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Cascade: No. 70, Winter 2009

Principles of Sound Central Banking

Editor's Note

Community Affairs has received inquiries about the Federal Reserve System’s response to problems in the credit markets. We think that Cascade readers will be interested in comments on these matters by Charles I. Plosser, Ph.D., president of the Federal Reserve Bank of Philadelphia. The following article is adapted from several of his recent speeches. For the full text of speeches by Dr. Plosser, go to www.philadelphiafed.org/publications/speeches/plosser.

The current financial crisis and the actions by the Federal Reserve and Treasury to address it are leading to a restructuring of the financial services industry. We are already seeing major investment banks become bank holding companies, weaker financial institutions consolidate into healthier ones, and various types of nonbank financial firms substantially revising their business models.

The financial turmoil and the resulting restructuring in the marketplace have prompted calls for the Fed to assume expanded responsibilities. Some envision the Fed becoming the supervisor and regulator of a broad array of financial firms in order to ensure financial stability. Some want to expand the Federal Reserve’s authority or give it a sweeping mandate to prevent systemic risk. Some want the Fed to lend to a wider range of financial institutions. Yet, before we seek to expand dramatically the Fed’s responsibilities, I believe it is important to recognize the limits of what a central bank can and should do.

In general, we should avoid giving the Fed overly broad mandates, missions, or goals that conflict with the one goal that is uniquely the responsibility of a central bank — price stability. Instability in the general level of prices — whether inflation or deflation — is itself a significant source of financial instability. Consequently, we must make sure that in trying to cure one source of financial instability we do not sow the seeds of another.

Charles I. Plosser, Ph.D., President, Federal Reserve Bank of PhiladelphiaCharles I. Plosser, Ph.D., President, Federal Reserve Bank of Philadelphia

The Fed has learned much over the past two decades about how to conduct monetary policy more effectively by following four general principles:

  • Clarity. Policymakers should set clear and explicit objectives. These objectives must be realistic and feasible, and not just what might be desirable.
  • Commitment. Policymakers must commit to conducting policy in a systematic way over time, even when it seems expedient to abandon it.
  • Transparency. Policymakers must be as transparent as possible in communicating their policies and actions to the public.
  • Independence. Experience has shown that monetary policy yields better outcomes when it operates independently of fiscal and political influence.

I believe that these four principles also apply broadly to other central bank roles, including our role in promoting financial stability.

With these guiding principles in mind, I want to mention three areas I believe will be crucial as we move forward: Specifying the objectives for regulatory reform, establishing resolution mechanisms for failing financial firms, and defining the scope and scale of the Fed’s role as lender of last resort.

A Systematic Approach to Regulatory Reform

History tells us that financial crises invariably lead to regulatory reforms. Yet, there are risks in rushing into regulatory reforms unless legislators and policymakers establish in advance the guiding principles and objectives for such regulations.

For example, we should aim to lower the chances of financial crisis in the first place by setting capital and liquidity standards that encourage firms to manage risk appropriately. We also should think about ways to strengthen market discipline, market infrastructures, clearing mechanisms, and resolution procedures that will make our financial system more resilient to shocks.

In addition, rather than focusing on more regulation, we should focus on better regulation. In particular, we should avoid regulatory reforms that stifle innovation. For example, despite the problems with subprime mortgages, the majority of homeowners who financed their homes with these new instruments are meeting their obligations. Indeed, these new types of mortgage products have given many families an opportunity they might never have had before — to live in their own home.

We must be careful that heavy-handed regulation does not discourage the kinds of innovations that make such progress possible.

We also should concentrate on financial markets that are critical to the efficient functioning of the payment system, rather than focusing on individual firms. Indeed, it would be desirable to be in an environment where no firm was too big, or too interconnected, to fail.

Even so, we must be realistic and recognize that no system of financial regulation and supervision can prevent all types of financial instability. Instead, our goal should be to lower the probability of a financial crisis and the costs imposed from any troubled financial institution.

Resolution Mechanisms for Failing Financial Firms

The rationale for banking regulation stems, in large part, from the dangers posed by systemic risk. Systemic risk generally refers to the risk that problems at one financial institution will spill over to a broad set of otherwise healthy institutions, thereby posing a threat to the integrity of the financial system as a whole. This spillover can occur because of linkages among financial institutions through counterparty borrowing and lending arrangements or through payment and settlement systems. Lack of transparency, imperfect or asymmetric information, and uncertainty about exposures can all give rise to such financial contagion.

One of the lessons from the current financial crisis is that, for policymakers, bankruptcy is not an attractive option for a failing financial institution that poses systemic risk. Therefore, policymakers are often left with one of two unappealing outcomes: (1) very costly failures; or (2) very costly bailouts to avoid the failure.

Since normal bankruptcy proceedings make no provision for systemic concerns, we have long had a specialized regime for dealing with bank failures. However, there is no similar mechanism for the orderly liquidation of most nonbank financial firms. So legislators and policymakers should consider establishing alternative resolution mechanisms for nonbank firms that pose systemic risk as one way to improve our ability to ensure financial stability in the future.

The Scope and Scale of the Fed’s Role as Lender of Last Resort

As policymakers and legislators consider regulatory reform, they also will need to define the scope and scale of the Fed’s role as lender of last resort. By any measure, we have expanded this role of the Fed to historic proportions to deal with the current financial crisis and to help funding markets function more effectively.

Perhaps the expansion of the scope and scale of Fed lending might not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And our lending might not have become so wide-ranging had there been better regulations, including more transparency about the markets for mortgage-backed securities and credit default swaps.

Eventually we must consider how to wind down some of these facilities as “unusual and exigent circumstances” abate. We then must consider a systematic approach to how we should operate the discount window in “normal” times, and how we should proceed the next time a crisis arises. Intervening too often or expanding too broadly the set of institutions that have access to the central bank’s credit facilities can create moral hazard, distort the market mechanism for allocating credit, and thereby increase the probability and severity of a future financial crisis.

It can also undermine central bank independence. Just as we know that independence leads to more effective monetary policy, free from fiscal and political influence, I believe independence is vital to a more effective lending policy.

To protect that independence, the central bank’s lending policies should avoid straying into the realm of allocating credit across firms or sectors of the economy, which I believe is appropriately the purview of the market. If government must intervene in allocating credit, the fiscal authority should do so rather than the central bank.

Conclusion

To sum up, the past year has been a challenging time for the U.S. economy and for policymakers. The Fed responded to the deteriorating economic outlook and ongoing stresses in financial markets with monetary policy and extraordinary actions to ensure financial stability. Because of the financial crisis and the response by the Treasury and the Fed, restructuring is occurring in the financial services industry, and it is clear that when some normality returns to the markets — which eventually it surely will — some type of regulatory reform will be needed.

Some people may think expanding the Federal Reserve’s regulatory and supervisory authority would prevent the types of financial crises we have been experiencing this year. Yet, I believe it is important to be realistic about recognizing the limits of what a central bank can and should do. A modern financial system will never be immune to all financial stress. Setting up expectations that the Fed will surely be unable to fulfill would undermine our ability to achieve our primary monetary policy and financial stability objectives.

As legislators consider regulatory reforms, they should avoid giving the Fed new missions or goals that conflict with the one goal that is uniquely the responsibility of a central bank — price stability — the one objective that cannot be delegated to an agency other than the central bank.

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