Can the Fed, a Facilitator of Systemic Risk, Successfully Contain It?

I am in Washington, DC, today, so President Obama’s regulatory reform plan is very much on my mind. As I think about what has been proposed, I keep coming back to the same question: how exactly the Federal Reserve is going to monitor and limit systemic risk.

Under President Obama’s plan unveiled yesterday, the Federal Reserve would be given broad powers to contain systemic risk through a newly created Financial Services Oversight Council. While this council’s mandate seems simple enough – stem systemic risk before it hijacks the national economy – its implementation is anything but. The Wall Street Journal rightly pointed out today that the modulation of systemic risk could conflict with the Fed’s monetary policy, presumably because, say, lowering interest rates could erode a large financial institution’s net interest margins, further harming an already teetering firm.

My questions about this plan go further than that. The president’s white paper yesterday offered little (if any) details on the most critical aspects of the proposed Financial Services Oversight Council. They are:

How does the Fed define systemic risk?

This can’t be a you-know-it-when-you-see-it sort of approach. More than any other federal agency, the Fed was perhaps the best positioned to spot systemic risk and it failed to do so – twice. It missed the tech bubble and it did not just miss the housing bubble, but it essentially fostered it. And now we are going to give the Fed the responsibility to, uh, minimize systemic risk? You suspend a reckless driver’s license, not gift him a Ferrari.

What exactly would the Fed do to minimize (or preferably eliminate) systemic risk?

Now the folks at the Fed will probably disagree with this, but there are institutions today that remain out and about, yet which pose a dramatic systemic risk to the nation’s economy. Strip away the government backstops and you’ve got banks with upside down balance sheets. If given these powers to contain systemic risk today, what would the Fed do, because it clearly did not minimize systemic risk during the height of the credit crisis; it amplified it. I found it uniquely disturbing to see in The Wall Street Journal this morning an advertisement promoting “Bank of America Merrill Lynch” just three pages before the paper’s coverage of the regulatory reforms. “Our two top-tier firms are now one financial powerhouse,” the ad reads. As the line from the old Monty Python movie goes, “better get a bucket.” It’s nauseating, and it is the doings of the Fed. With its new powers, does anyone see the Fed taking an ax to this or any other “financial powerhouse”? I didn’t think so.

My expectation is that the Fed will tack on reserve requirements and government backing to financial institutions it scarlet-letters as too risky. Peter Willison in a WSJ Op-Ed today described it as making a GSE out of the despot firm. In some cases, additional capital requirements will be enough to avoid an AIG syndrome. But there is equally a need to completely dismantle the risk concentrations still percolating in the financial system. Today’s Fed, in its current incarnation, does not exhibit the willpower necessary to resolve such concentrations, and I have serious doubts that it can make the leap necessary to be a true policeman of systemic risk.

This is no trivial matter. There is not a more important mandate for the new administration than containing systemic risk. It is not enough for President Obama to pin the Fed with the job of controlling systemic risk. He must set stringent and clear rules for containment – and many, if not all, of those rules need to be invented, not cribbed from an existing regulatory playbook. The trouble is that the Fed doesn’t do “clear and transparent” very well. Does anyone see the Fed differently? I didn’t think so.