Tuesday, November 10, 2009

The Agency for Financial Stability? Good idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed
There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk
The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.


Immortal said...

Agree with u FED must not be blamed...Wat you need is separation between Commerical n Investment Banks to prevent them for takin systemic risk...Glass-Steagall Act needs to be relooked again...repeal of this act allowed 3 key entities(Commercial bnks, Investment banks, Insurance Co) involved in this Financial Crisis to operate together...Wake Up Uncle Sam!!!

Whatever you want it to be... said...

Nice piece sir! Very enlightening.

Somehow, I disagree with your view that no agency across the world saw the crisis coming. Of course, no one predicted the date and time. But I think some agencies were more cautious than others.

The Indian Central Bank (RBI) for example had always been wary of complex derivative instruments and CDS and such. It prohibited reckless investments by Indian banks abroad and also didn't allow complex and exotic products to be traded unabated in India. Now I am not suggesting this was done as a well thought out plan or anything. In fact, the primary reason for these 'measures' was probably that the economists at the RBI weren't even sure of how the instruments would impact the Indian scene. But there is still a lesson to be learned there.

It might be possible (and I think probable) that the Fed wasn't too sure of how some of the mortgage derived instruments and their securitized offsprings would play out eventually. However, in a bid to promote 'innovative' instruments, it allowed the investment banks to structure, package and sell products that would prove to be toxic.

The line between being cautious, overcautious, and retrograde might look thin to some. But in times where the brightest brains clamored with each other in a bullring arena to churn out the most complex and impossible-to-understand products, that would be sold to those who only saw the potential upside to it, I feel the FED playing the sceptic would have brought some sanity to things. That of course, happens to be the hindsight.

But it just goes on to show that to reign in a brigade of the smartest minds, simple and plain old good intentioned naivette can help. Guess it does take all kinds of people to make this world!

Aswath Damodaran said...

To point out that the Indian Central Bank is cautious means very little, since it has always been cautious.In fact, you are ague that inertia at the bank has cost India more than it has gained.

A more revealing example would be an agency that turned cautious in 2007, before the world came crashing down.

Mahesh Sethuraman said...

Mr. Cool

Take it from an insider, the number of companies who lost money betting on exotic derivatives is insanely large even though the whole derivative market opened up fairly late in India and that too with so many restrictions. If I have to write a book on just what I have seen in the deriv market in India so far - it'll be very similar to "Fiasco" on a smaller scale.

And RBI did release a white paper on introducing CDS in India in 2007 and due to administrative delays rather than superior intelligence that the implementation got delayed and then the crisis happened - so its more luck than foresight if u ask me.

Also RBI was one of the few central banks which was hiking interest rates fearing the double digit inflation prevalent in late 2007 and early 2008
when the crisis was looming large across the globe.

Like Prof.Aswath said its coz they have been historically conservative that RBI or India didnt suffer so much and not co z of their superior foresight. Infact for a historically conservative central bank, they moved for reforms at exactly the wrong time - thankfully the scale was not big enough to cause colossal damahe.

Gaurav Mehta said...

I think the agency for financial stability can help identify bubbles before thinks get out of hand. This is like a credit risk team within banks, though i must admit once the economy is out of trouble, these risk teams become paper signing machines where as they should be more active when things seem to be going great. Some how the economy always looks great when a big trouble is near by.

However, if you could have a team which could look at excesses in the world when things are going great it can be of help atleast to identify the excesses. Also i think it definately makes sense to not allow a company / bank to grow to a too big to fail stage and it would make sense to break companies like Citi once the economy stabilizes. To think of it IceLand AAA rated company came to the brink of failing because of a few banks.

One example where an agency has been effective is Office of Fair Trade in UK by not allowing Tesco to acquire any more companies as it already owns more than 33% of the retail market in the UK.

As for the comment regarding RBI, even though they would have got into the derivative stuff had regulations been easy to deal with in india but i still feel its one of the best run central banks in the world and all the steps that it has taken in the crisis have been widely appreciated. I don't think there was anything else they could have done extra in the crisis.

Compendium said...

Hello Professor Damodaran.

Thanks for the post on systematic risk and the useless prospects of forming a federal risk control agency.

You mentioned that Fed doesnt have conflicts of interest. There could be a small conflict of interest. Fed would tend overlook impending bubbles, saying that rise was based on economic fundamentals, as it has done in this collapse. This would make the President and the administration look really good. The chances of the bubbles happening every time are small, so the Fed enourages risk taking behavior. Regulation puts a damper on risk taking and therefore a damper on the exciting news that Fed would like to make otherwise.

As for the systematic risk fund, it seem like an IMF model.


Thomas said...

Hello professor. Just found your site through spec-list. Interesting observations. I disagree with your comments on the Fed. They had certain regulatory powers during the last bubble and didn't exercise them. More resources will not necessarily shift the focus to regulatory oversight. This comes from the main mandate of the agency. The Fed is not focused on this.

Aswath Damodaran said...

Here is my response. What agency, even one that had the mandate to regulate, used it? It seems selective to pick on the Fed for this failure.

sharmaG said...

Hi Sir, i would like to disagree as far as RBI is concerned. Although it has been consistently cautious, the countercyclical monetary policy followed by it went a long way in protecting Indian banking system and overall economy.

I would like to make two points,
1. We need to revisit the mandates given to central banks around the world especially in an environment of rapid financial innovation,
2. and as Immortal said, we do need another act along the lines of Glass-Steagall Act.

But all this should be done even as G-20 and other related multilateral organizations take care of regulatory and tax arbitrage across the world. A national agency for financial stability will have no impact if financial firms have global operations in multiple jurisdictions.

Uwe Kaiser said...

Don't stop asking this form of questions - money is substantial!