Financial Regulation in the Twenty-First Century
Yesterday I felt obliged to strongly dissent from Greg Mankiw's claim that Austan Goolsbee, in endorsing his boss Barack Obama's position on the regulation of investment banks, had sold his share of the grand Chicago intellectual tradition for a mess of political pottage. Mankiw wrote, of Austan:
Greg Mankiw's Blog: George Stigler rolls over in his grave: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more. A reader alerts me to this news: "Investment banks that obtain Federal Reserve Bank loans during a financial crisis should face much closer regulatory scrutiny, a key economic adviser to Democratic presidential candidate Sen. Barack Obama said. Austan Goolsbee, an economics professor at the University of Chicago and one of Sen. Obama's closest advisers on economic issues, said the senator believed strongly in enhanced regulation of any financial institution that has access to the Fed's discount window..."
This claim of Mankiw's seemed to me to be (i) simply wrong in its understanding of the Chicago tradition on financial regulation, as I argued yesterday, (ii) wrong in its analysis of why the Federal Reserve believes it needs authority to both lend to and regulate non-bank banks, as Mark Thoma argued yesterday, and (iii) wrong in its misidentification of the source of the push for enhanced regulatory authority--which comes not out of Barack Obama and the Democratic Party as a partisan issue but out of the Federal Reserve as a technocratic issue. This last is, I think, especially important: getting financial regulation right to deal with financial crises is not properly a partisan or ideological issue, and nobody should try to make it one.
And lo and behold, in this morning's Financial Times we have New York Fed President Tim Geithner explaining what he believes needs to be done: enhanced regulation of any financial institution that has access to the Fed's discount window--with which institutions have access something determined by the regulators in the interest of system stability:
http://us.ft.com/ftgateway/superpage.ft?news_id=fto060820081845293842: Since last summer, we have lived through a severe and complex financial crisis.... Many assets were financed with significant leverage and liquidity risk and many of the world's largest financial institutions got themselves too exposed to the risk of a global downturn. The amount of long-term illiquid assets financed with short-term liabilities made the system vulnerable to a classic type of run. As concern about risk increased, investors pulled back, triggering a self-reinforcing cycle of forced liquidation of assets, higher margin requirements, increased volatility.
What should be done to strengthen the system in the future? First, when we get through this crisis we have to increase the shock absorbers... more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning. They should be set high enough to offset the benefits that come from access to central bank liquidity, but not so high that they succeed only in pushing more capital to the unregulated part of the financial system.
Second, we have to... [take] some of the risk out of secured funding markets, increasing resources held against default in the centralised clearing house, and encouraging more standardisation, automation and central clearing....
Third, the regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions. I do not believe it would be desirable or feasible to extend capital requirements to leveraged institutiions such as hedge funds. But supervision has to ensure that counterparty credit risk management in the supervised institutions limits the risk of a rise in overall leverage....
Fourth, we need to streamline and simplify the US regulatory framework.... The institutions that play a central role in money and funding markets - including the main globally active banks and investment banks - need to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity. To complement this, we need to put in place a stronger framework of oversight authority over the critical parts of the payments system - not just the established payments, clearing and settlements systems, but the infrastructure that underpins the decentralised over-the-counter markets.... At present the Fed has broad responsibility for financial stability not matched by direct authority and the consequences of the actions we have taken in this crisis make it more important that we close that gap.
Finally, we need a stronger capacity to respond to crises...
