Federal Reserve & Interest Rates

During an economic conference at the Federal Reserve Bank of Boston, Chairman Bernanke called for legislative action from Congress to close regulatory gaps,  as well as give regulators the power to unwind failing non-banking firms.  Only the FDIC currently holds such power over financial institutions with bank holding companies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers.

On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firmwide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or systemwide, approach that should help us better anticipate and mitigate broader threats to financial stability.

States which regulates insurance companies and the SEC which had regulated the now defunct investment banking sector had little such power, which led to little choice last year but to let Lehman Brothers collapse and AIG receiving a massive federal bailout.  While both Citigroup and Bank of America also required substantial federal aid subsequently, much of that was due to the global liquidity crisis which ensued following the problems of the two above mentioned institutions.

While Congress has been expected to act for some time and many changes are expected in the financial regulatory structure, little has been done thus far with it’s main focus on healthcare reform at the moment.  A plan which has gained steam recently is the creation of a regulatory council made up from a number of federal agencies with the power to supervise firms deemed systemic risks to the greater economy.

There have also been many calls to break up so called firms that are “too big” to fail in order to avoid a repeat of last year where substantial taxpayer dollars were put at risk in order to rescue the economy from financial collapse.

Federal Reserve Chairman Ben Bernanke gave testimony before the House’s Committee on Financial Services on Thursday, discussing his views on financial regulatory reform.  He believes a consolidated approach is needed and that a number of elements are necessary to safeguard the economy from systemic risk.

The current financial crisis has clearly demonstrated that risks to the financial system can arise not only in the banking sector, but also from the activities of other financial firms–such as investment banks or insurance companies–that traditionally have not been subject to the type of regulation and consolidated supervision applicable to bank holding companies.

To close this important gap in our regulatory structure, legislative action is needed that would subject all systemically important financial institutions to the same framework for consolidated prudential supervision that currently applies to bank holding companies. Such action would prevent financial firms that do not own a bank, but that nonetheless pose risks to the overall financial system because of the size, risks, or interconnectedness of their financial activities, from avoiding comprehensive supervisory oversight.

For some time it was thought that the Fed would gain more control after the regulatory shakeup but Congress has been reluctant to give more power to the Fed and Bernanke agreed that a supervisory oversight council may be more appropriate.  The Fed hasn’t been immune to it’s own share of criticism, despite the praise it has received for bringing the financial system back from the brink of collapse.

Of course more regulation will also be needed for the derivatives market, which allowed many financial institutions to raise their leverage levels without sufficient capital reserves to back them up.  Many critics are advocating breaking up systemically risky firms but that doesn’t appear to be the path that Congress will take.

Also discussed was that while the FDIC is charged with the orderly breakup of failing commercial banks, there is no real authority in charge of the breakup for the insurance or investment sector, although with the last two major investment banks converting to bank holding companies the latter may be a moot point.  It was pretty much the bankruptcy of Lehman Brothers and it’s disorderly breakup, after the government declined to offer them a bailout that lead to last year’s financial panic.

Another key figure from the Federal Reserve gave testimony this week before the Committee on Banking, Housing and Urban Affairs of the U.S. Senate.  Congress will be attempting to rework the nation’s financial regulatory structure in an effort to prevent a re-occurrence of the events that nearly lead to a collapse of the banking system.

Improved prudential supervision–the topic of today’s hearing–is a necessary component of the policy response. The crisis revealed supervisory shortcomings among all financial regulators, to be sure. But it also demonstrated that the framework for prudential supervision and regulation had not kept pace with changes in the structure, activities, and growing interrelationships of the financial sector. Accordingly, it is essential both to refocus the regulation and supervision of banking institutions under existing authorities and to augment those authorities in certain respects.

In my testimony today, I will begin by suggesting the elements of an effective framework for prudential supervision. Then I will review actions taken by the Federal Reserve within its existing statutory authorities to strengthen supervision of banks and bank holding companies in light of developments in the banking system and the lessons of the financial crisis. Finally, I will identify some gaps and weaknesses in the system of prudential supervision. One potential gap has already been addressed through the cooperative effort of federal and state banking agencies to prevent insured depository institutions from engaging in “regulatory arbitrage” through charter conversions. Others, however, will require congressional action.

This all comes at a time when markets are growing increasingly concerned over what direction the Fed will be heading, as current Chairman Ben Bernanke’s term is set to expire at the end of the year.  So far the Obama administration has been vague on whether or not Bernanke will or will not be re-confirmed as head of the Fed.

While he has received praise for his handling of the financial crisis from many circles, it can’t be overlooked that he was at the helm when the events leading up to the recession took place.  Although most of the criticism has been aimed at his predecessor Alan Greenspan, he does share some of the blame.

That being said many analysts expect the Fed’s regulatory powers to grow after the regulatory shake up that is coming.  It will likely gain broad powers in order control systemic risks.  Many business are also wondering how heavy handed the government will be after the paint dries.

The government has pretty much took a hands off approach since the 1980’s, but now with so many tax dollars at risk, that will no longer be the case.  Along with increased supervision of the banking system, Congress will also take a look at reigning in rampant speculation in the commodities market, as well as trying to figure out how to get a handle on derivatives markets and credit default swaps.

Most of the changes won’t happen overnight and business should have an opportunity to peruse the new regulatory landscape before they map out plans to deal with it.  Hopefully Congress will be able to find the right balance between a stifling regulatory structure and one that has the proper controls in place to prevent another financial meltdown.