Treasury renews call for re-think of Fed's oversight role

Real Estate Weekly,  May 7, 2008  by Daniel Geiger

Tags: Federal Reserve Board, Treasury

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The Assistant Secretary for Financial Institutions at the Treasury Department, David Nason, has asserted the need to recast the Federal Reserve's role as part of an overhaul of the U.S. financial system proposed by the Treasury Department last month.

Coming a day before the Fed's open market committee met to decide on monetary policy, Nason repeated the Treasury Department's vision to have the Fed assume a broader position as a macroeconomic regulator. Under Treasury's plan, the Fed would seek to identify and take action against economic trends and practices that could threaten the health of the financial system.

Nason noted that during normal economic conditions, the Fed's role of balancing inflation and growth by setting short-term interest rates was sufficient in regulating the country's financial health. But the Fed's recent series of policy maneuvers, including extending vast amounts of credit to ailing financial firms and helping to negotiate and underwrite the emergency acquisition of Bear Stearns, showed that the Fed's normal economic controls were insufficient in periods of financial crisis.

"As the current conditions in credit markets and other past episodes of financial instability illustrate, the traditional toolbox of monetary policy and the regulatory framework associated with financial institutions might not be well suited to deal with transmission of financial shocks to the real economy in today's financial markets," Nason said.

Nason gave his comments in front of the New Financial Frontiers conference in London last week. Central to the Treasury Department's proposed reshaping of the country's regulatory oversight is not only focusing regulation on the identification and avoidance of financial crises, but, as The New Yorker's financial page recently explained, streamlining the system to rely on principals rather than the tedious and expensive system of strict accounting and filings that is currently in place.

There have been fears that the web of financial reporting rules in this country is weighing down U.S. corporations, while the looser regulatory framework in Europe is giving cities like London an advantage over the U.S.'s financial capital, New York City, as a home base for commerce.

"We recommended recasting the role of the Federal Reserve as our market stability regulator to expand its assessment and authority over potential risks in the overall financial system, including correlations and common exposures across financial institutions," Nason said. "This contrasts with its existing regulatory authority that focuses primarily on the health of individual financial institutions. This new responsibility can be referred to as "macro-prudential regulation" and the latter as "micro-prudential regulation"."

The problem with this system of course is the question of whether the Fed, or any other institution for that matter, would be able to identify complex financial problems before they sprout into full-fledged crises.

Some of the biggest losers in the subprime crisis for example were U.S. banks, like Citibank, which are already regulated by the Fed. Yet the Fed hadn't been able to identify the scope of the bank's liabilities nor foresee the problems that would surround the risky mortgage securities. Nason acknowledged the difficulties.

"Undoubtedly, the tasks of the market stability regulator would be difficult. Some have likened it to an impossible task of piercing asset bubbles or having an omnipresent view of risk in the financial system," Nason said. "In a dynamic market economy it is impossible to eliminate instability through regulation. At a fundamental level, the root causes of market instability are difficult to predict and past history may be a poor predictor of future episodes of instability. Nonetheless, we should not stop trying to understand better and mitigate instability. Yes, the task is difficult, but the task remains."

COPYRIGHT 2008 Hagedorn Publication
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