Ongoing market gyrations are sparking calls for greater regulation of investment banks and other financial institutions. Such calls for more government oversight represent a reversal after three decades of reduced financial regulation. The political climate is such that greater regulation seems both prudent and inevitable. But what sort of regulation we will adopt, and what we are learning from our mistakes, is less clear.
Former Federal Reserve Chairman Alan Greenspan, perhaps the most orthodox libertarian ever to hold such a position of government power in our country, stood strongly in the minimal regulation camp. Moreover, he chaired the Fed during a period when successive legislation, culminating in the 1999 Gramm-Leach-Bliley Act, dismantled much of the government financial regulation enacted in the 1930s in response to the Great Depression.
In his memoir, The Age of Turbulence, Greenspan writes that today’s financial system is far more complex than when the regulations governing the markets originally were written. “Today, oversight of these transactions is essentially by means of individual-market-participant counterparty surveillance. Each lender, to protect its shareholders, keeps a tab on its customers’ investment positions. Regulators can still pretend to provide oversight, but their capabilities are much diminished and declining.”
In the 15 months since Greenspan’s book came out, we’ve learned that most “pretending” was on the part of lenders. Their ineptitude in counterparty surveillance and oversight of their own and their customers’ investment positions was such that shareholders are out several hundreds of billions of dollars, while taxpayers are on the hook for a couple hundred billion more.
The fact remains, however, that supervising and regulating financial institutions requires information. Does government have any better access to information than the private firms directly involved? And if not, what does regulation add?
According to an article this week in the Financial Times, the Fed asked big Wall Street banks “to put their balance sheets through a battery of tests to see how they would fare in a major liquidity shortage or downturn in capital markets.”
The response was enlightening: “Senior Wall Street figures welcomed the move by the Fed … It was helpful to have more clarity on their liquidity positions and capital requirements.”
The question cries out why such major institutions, employing battalions of highly trained and well-paid financial analysts, were not performing such tests on their own as a matter of course. These banks have much to lose. As the collapse of Bear Stearns has shown, so do their shareholders. Yet, it took nudging from the Fed for these firms to take a step to generate information their CEOs find “helpful.”
In his book, Greenspan argues that “Market failure is the rare exception.” The last year has proved him wrong. But where do we go from here? Do we reinstate the restrictive Glass-Steagall Act that has been dismantled over the past 20 years?
Unfortunately, we seem to be moving in the direction of making the Federal Reserve responsible for regulating a much broader slice of financial markets, effectively displacing the Securities and Exchange Commission as the primary overseer of investment banks and securities markets.
There would be a certain logic to such a move. The Bear Stearns bailout set some bad precedents. If we expect the Fed to gallop to the rescue with wagonloads of money each time a big investment bank goes under, we’d better give the Fed power to regulate the business practices of those institutions.
The problem is, this ignores the core function of a central bank. Many different institutions can audit banks. Governments can handle their own disbursements and tax collections in various ways. Private companies can handle day-to-day operation of check-clearing and electronic-payments systems. The fact that the Fed does these things in the United States does not mean it has to do them.
Only a central bank can regulate the money supply effectively. That is why we created the Fed in 1913, and that remains the fundamental reason for its existence.
The more we turn the Fed into some sort of financial super-regulator and load it down with overseeing myriad financial institutions, the more we cloud this primary responsibility. That is a bad idea.
The current trend is one driven by pragmatic desperation. On a day-to-day basis, President Bush, Treasury Secretary Henry Paulson and Congress all want to keep the U.S. economy afloat. The Fed seems to be the one institution that can do that. Fed Chairman Ben Bernanke is an eclectic pragmatist willing to try new things and take on new tasks.
The problem is that we really are not thinking this through. If we don’t do so, we will regret it later.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.