Congressshouldcreateaprompt Oversight(OHFEO)areinadequate.I’llconcen- correctiveaction(PCA)policyregimeforthe trateonthehousingGSEs—FannieMaeand GSEsthattrulymimicstheonethatwasintro- FreddieMac.ThisisatopicI’veaddressedseveral ducedintoU.S.bankinglaw15yearsago.1The timesinthepast(Poole,2003and2004)andI’ll ideabehindPCAissimple—ifaregulatedfirm notrepeatthoseargumentsinanydetailhere. holdsonlyasmallbufferofcapitaltoprotectthe AlthoughtheGSEsarenotformallyinsuredby firm’sdebtholdersfromloss,itiscriticallyimpor- thefederalgovernment,themarketclearly tantthatthefirmfaceimmediateandincreasingly believesthattheyareeffectivelybackstopped. stringentrestrictionsonitsactivitiesasitscapital AsI’veemphasizedbefore,theFederalReserve dwindles.Otherwise,anundercapitalizedfirm doesnothavethelegalauthoritytobailouta experiencesevenstrongerincentivestoexploit troubledGSE.TheFedcanprovideliquidity itsunpricedrealorperceivedguarantees. supportthroughitsdiscountwindow,butonly ThePCAregimeiswellestablishedforbanks indirectlythroughcollateralizedloanstobanks butthesituationforthehousingGSEsisnotso thatwouldthenbearthecreditriskofmaking clear.Unfortunately,OFHEOdidnotpublisha loanstoatroubledfirm.Underemergencycon- finalruleimplementingitsversionofPCAuntil ditions,theFeddoeshavetheauthoritytomake 2002,andevennowOFHEOlacksthelegalauthor- loansdirectlytoaGSE,buttheloansmustbe itytoimposetheultimatePCAsanctionona fullycollateralized.TheFedisobviouslydisin- criticallyundercapitalizedGSE,namely,closure clinedtouseitsemergencypowerstolendto oftheinstitutionandappointmentofareceiver. firmsotherthanbanks;despitenumerousfinan- Thus,thepromiseofPCAforreducingrisksto cialupsetsovertheyears,theFedhasnotused financialstabilityposedbytheGSEsremains thisauthoritysincethe1930s. unfulfilled.Newlegislationshouldprovidethe Giventheobviousmoralhazardfacingthe GSEs’supervisorwithclearandcrediblereceiver- GSEs,thefirstbestsolutionwouldbetoturnthe shipauthority.Carriedoutfaithfully,adistressed GSEsintofullyprivatefirmssubjecttonormal GSEwouldbesubjecttoaPCAregimeofphased marketdisciplinesandwithnospecialconnec- earlyintervention(includingpromptclosure,if tiontothefederalgovernment.Absentthatstep, warranted)andrequiredrecapitalization.2 whatsupervisorypolicyactionscouldreduce ThePCAregimehasamajoradvantagefor thethreattheyposetofinancialstability?The regulatorsinthattheyareinstructedbylawnot twoitemsofhighestpriorityare,first,thatthe toengageinregulatoryforbearance,thesourceof GSEs’portfoliosshouldbelimitedinbothscope someoftheproblemsthateventuallyledtothe andscaletoassetswithaclearpublicpurpose; collapseofnumeroussavingsinstitutionsinthe and,second,capitalattheGSEsshouldbehigher— 1980sandearly1990s.Theonlywaytodealwith substantiallyhigher.AsIhavearguedbefore,the timeinconsistencyistomakebailoutsunlikely 1 Thestatutoryauthorityforpromptcorrectiveactionappliedtodepositoryinstitutionsisfoundinthe1991FederalDepositInsurance CorporationImprovementAct(FDICIA)at12USC18310;fortheGSEs,itisinthe1992FederalHousingEnterprisesFinancialSafetyand SoundnessAct(FHEFSSA)at12USC4611through4623. 2 ForevidencethatthePCAregimehasbeeneffectiveinminimizingtheFDIC’slossesatbanks,seeAggarwalandJacques(1998). 2 RespondingtoFinancialCrises:WhatRolefortheFed? bytyingthehandsofregulators.Takingawaythe concentrateonmanagingtheirowninherent powertoprovideabailoutpermitsregulatorsto businessrisksmoreeffectively.Inthefloodcon- putmorepressureonfirmsearlier.Moreover,in trolcase,individualsandfirmsmakemistakes theabsenceofregulatorydiscretion,firmsknow becauseofpoorestimatesoffloodrisksandthe thatabailoutrequiresasuccessfulapproach expectationofcompensationshouldtherebea directlytoCongress,whichmightormightnot flood.Unlikethatcase,firms’responsestoamore besuccessful.Uncertaintyovercongressional stablemacroeconomicenvironmentimprove actionaddstomarketdiscipline. productivitybecausetheyconcentrateonbusi- TheFed’sroleincontributingtogeneral nessriskstheycanaffectratherthanonmacro- financialstabilitythroughapolicyofmaintaining economicrisksbeyondtheircontrol.Iknowof pricestabilityisalsoimportant.Historically, noconvincingargumentsthattheFedcould periodsofrestrictivemonetarypolicydesigned improveproductivityandgrowthbydeliberately tobringinflationdownhaveoftenbeenaccom- introducingrandomdisturbancestotheeconomy. paniedbyfailuresofmanyfinancialandother Ifthatpointisaccepted,thentheconversemust firms.TheFedalsocontributestogeneralfinan- alsobetrue—reducingmacroeconomicinstability cialstabilitybycushioningdisturbancesto improveseconomicefficiency.Ofcourse,there employmentandoutput.TheFedcannotmake isanimportantcorollary:IftheFedfailstomain- theeconomyrecession-proofbutitcanreduce tainpricestabilityafterachievingitandcreating theseverityofrecessions. expectationsofitspermanence,thenthedisrup- SomehavearguedthattheFed’ssuccessin tiontotheeconomyfromrenewedinflationwill stabilizinginflationatarelativelylowleveland beconsiderablepreciselybecausefirmsceased moderatingrecessionsduringtheperiodsince toplanforsuchanevent.Unlikethesituation theearlyVolckeryearshasactuallymadethe withnaturalvariabilityofrainfall,however,infla- financialsystemlessstable.Theargumentisthat tioniscontrollableandnotinevitable. amorestableeconomyreducesriskandmakes financialfirmsmorewillingtopursuerisky strategies,justasflood-controlprojectsactually DEALING WITH FINANCIAL increasefloodlossesbyencouragingpeopleto UPSETS buildonfloodplains.Eventually,alargeflood overwhelmsthedefenses,thefloodplainisinun- Nowforthetopicofthepanel.Whatshould datedandthosewhothoughtitsafetobuildon theFeddowhenfinancialinstabilitystrikes? thefloodplainsufferlargelosses. Inmostcases,nothing.Theimportantprin- Ibelievethatthereisanimportantdifference ciplehereissupportforthemarketmechanism betweenfloodcontrolexperienceandtheeffectof ratherthansupportforindividualfirms.TheFed greatermacroeconomicstability.Macroeconomic has,appropriately,permittedmanyhighlyvisible stabilitydoesnoteliminateriskfrommicroeco- firmstofailwithoutanyattempttoprovidesup- nomicadjustments.Inourvigorouslycompetitive port,orevenanyparticularcommentexceptto economy,onefirmcantakemarketsharefrom saythatitdoesnotintendtointervene. another,creatingrisksandopportunitiesforboth Ofcourse,theFedhasintervenedfromtime firms,withoutaffectingaggregateeconomic totime.Oneimportantcasewastheprovisionof activity.Diversificationacrossfirmscanreduce additionalliquidityandmoralsupporttothe portfolioriskforindividualinvestorswithout marketswhenthestockmarketcrashedin1987. affectingtheincentivesindividualcompetitive TheFedalsoprovidedsupporttothemarketat firmshavetomanagetheirrisksappropriately. thetimeofthenearfailureofLongTermCapital Infact,reducingmacroeconomicrisk,such Managementin1998.InbothcasestheFedcut asriskfromcurrencyinstabilitythroughcounter- thefederalfundsrate,whichprovidedevidence feitingorgeneralizedinflation,permitsfirmsto tothemarketsthattheFedwasonthejoband 3 FINANCIALMARKETS preparedtoprovideextraliquidityasneeded.I countwindowandinotherwayspreventeda realizethattheFed’spresenceinthenegotia- cascadingofdefaultsaroundtheworld.Nopri- tionsforadditionalfinancialsupportforLTCM vateentitywouldhavebeenabletoprovideliq- fromotherfirmsiscontroversial;Iwouldsimply uidityonsuchamassivescale. emphasizethattheFeditselfdidnotprovideany Idonotknowwhatatotallyunanticipated financialsupportand,inmyopinion,wouldnot futuresystemicshockmightbebutamsurethat havedonesoiftheefforttoencouragesupport theFedneedstobereadytorespond,andtosome fromotherfirmshadfailed. extent,inventtheappropriateresponseonthe Someobservershaveviewedthelargeexpan- flytoacurrentlyunimaginableshock.Thatis sionofhedgefundsasarisingdangertofinancial surelywhatacentralbankisfor,amongother stability,requiringadditionalregulationandFed things.Atthesametime,agreatreluctanceto readinesstointervene.Imyselfbelievethedangers intervenewillservetheeconomywellinthe ofsystemicproblemsfromhedgefundfailures longrun. arevastlyoverrated.Thehedgefundindustryis indeedlargebutitisalsohighlydiverseand competitive.Manyandperhapsmostofthelarge CONCLUDING REMARKS positionstakenbyindividualfirmshaveother Icansummarizemypositionverysuccinctly. hedgefundsontheoppositesideofthetransac- TheFedhasaresponsibilityabovealltomaintain tions.Itrustnormalmarketmechanismstohandle pricestabilityandgeneralmacroeconomicsta- anyproblemsthatmightarise. bilitytoreducethelikelihoodofeconomiccon- TheFedhasnothadtofacetheissueofa ditionsthatwouldbeconducivetofinancial potentiallargebankfailuresinceenactmentof instability.Includedinthisresponsibilityispro- theFederalDepositInsuranceCorporation visionofadvicetoCongressonneededlegislative ImprovementAct(FDICIA)in1991.Ibelievethat actiontodealwithpossiblerisks.Thelargestof thecorrectprincipleisthatnobankistoolarge theserisksonmyradarscreenarisesfromthe tofail,althoughabankmaycertainlybetoolarge thincapitalpositionsmaintainedbygovernment- toliquidatequickly.Asalreadynoted,theFed sponsoredenterprisesandtheambiguityof canprovideliquiditysupportbutcannotprovide whetherCongresswouldorwouldnotacttobail capitaltopropupafailingfirm.Ultimately,the outatroubledfirm.Thetimetodealwithpoten- onlysourceofcapitalfromthefederalgovern- tialfinancialinstabilitycausedbystructuralweak- ment,absentnewlegislation,isfromtheFederal nessesoftheGSEsandtheirregulatoryregimeis DepositInsuranceCorp. beforeinstabilitystrikes.ThestepsIoutlined Averyinterestingcasearosewiththeterror- earlierwouldgoalongwaytoimproveprospects istattackson9/11.Thinkingbacktomyacademic forsustainedfinancialstabilityincomingyears. yearsbeforecomingtoSt.Louis,Irecallnodis- Althoughpreventionisthemostimportant cussionorjournalarticlesanalyzingthepossibil- oftheFed’sresponsibilities,withoutquestionthe itythatthepaymentssystemmightcrashbecause Fedneedstobepreparedtoprovideliquidity ofphysicaldestruction.Butthatiswhatnearly supportshouldmarketsbeindangerofceasing happened,becausetheBankofNewYork,amajor tofunction.Weknowalotaboutthissubjectand clearingbank,wasdisabledwhenthetwintowers haveinplacedeepcontingencyarrangementsto camedown.Moreover,tradingclosedintheU.S. assurethattheFeditselfwillremainoperational Treasuryandequitymarkets,andbankswere atalltimes.Idonotseeanywaythatthesefunc- unabletotransferfundsbecausetheBankofNew tionscouldbeprivatized;Ibelievethemarkets Yorkwasnotfunctioning.Withnormalsources dohaveconfidencethattheFedhasnecessary ofliquidityshutdown,manybanksfacedthe legalauthorityandtheinternalstrengthtoactas prospectofbeingunabletomeettheirobligations. necessary.Thatsaid,theFed’sreluctancetoact TheFed’sprovisionoffundsthroughthedis- isalsoanimportantelementofstrength. 4 RespondingtoFinancialCrises:WhatRolefortheFed? REFERENCES Aggarwal,RajandJacques,KevinT.“Assessingthe ImpactofPromptCorrectiveActiononBank CapitalandRisk.”FederalReserveBankofNew YorkEconomicPolicyReview,October1998, pp.23-32. Poole,William.“HousingintheMacroeconomy.” FederalReserveBankofSt.LouisReview,May/June 2003,85(3),pp.1-8. Poole,William.“TheRisksoftheFederalHousing Enterprises’UncertainStatus,”inFederalReserve BankofChicago,Proceedings:40thAnnual ConferenceonBankStructureandCompetition. PanelonGovernmentSponsoredEnterprisesand TheirFuture.May2004,pp.464-69. 5

William Poole (2006, November 15). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20061116_poole

@misc{wtfs_speech_20061116_poole,
  author = {William Poole},
  title = {Speech},
  year = {2006},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20061116_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}