Financial Regulatory Reform--Posner's Comment

I have blogged at considerable length about the July 17 report, see http://correspondents.theatlantic.com/richard_posner/, and also written a short op-ed on the subject, published in the New York Times on July 25 ("Our Crisis of Regulation," p. 21). I have emphasized both what seem to me fundamental failings in the report and weaknesses in particular proposals. The fundamental failings include prematurity, one-sidedness, and overambitiousness, and let me dwell for just a moment on the first of these, or rather one aspect of the first, and that is the Administration's determination to revamp financial regulation in light of the financial crisis of last fall before the causes of that crisis have been determined. In other words, first the sentence, then the trial to determine guilt, specifically the guilt of the finance industry (of "banking" in a broad sense that includes other financial intermediaries--the members of the "shadow banking" system, of which more shortly). Without pointing to evidence, the report asserts that the financial crisis was the product of irrational decisions both by lenders and borrowers and of major gaps in the structure of financial regulation. Ignored is the role of error and inattention by the regulators, notably including the Federal Reserve and the Securities and Exchange Commission; the deregulation movement in finance; lax enforcement of the remaining regulations; and failures of understanding by the economics profession. And thus the role of the Fed in forcing interest rates too far down, and keeping them too far down for too long, during the early years of this decade, and in neglecting growing signs of housing and credit bubbles (caused by low interest rates), goes unmentioned. Since senior economic officials in the Administration were implicated in these failures of regulation, and since the thrust of the report is that we need more regulation, it is not surprising that the report should give regulators a pass. It should be a rule of regulatory reform that before the regulatory structure is changed, which is likely to be a time-consuming endeavor with at least some unanticipated consequences, the government make sure that the regulators are employing their existing powers to the full. And indeed just last week the SEC announced that it is imposing reserve and capital requirements on money-market funds, requirement that had they been in force last September would have reduced the systemic consequences of Lehman Brothers' collapse (see below). Had this rule been honored by the authors of the report, there would have been much less emphasis on structural reform, as in the proposed creation of new regulatory entities and the proposed expansion in the powers of the Federal Reserve. The centerpiece of the Administration's proposal, and the only specific proposal in the report that I will discuss in this comment, is the proposal to authorize the Federal Reserve Board to regulate any financial enterprise that creates "systemic risk." The Fed would designate the enterprise a "Tier 1 Financial Holding Company," and having done so would have the same (perhaps even greater) powers that it has over commercial banks that are members of the Federal Reserve System. Its focus would be on "macroprudential" regulation--that is, on assuring that a failure of the Tier 1 FHC would not imperil the financial system as a whole. The Fed would be expected to limit the leverage of these firms (the debt-equity ratio in their capital structure) and take other measures to reduce the risk of failure, for example by forbidding them to engage in proprietary trading (that is, speculating with their assets). To prevent the gaming of this new regulatory power by firms that would go up to the very edge of whatever line was chosen to separate Tier 1 FHCs from other nonbanks, the Fed would have a broad discretion in so classifying financial firms. Financial firms that are not commercial banks are now significantly larger sources of credit than banks, and they can create systemic risk. An example is (or rather was, because it is now defunct) Lehman Brothers, a broker-dealer. Lehman, among its other activities, was a dealer in the commercial paper and money-market markets. It would issue its own commercial paper (short-term promissory notes) to money-market funds and use the money it borrowed in this manner from the funds to buy commercial paper from (that is, lend to) nonfinancial firms with sterling credit records, such as Proctor & Gamble, that finance their day-to-day operations by issuing commercial paper. When, last September, Lehman Brothers became insolvent because of losses in other parts of its business, it could not repay its loans from the money-market funds or lend money to issuers of commercial paper. The commercial-paper and money-market funds froze, contributing to the credit crisis. Lehman was not among the largest nonbank financial enterprises, but because of its interdependence with other participants in the overall credit market its sudden collapse had serious repercussions. Although the Federal Reserve claims that it lacked the legal authority to save Lehman from collapsing by lending it the money it would have needed to stave off bankruptcy, the claim is unpersuasive. Section 13(a) of the Federal Reserve Act authorizes the Federal Reserve to lend money to a nonbank provided the loan is "secured to the satisfaction of the Federal reserve bank." Lehman did not have good security for the loan it needed, but, in the emergency circumstances of a collapsing global financial system, the Fed could, it seems to me, have been "satisfied" with whatever security Lehman could have offered. If this interpretation seems a stretch, Congress could amend the statute easily enough to add "in the circumstances" or "in the sole discretion of the Federal Reserve Board," after "satisfaction," or it could delete the reference to security altogether. But the fact that the Federal Reserve, has, as it seems to me, all the power it needs to prevent a nonbank that poses systemic risk from failing, and in failing carrying part or all of the entire financial system with it, is not a rebuttal of the Administration's proposal, because the government would like to be able to prevent the collapse of such enterprises rather than having to spend tens or hundreds of billions of dollars to save them. The first question to ask, however (it is not addressed in the Administration's report), is whether these enterprises that are not banks but might create systemic risk are already regulated. I mentioned money-market funds, which are regulated by the SEC, as are broker-dealers. One might think that closer liaison between the SEC and the Fed would go far to minimize the "macroprudential risk" posed by broker-dealers. Most important, if the Federal Reserve simply identified the firms that it believes pose systemic risk, a combination of market forces, public and legislative opinion, and the implicit risk of regulation would probably impel the firms to take steps to reduce the systemic risk that they pose. This possibility should at least be explored before the Federal Reserve is given enhanced regulatory powers. After all, the principal reason--or so at least I think--for the financial collapse last September was that the regulators were asleep at the switch. They are now awake, indeed insomniac. If the Federal Reserve needs some additional staff, and perhaps authority to require financial information from financial enterprises that it does not at present regulation in order to identify the firms that pose systemic risk to the financial system, and perhaps some minor tinkering with the Federal Reserve Act to clarify its existing authority to deal with nonbank banks, these modest reforms can be adopted without restructuring the entire system of financial regulation, as the report proposes.

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