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Plosser Defines Key Issues in Financial Reform

May 5, 2010

Remarks
Joint Economic Committee Staff Meeting
U.S. Congress

Thank you for inviting me to share some thoughts about regulatory reform.

The recent financial crisis has clearly indicated a need to reassess our approach to financial regulation and oversight. Regulators from every agency, and every country, failed to see the dangers that had emerged. And all have been humbled by the experience.

The challenge now is to implement regulatory changes that are most likely to prevent similar crises in the future.

My remarks today will focus on two key issues in designing such a regulatory structure: the need for a credible process for resolving failed financial institutions and the importance of a broad-based supervisory role for the Federal Reserve to ensure that it continues to possess a Main Street perspective and not just a Wall Street or Washington perspective. I will end with some cautionary comments on political efforts to undermine the credibility of our nation’s central bank and the real dangers that poses for the economic well being of our country.

I believe that, first and foremost, financial reform must eradicate the notion that any financial firm is considered too big to fail (TBTF). If it does not, we are sowing the seeds of the next financial crisis. We must remember, however, that investors and creditors are the first line of defense in controlling a firm’s risk-taking, because they have a strong incentive to protect their own interests. Those incentives are undermined, though, if creditors believe there is a high probability of a government bailout of any kind. We have no clearer case study of this reaction than the failures of Fannie Mae and Freddie Mac, which are likely to prove to be more costly than all other taxpayer bailouts. There are not enough regulators to replace markets, nor are regulators more omniscient than the market. Therefore, we must enlist the aid of markets in monitoring risk-taking and treat them as an ally rather than an enemy, if regulatory reform is to be successful.

In order to end TBTF, we must have a resolution mechanism that credibly convinces large financial firms and their investors and creditors that firms on the verge of failure will, in fact, be allowed to fail. If the resolution mechanism is vague or if it gives regulators or policymakers the latitude to rescue firms through subsidies or bailouts, then market discipline will not work to control excess risk-taking. Troubled firms may even deliberately put themselves in a position to argue that the risks of failure are so severe and systemic that they must be rescued. This is what we saw in the recent crisis as firms tried to make the case for taxpayer support. To prevent this behavior, a credible, and I emphasize credible, commitment by government to not intervene must be the centerpiece of reform. This would strengthen the private incentives to control risk-taking.

I believe the most credible way to do this would be to amend the bankruptcy code to deal with nonbank financial firms and bank holding companies. Expanding the bank resolution process established under the FDIC Improvement Act, as the current Senate bill does, would give regulators and policymakers the opportunity to exercise a great deal of discretion in a liquidation or restructuring to reward some creditors and not others. A bankruptcy proceeding would follow the rule of law and thus would be less susceptible to manipulation by private parties or the political process.

I recognize that the current bankruptcy code does not adequately address the inherent challenges in liquidating such firms without risks to the market. Yet, I believe changes could be developed to address these risks and greatly reduce discretion. A modified bankruptcy process would also strengthen market discipline by permitting creditors as well as regulators to place a firm into bankruptcy. So, again, that first line of defense, the investors and creditors, would have the incentive to scrutinize these firms for risky behavior.

In short, limiting government’s choices and leaving resolution to the rule of law and the court system is, in my view, the best way to end bailouts, limit risk-taking, and extinguish the notion that some institutions are too big to fail.

On my second point, I believe the credibility of the Senate’s plan to end TBTF is further and significantly undermined by the proposal to restrict the Federal Reserve’s supervision to approximately 50 of the largest financial firms. By singling out these firms for special attention by the Fed, the Congress is sending markets the message that they are indeed too big to fail. These firms are then likely to undertake activities that ensure that outcome to preserve the funding advantage they have over other firms arising from the government backstop.

Restricting the Federal Reserve to the supervision of these large institutions also serves to shift the Fed’s focus away from Main Street and toward Wall Street at the very time that many people believe that the Fed has already paid too much attention to Wall Street.

Congress designed the current governance structure of the Federal Reserve with 12 independent Reserve Banks with the purpose of providing checks and balances and to protect against the concentration of authority on Wall Street and in Washington. Making the Fed the regulator of only these TBTF firms would be a serious mistake and undermine the Fed’s breadth, diversity, and credibility with the public.

Moreover, attempts to politicize the Fed by making the political appointment process reach ever further down in its governance structure would undermine its independence and ensure that its leaders were more attuned to short-run politics than to the economic well-being of this diverse nation.

The Reserve Banks have deep roots in the communities where they are located through their boards of directors, their advisory councils, and the hundreds of community banks they supervise. That perspective is essential in understanding how this large and diverse economy is evolving. It provides an independent and broad perspective on how Main Street is doing, not just on how Wall Street is performing. Reserve Bank presidents bring these diverse and independent views to Washington. And I believe our monetary policy is better off because of it. As that great American journalist Walter Lippmann once said, “Where all men think alike, no one thinks very much.” Thus, steps that undermine the role and independent views of Reserve Banks in order to concentrate more authority and power in Washington and on Wall Street would be a mistake.

If we are to avert similar crises in the future, bank supervision needs to include a greater focus on macro-prudential supervision. That means looking at the risks and exposures across institutions of all sizes, not just large firms, and determining how they interact with the larger economy.

Macro-prudential supervision requires more than just knowledge of large banks, because macro risks need not arise only from large banks. For example, the current problems in banks’ commercial real estate portfolios are predominantly concentrated in the small to medium-sized banks, not at the largest banks and financial institutions. Moreover, to carry out macro-prudential supervision correctly, the oversight of all bank holding companies should reside with the central bank; otherwise, aggregate or macro risks can grow undetected.

Macro-prudential supervision also requires a deep knowledge of economics and the macro economy. The Fed is in the best position to put these important elements together because of its role in conducting monetary policy.

For these reasons, I believe it would be best for the Federal Reserve to retain supervisory authority over all bank holding companies, regardless of size, and over state member banks. Senator Hutchison has offered an amendment (SA3759) with bipartisan support that would do just that.

Finally, I must note that the ability of modern central banks to conduct effective monetary policy and to achieve their mandates crucially depends on their credibility in the marketplace and with the public. The perception that monetary policy decisions could become politicized or be shaped by short-run political pressures fundamentally undermines that credibility.

The chance that political influence might be exerted, either directly or indirectly, to keep interest rates too low for too long to support near-term political goals at the expense of longer-term economic objectives or to support spending policies by monetizing the public debt would undermine the credibility of the Fed and fan fears of inflation, resulting in rising interest rates, a falling dollar, and higher inflation. This is not a healthy outcome for the nation, and this is why the so-called “audit the Fed” provisions pose a real threat to economic stability.

These are not audits in the usual sense of the term, but measures to second-guess and undermine the credibility of policy decisions, making them more susceptible to political interference. Markets are highly affected by expectations, and expectations that monetary policy could become politicized would be detrimental for our economy, both domestically and internationally. So, I would urge you not to go down this path, as the unintended consequences could be dire.

I am a proponent of transparency and have no problem with increased communication and transparency about almost all of our activities, including those that come under the Fed’s 13(3) authority. But sound governance calls for separating those that spend the money from those that print it, and the proposed audits of monetary policy decisions and deliberations violate that sound principle.

Thank you.

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