The real questions the Fed should ask itself

Don’t mistake relative calm in the financial system for a sign that the central bank’s work is done

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Nov 08, 2017

Sections Public Policy

Collections Monetary Policy

When Federal Reserve Chair Janet Yellen spoke at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming, this August, her topic—financial stability and the Fed’s role in financial regulation and supervision—said a lot. Financial regulation, supervision, and direction is much more centrally a part of what the Fed is and does these days than is standard monetary policy. Whether overnight interest rates go up or down a quarter of a percentage point may be the subject with the greatest ratio of talk to action, and of commentary to actual effect, in all of economics. (Bottom line: interest rates in the United States are likely to stay around 1 percent for the foreseeable future. Get used to it.) But the Fed is deeply involved in running the financial system, and all the talk points to it becoming more so. 

Rather unsurprisingly, Ms. Yellen did not give a speech bemoaning the current state of affairs. She’s been in charge, after all. If she viewed the Dodd-Frank Act as a grossly complex Rube Goldberg contraption, and the Fed as only following silly rule-making dictates to comply with the law, she would have said so loudly, and long before August. Nonetheless, I was left a bit disappointed after reading it. She devoted just three paragraphs to a section entitled “Remaining Challenges,” and yet there are far more questions to be asked, paths to choose, and fundamental choices to be made than could be covered so briefly. With President Donald Trump having recently nominated Jerome H. Powell to replace Ms. Yellen as chair when her term expires in February, this is an opportune time to consider them.

Which deregulation? 

The call from many policy makers, including some within the Trump administration, to roll back our regulatory structure can be read two ways: 1) reduce the insanely complex rules, and the even more intrusive discretionary supervisory regime, designed in a futile attempt to make sure banks never lose money, and replace them with higher capital standards so that banks’ losses pass smoothly to shareholders without threatening the economy; or 2) reduce capital and leverage ratios, keep the complex, anticompetitive rules on the books, let banks continue to slowly capture the discretionary regulators, and keep the wink-wink bailout regime in place. Let profits roll in to the big banks. Until the next crisis. 

You can guess which one I favor. I sense Ms. Yellen is mostly pushing back on the second, especially the desire by big banks for less capital and more trading freedom. But aside from acknowledging that “there may be benefits to simplifying aspects of the Volcker Rule . . . and to reviewing the interaction of the enhanced supplementary leverage ratio with risk-based capital requirements,” she concludes in her speech that “any adjustments to the regulatory framework should be modest.” Really? Is every provision of the Dodd-Frank Act wise? Is there no room, after 10 years and a lot of experience, for a thoughtful evaluation and revision of the tens of thousands of pages of rules?

Are we any safer? 

The most important question, really, is whether the system is in fact safer, more resilient, and ready to deal with the next crisis, especially if that crisis comes from a new source—say pensions, student debt, or worst of all, global sovereign debt. Ms. Yellen asserts in her speech that, yes,

reforms have boosted the resilience of the financial system. Banks are safer. The risk of runs owing to maturity transformation is reduced. Efforts to enhance the resolvability of systemic firms have promoted market discipline and reduced the problem of too-big-to-fail. And a system is in place to more effectively monitor and address risks that arise outside the regulatory perimeter.

Really? How and why?

Loss-absorbing capacity among the largest banks is significantly higher, with Tier 1 common equity capital more than doubling from early 2009 to now. The annual stress-testing exercises in recent years have led to improvements in the capital positions and risk-management processes among participating banks. Large banks have cut their reliance on short-term wholesale funding essentially in half and hold significantly more high-quality, liquid assets.

Economic research provides further support for the notion that reforms have made the system safer. Studies have demonstrated that higher levels of bank capital mitigate the risk and adverse effects of financial crises. Moreover, researchers have highlighted how liquidity regulation supports financial stability by complementing capital regulation.

Yes! Capital, capital, capital, and the more the merrier. But we don’t need 10,000 pages of regulations, or annual stress tests, just to demand more capital. The questions are: Just how much capital should we demand, and how should it be measured? 

Apart from capital requirements, Yellen made reference to metrics, both market based and “supervisory,” that we can use to gauge safety, and conceded that each has its flaws. But perhaps their biggest flaw is that they have to be interpreted and acted upon—at just the right time and in just the right way—by policy makers, who have proven spectacularly unequal to this challenge in the past. How much better is Ms. Yellen’s feeling that the banking system is safe than was former Fed Chair Ben Bernanke’s similar feeling in 2007, and on what basis? More deeply, what justifies her faith that this time, policy makers monitoring “a range of supervisory and market-based indicators of financial system resilience” will see the crisis coming, and do something about it? Ms. Yellen herself acknowledged that those who assembled at Jackson Hole 10 years ago were fairly sanguine about the stability of the financial system.

The screaming lesson of the last crisis ought to be that we need a resilient system, not purportedly clairvoyant policy makers monitoring—and, by implication, guiding—the system. Crises are, by definition, unpredictable. Any regime that relies on regulators to see it coming is doomed to failure. Again. 

Regulation or supervision?

An analogy: the highway patrol, the Department of Motor Vehicles, and the Department of Transportation are in charge of highway safety. By and large they set rules: drive 55 mph here and 35 mph there; stop at red lights; stay within lane lines. They do not tell us, “Submit your plan to drive to Los Angeles for approval”; nor do they put an employee in the back seat to tell you when it’s time to pull over and rest. We tend to call all of the above activities “regulation,” but “supervision” is a polite word for the latter endeavors. There are many impolite words.

So is the Fed’s job to set up stable rules of the game, standards such as capital requirements, so that the system is resilient on its own? Is it in charge of writing the fire code, and determining how many sprinklers and extinguishers should be in each house? Or is the Fed’s job to be the fire department, spotting fires as they break out, rushing to the rescue? Or, should it send its employees to watch over how we cook dinner, as its embedded employees watch the big banks?

Practically nobody stops to ask: Just because a central bank can affect the economy through its regulatory or asset purchase powers, should it do so?

Central banks are giant discretionary financial regulators, making little distinction between the sit-back-and-make-rules versus decree-actions-and-outcomes approaches. It’s no surprise, then, that their regulatory, supervisory, and policy activities are merging. When a little stimulus is needed, they can just tell banks to lend, or they can use quantitative easing to push up asset prices. If a bubble is diagnosed, they can tell banks to cut back, or they can tighten regulations, or they can sell some assets. 

Hundreds of academic papers find that central banks can affect this or that by buying securities, changing bank regulations, changing financial regulations, and so on. Then they segue into policy conclusions on how central banks should use these dandy new tools. Practically nobody stops to ask: Just because a central bank can affect the economy through its regulatory or asset purchase powers, should it do so? The question, “Do we really want an independent central bank routinely dialing up and down levers of cash-out refinancing, with an eye to raising or lowering stimulus?” just never occurs to anyone.

That constitutional question is the big one we all should be asking as central banks move to financial regulation and discretionary supervision. 

What’s systemic anyway? 

Just what do we mean by a “systemic” crisis? That would seem to be a foundational question that a Fed chair should weigh in on, yet the answer is decidedly muddy.

It bears on policy. For example, right now there is a movement around the world to declare that asset managers are systemic dangers. How is that possible? The manager buys and sells your stocks. If he or she invests in a stock and it goes down, you can’t demand your money back, you can’t run, and you can’t force the manager into bankruptcy. Shouldn’t asset managers get a nonsystemic gold star, for not issuing run-prone securities? Well—the story goes—they might “herd” or be prone to behavioral biases, and, heaven forbid, sell stocks, which might, heaven forbid, go down. “Financial stability” now seems to mean nobody should ever sell anything, and stocks should never go down. 

Are insurance companies systemic? Are retirement plans systemic? Just who gets saved when?

Or to take the other half of the phrase: What is a crisis? Is it just a bunch of bankruptcies? What is the nature of contagion? Is it a domino effect—Bank A fails, Bank A owes Bank B money, so Bank B fails? Is it a run—Bank A fails, so people question Bank B and pull out run-prone assets? The system seems to handle even big bankruptcies fine at some times but not at others. What makes those times different? How do you “resolve” a bank during a crisis?

Ms. Yellen points to liquidity being a problem in a crisis, and her Fed now encourages institutions to have lots of liquid assets to sell in the event of losses. But sell to whom? Isn’t there something deeply wrong about a system in which everyone’s risk-management plan is to sell assets in the event of price declines?

Ms. Yellen’s account of the 2007–10 financial crisis, as presented in her Jackson Hole speech, is largely a familiar story of behavioral excess (by market participants and regulators), with no mention of mechanics. Yet the Fed chair’s job is to fix the machine, not to wish for smarter people. If the explanation for the crisis is all “madness of crowds,” there is absolutely nothing in the new regulatory regime to stop a crisis from happening again.

I have a view on this. The crisis was a run—and not one of the other stories. Runs are by definition unpredictable. The essence of a run is not the riskiness or illiquidity of bank assets; it is the run-prone nature of bank liabilities. We can set up our financial system so that it will never again have a crisis by insisting banks fund themselves with run-proof liabilities, predominantly common equity, and isolate any needed leverage outside the banking system. Such a system requires an order of magnitude less regulation, and two orders less supervision. Well, I don’t run the Fed. But those who do desperately need clear answers to these questions, and a clear vision of the Fed’s role in managing the financial system. 

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blogThe Grumpy Economist.