Financial Regulatory Reform: V--A Wrap-Up

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I am surprised by how quickly the media publicity concerning the Administration's blueprint for financial regulatory reform, issued on July 17, has dissipated. Does this mean the plan is DOA (dead on arrival)? The plan has serious flaws, as I have argued in my previous blog entries in this series, and we should not be sad to see it die, and the entire reform program deferred until the causes of the financial crisis have been studied in greater depth than has been possible so far. The theory behind the Administration's plan seems to be first impose sentence and then conduct the trial to determine whether the bankers, the homebuyers, and the other culprits identified in the Administration's report are really the culpable ones.

Ignored, along with other regulatory failures, is the role of the Federal Reserve 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. Since senior economic officials in the Administration were implicated in these failures of regulation and the thrust of the report is that we need more regulation, it is not surprising that the report gives regulators a pass by attreibuting their failures (when mentioned at all, which is infrequent in the report) to lack of authority, attributable to gaps in the regulatory structure.

Before any ambitious plan of regulatory reform is adopted, with all the delay and confusion and unintended consequences that are inevitable, we should make sure that the regulators are employing their existing powers to the full and yet nevertheless there is need for more regulation. Just last week the SEC announced that it is imposing reserve and capital requirements on money-market funds, requirements that had they been in forced last September would have reduced the systemic consequences of Lehman Brothers' collapse. Let us wait, and see what more the fresh crew of regulators installed by the new Administration can do.

I want to apply the principle of no regulatory restructuring until the regulators have exerted their existing powers to the full to the centerpiece of the Administration's proposal, which is to constitute the Federal Reserve as the nation's "systemic risk regulator." The Fed would be empowered to designate any financial enterprise a "Tier 1 Financial Holding Company" and having done so impose on the enterprise whatever restrictions it thought necessary to eliminate it as a source of systemic risk, which is to say the risk that if the enterprise failed it would carry down with it all or part of the entire financial system.

What is true, as I have explained in previous blog entries, is that financial firms that are not commercial banks--and these nonbanks or "shadow banks" are now in the aggregate a larger source of credit than commercial banks are--can create systemic risk. I have illustrated in previous entries with Lehman Brothers, and to recapitulate briefly, Lehman, a broker-dealer, was among its other activities a dealer in the commercial paper and money-market fund markets. It would issue its own commercial paper (short-term promissory notes) to money-market funds and use the money that it borrowed in this manner to buy commercial paper from (that is, to lend to) nonfinancial firms that finance their day-to-day operations by issuing commercial paper. When Lehman became insolvent because of losses sustained elsewhere in its business, it could not repay the money-market funds or continue lending to issuers of commercial paper. As a result of Lehman's distress and that of similarly situated broker-dealers, the commercial-paper and money-market funds markets froze, greatly exacerbating the credit crisis. Lehman was not one of the largest nonbank banks, but because of its interdependence with other participants in the overall credit market, as I have illlustrated, its sudden collapse had serious repercussions.

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. I am not persuaded. Section 13(3) of the Federal Reserve Act, 12 U.S.C.  § 343 authorizes the Fed 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 created by a collapsing global financial system, the Fed could have declared itself "satisfied" with whatever security Lehman could have offered. The statutory term "secured to the satisfaction" is not defined either in the statute or in regulations issued by the Fed, and although there is disagreement over its meaning, a recent article states that "The Fed was effectively granted complete discretion to accept any types of collateral for a [loan] made in 'unusual and exigent' circumstances." Thomas O. Porter II, "The Federal Reserve's Catch 22: A Legal Analysis of the Federal Reserve's Emergency Powers," 13 North Carolina Banking Institute 508 (2009). Although the amount by which Lehman's liabilities exceeded its assets is unclear, the usual figure suggested is $30 billion. This is a large number, but small relative to the potential losses on other loans made by the Fed during the acute phase of the financial crisis.

My suggested interpretation may seem a stretch, and if so Congress could amend the Federal Reserve Act 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.

Of course the government woud like to be able to prevent the collapse of enterprises that create systemic risk, rather than just being able to save them from collapsing, at a cost of tens of billions of dollars, or more. But the first question to ask (which I do not find addresssed in the Administration's report) is whether the 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. Closer liaison between the SEC and the Fed might go far to minimize the "macroprudenteial risk" posed by broker-dealers. And I imagine that if the Fed simply identified the firms that it believes pose systemic risk, a combination of market forces, public and legislative opinion, and the implicit threat of tighter regulation, would impel those firms to take steps to reduce the systemic risk that they pose. This possibiltiy should be explored before the Federal Reserve's express regulatory powers are enlarged. After all, the main reason for the financial collapse last September was that the regulators were asleep at the switch. Theyare now awake, indeed insomniac. If the Federal Reserve needs additional staff, and perhaps additional statutory authority to require financial information from enterprises that it does not at present regulate in order to identify potential systemic-risk creators, and perhaps some other tinkering with the Federal Reserve Act to clarify its authority to lend to nonbanks in emergencies, these modest reforms could be adopted without restructuring the entire financial regulatory system, as the report proposes, with all the turmoil and uncertainty that would ensue.

Another modest suggestion for reform, which is based on my academic writings on domestic security, is the role of state banking and insurance regulators in a system of early warning of impending financial crises. These regulators should be regarded as a part of a nationwide system of financial intelligence coordinated at the federal level. 

These suggestions may seem tepid, and I certainly do not offer them as definitive solutions to the problems of financial regulation flagged by the current crisis. In the longer term serious consideration should be given to more radical proposals--but only after the causes of the current crisis have been carefully and responsibly and impartially studied. It is possible for example that, along the lines of the Public Utilities Holding Company Act or the Glass-Steagall Act, both passed in the 1930s, money-market funds and other nonbank banks should be required to be spun off from firms that engage in proprietary trading or other high-risk activities. The reason is not only the contagion of the kind that brought down Lehman Brothers, but also the danger from combining disparate business cultures in a single firm. It is difficult to combine different cultures in the same firm without one becoming dominant. A "safe" banking operation will attract a different type of business person from a speculative trading operation, a more cautious person and one who will be differently--and less munificently--rewarded. The profitability and generous remuneration of the traders will tend to induce the bankers (or induce top management to pressure the bankers) to increase the risk and return of their own operations, making them less safe.

And should not consideration be given, in any far-reaching long-term study of financial regulatory reform, to reorganizing the Federal Reserve System? Why are there regional banks--why is there not a single central bank in Washington--and why should the regional banks, whose presidents participate in the establishment of the nation's monetary policies, be quasi-private institutions? Is the structure of our central banking system rational, or is it just a fossil remnant of Andrew Jackson's suspicion of a national bank?

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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