WASHINGTON (MNI) – The following is the third and final part of the
full text of the speech by Richmond Federal Reserve President Jeffrey
Lacker Wednesday, giving an early assessment of the regulatory response
to the financial crisis:
With market discipline increasingly compromised by a growing
financial safety net, regulatory oversight becomes the main defense
against excessive risks in the financial system. And if bank-like
risk-taking in the form of maturity transformation takes place outside
of the formal banking sector but is still likely to elicit support in a
crisis, then regulation would need to extend to these activities as
well. But financial markets in the past have shown a seemingly endless
capacity for inventing ways to engage in bank-like maturity
transformation in new forms and new places, just outside the reach of
regulation. To successfully limit excessive risk taking in a world of
safety net ambiguity, regulation needs to anticipate and constrain
innovation. This is a daunting task, because it requires distinguishing
between beneficial and detrimental innovations. As a result, new forms
of financial fragility seem inevitable, and financial crises are likely
to recur.
This logic suggests a vicious circle. Regulation seeks to rein in
the adverse incentives created by the safety net. Regulation, in turn,
creates the incentive to find innovations that by-pass existing
constraints but create potentially fragile financial arrangements that
could well receive support in a crisis. The prospect of support makes
these new arrangements less costly and leads to their being over used,
contributing to a build-up of risks in the financial system. When a
crisis occurs, safety net ambiguity may once again be resolved in favor
of protection, necessitating a further expansion of regulatory reach.
To the extent this vicious circle has driven the expansion of an
implicit safety net whose incentive effects were responsible for the
crisis, the problem prior to the crisis was not solely or even primarily
insufficient regulation. As much if not more responsibility ought to be
attributed to the long-standing tolerance of an open-ended, unlegislated
and implicit safety net commitment for large financial firms. So to my
mind, assessment of the regulatory response to this crisis will depend
predominantly on how well it clarifies and places discernable boundaries
around the federal financial safety net.
Bills currently under consideration in Congress seek to break this
cycle of regulation, by-pass, crisis, and rescue by giving policymakers
the discretion to extend the scope of regulation to any financial
institution whose failure might induce government support. The success
of this strategy will depend critically on ability of regulators to
identify ex ante the risk-taking that can cause so much damage ex post.
While regulators have a fairly good record of preventing exact replicas
of past crises, it is another matter entirely to foresee the distress
that might result from the confluence of innovative financial
arrangements and shocks to unanticipated macroeconomic fundamentals.
The bills before Congress also would expand the tools available to
policymakers by providing the Treasury and the FDIC with the authority
to seize and liquidate failed nonbank financial institutions. This seems
like a natural extension of the FDIC’s existing powers to resolve
failing banks, but the FDIC would be allowed to provide funds to the
receiver that could be used to settle short-term debts as they came due.
Even if shareholders are dutifully “wiped out” and the firm ultimately
closed, the protection of short-term creditors weakens the incentives of
the most critical liability holders. If, in a crisis, regulators remain
focused on alleviating ex post distress, they are likely to err on the
side of rescue and further weaken market discipline. A provision of the
Senate bill that provides for “clawbacks” of funds advanced in excess of
what a claimant would receive in liquidation could restore some
discipline to the process. But limitations in the clawback mechanism
could mean that short-term creditors still benefit from the use of
public funds.
The tensions evident in the negotiation of the Senate provisions on
resolution authority mirror the tensions between an ex post and an ex
ante perspective on policy questions. The expansion of the implicit
safety net has been driven by the pursuit of ex post efficiency – that
is, doing whatever it takes to alleviate the adverse impact of financial
distress once it has occurred. Future economists may continue to debate
whether official interventions in this crisis have achieved significant
ex post efficiency gains, but our true goal ought to be ex ante
efficiency, not ex post efficiency. That is, people’s expectations about
ex post policy interventions affect their choices ex ante, and policy
evaluation should take that into account.
When the pursuit of ex post efficiency and ex ante efficiency is in
conflict – that is when there is a “time consistency problem” – two
broad strategies are possible. One is to tie one’s hands by preventing
the actions one would take to pursue ex post efficiency when it
conflicts with ex ante efficiency. This motivates the clawback provision
of the Senate resolution title, which attempts to limit actions
regulators might be tempted to take to provide short-term creditors of a
failing financial firm more than they would get in bankruptcy. And the
elimination of the Federal Reserve’s so-called Section 13(3) power to
extend emergency loans to individual entities outside the banking system
certainly helps. But my early assessment is that the House legislation –
and to some extent even the Senate version – creates enough
discretionary rescue powers to dampen market discipline and sustain the
vicious circle that brought us an expansive financial safety net.
An alternative strategy is for policymakers to invest in a
reputation for pursuing ex ante efficiency rather than ex post
efficiency. This, arguably, was the strategy pursued by the Volcker FOMC
to reduce inflation in the early 1980s, when the short-run costs of
disinflation might have deterred a policymaker focused solely on ex post
efficiency. And, arguably, we will not break the cycle of regulation,
by-pass, crisis and rescue until we are willing to clarify the limits to
government support, and incur the short-term costs of confirming those
limits, in the interest of building a stronger and durable foundation
for our financial system. Measured against this gauge, my early
assessment is that progress thus far has been negligible.
(3 of 3)
** Market News International Washington Bureau **
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