FRBNY President And Former Goldman Partner Dudley Discusses Politicization Of The Fed

Tyler Durden's picture

The former Goldmanite discusses why the Fed will keep printing, printing, printing when the next leg of the Deferred DepressionTM hits, until such time as the ink runs out. And now, in addition to the usual Mutual Assured Destruction observations on why an audit of the Fed will cripple the world, Dudley adds his perspective on why the Fed should become a uber-regulator:

There are clear synergies between the supervisory process and
the Federal Reserve's monetary policy and financial stability missions.
The information we collect as part of the supervisory process gives us
a front-line, real-time view of the state of the financial industry and
broader economy. Monetary policy is more informed as a result. Only
with this knowledge can a central bank understand how the monetary
policy impulse will be propagated through the financial system and
affect the real economy...
Information sharing with other
agencies is simply not as good as the intimate knowledge and
understanding of markets and institutions that is gathered from
first-hand supervision. Indeed, many institutions at the center of the
crisis and arguably the most troubled—Bear Stearns, Lehman Brothers,
Merrill Lynch, AIG and the GSEs—were not supervised by the Federal
Reserve. Consequently, when those institutions came under stress, the
Federal Reserve had poorer quality and far less timely information
about the condition of these institutions than would have been the case
if we had had the benefit of direct supervisory oversight.

So in essence without having discrete knowledge over just how non-performing loans have taken over bank balance sheets, the Fed's monetary policy will be "blind." Is that an admission that all the prior bubbles the Fed managed to blow with such facility could have been avoided? But yes, otherwise it is simple a brilliant idea to give the bubble maker supreme oversight and regulation over all banks - this time it will be different: so promises the Goldman affiliate.

And speaking of Goldman, the monopolist bank is now supposed to be equated with god's true representative on earth, but as the equivalent of "public interest":

What is fundamentally at issue here is not “turf,” but
rather how we as a nation can best ensure that we never again re-live
the events of the past few years—that the legitimate public interests
associated with a safe, efficient and impartial banking and financial
system are well served.

If by "public interests" Mr. Dudley refers to the P&L risk of his former employer if and when mission-critical counterparties are not bailed out by taxpayers (while Fixed Income trading competitors are happily allowed to swallowed by bankruptcy courts after a surge in collateral calls), and AIG-type make whole arrangements continue in perpetuity, then we fervently agree.

Lastly, speaking of GSE's, just when will the Fed propose some regulatory framework with which to handle this stealthy multi-billion add-on to the taxpayer's balance sheet? Or should extend and pretend with housing continue until such time as the Fede is renamed to the New Century Reserve.

 


Remarks at the Partnership for New York City Discussion, New York City

It
is a pleasure to have the opportunity to speak here today. I will focus
on the important lessons of the recent crisis and how those lessons
should inform the regulatory reform effort. As always, what I have to
say reflects my own views and not necessarily those of the Federal Open
Market Committee or the Federal Reserve System.

In my opinion, this crisis demonstrated that a systemic risk
oversight framework is needed to foster financial stability. The
financial system is simply too complex for siloed regulators to see the
entire field of play, to prevent the movement of financial activity to
areas where there are regulatory gaps, and, when there are
difficulties, to communicate and coordinate all responses in a timely
and effective manner.

Effective systemic oversight requires two
elements. First, the financial system needs to be evaluated in its
entirety because, as we have seen, developments in one area can often
have devastating consequences elsewhere. In particular, three broad
areas of the financial system need to be continuously evaluated: large
systemically important financial institutions, payments and settlement
systems and the capital markets. The linkages between each must be
understood and monitored on a real-time basis. Second, effective
systemic risk oversight will require a broad range of expertise. This
requires the right people, with experience operating in all the
important areas of the financial system.

In this regard, I
believe that the Federal Reserve has an essential role to play. The
Federal Reserve has experience and expertise in all three areas—it now
oversees most of the largest U.S. financial institutions; it operates a
major payments system and oversees several others; and it operates in
the capital markets every day in managing its own portfolio and as an
agent conducting Treasury securities auctions. Also, as the central
bank, it backstops the financial system in its lender-of-last-resort
role.

Compared with where we were in late 2008 and early 2009,
financial markets have stabilized, and the prospect of a collapse of
the financial system and a second Great Depression now seems extremely
remote.
Even with this progress, however, credit remains tight,
especially for small businesses and households. Economic growth has
resumed, but unemployment has climbed to punishing levels. So while
circumstances have improved, they are still very far from where we want
them to be. We have no cause for celebration when the challenges facing
so many businesses and households remain so daunting.

Aggressive
and extraordinary official interventions were imperative to bring about
this nascent stabilization of our financial markets and economic
recovery. The Federal Reserve has been at the center of many of these
interventions. For example, its efforts over the past two years to
promote market functioning and minimize contagion were critical in
preventing the strains in our financial markets from resulting in even
more severe damage to the economy. These “lender of last resort”
interventions on the part of the Fed, including facilities such as the
Term Securities Lending Facility (TSLF) and the Primary Dealer Credit
Facility (PDCF), as well as programs such as the foreign exchange
reciprocal currency agreements, are examples of the rapid and
responsive application of basic central bank tenants to the unique
challenges we faced as this crisis evolved. Indeed, in many ways, the
crisis has underscored why the Federal Reserve was created almost a
century ago: to provide a backstop for a banking system prone to runs
and financial panics.

Where it proved necessary and feasible to
do so, the Fed also used its emergency lending authority to forestall
the disorderly failure of systemically important institutions. These
actions truly were extraordinary—well outside the scope of
our normal operations, but our judgment was that not taking those
actions would have risked a broader collapse of the financial system
and a significantly deeper and more protracted recession. Faced with
the choice between these otherwise unpalatable actions and a broader
systemic collapse, the Fed, with the full support of the Treasury,
invoked its emergency lending authority and prevented the collapse of
certain institutions previously considered to have been outside the
safety net.

The fact that the Fed needed to take those actions
provides a stark illustration of the significant gaps in our regulatory
structure, gaps that must be eliminated. Among those holes was the
absence of effective consolidated oversight of certain large and deeply
interconnected firms; the collective failure of regulators—including
the Federal Reserve—to appreciate the linkages and amplification
mechanisms embedded in our financial system; and the absence of a
resolution process that would allow even the largest and most complex
of financial institutions to fail without imperiling the flow of credit
to the economy more broadly. Addressing these shortcomings will require
important reforms in our country's regulatory architecture.

We
entered the crisis with an obsolete regulatory system. For one, our
regulatory system was not structured for a world in which an
increasingly large amount of credit intermediation was occurring in
nonbank financial institutions. As a result, little attention was paid
to the systemic implications of the actions of a large number of
increasingly important financial institutions—including securities
firms, insurance conglomerates and monolines. In addition, many large
financial organizations were funding themselves through market-based
mechanisms such as tri-party repo. This made the system as a whole much
more fragile and vulnerable to runs when confidence faltered.

With
the benefit of hindsight, it is clear that the Fed and other
regulators, here and abroad, did not sufficiently understand the
importance of some of these changes in our financial system. We did not
see some of the critical vulnerabilities these changes had created,
including the large number of self-amplifying mechanisms that were
embedded in the system. Nor were all the ramifications of the growth in
the intermediation of credit by the nonbank or “shadow banking” system
appreciated and their linkages back to regulated financial institutions
understood until after the crisis began.

With hindsight, the
regulatory community undoubtedly should have raised the alarm sooner
and done more to address the vulnerabilities facing our banks and our
entire financial system. But this was difficult because our country
didn’t have truly systemic oversight—oversight that would be better
suited to the new world in which markets and nonbank financial
institutions had become much more important in how credit was
intermediated. Without a truly systemic perspective, it was unlikely
that any regulator would have been able to understand how the risks
were building up in our contemporary, market-based system. The problem
was that both banking and nonbank organizations played an important
role in credit intermediation but were subject to differing degrees of
regulation and supervision by different regulatory authorities.

Although
these gaps had existed for years, their consequences were not apparent
until the crisis. Difficulties in one part of the system quickly
exposed hidden vulnerabilities in other parts of the system, in a way
that our patchwork regulatory system had not been designed to detect or
readily address. In the same way, the crisis revealed the critical
deficiencies in the toolkits available to the regulators to deal with
nonbank institutions in duress. Emergency lending by the Fed might be
enough to forestall the disorderly failure of a systemically important
institution and all the wider damage such a failure might cause, but it
was a blunt and messy solution, employed as a stopgap measure because
better alternatives were not available. What is needed—what our country
still lacks—is a large-firm resolution process that would allow for the
orderly failure even of a systemically important institution.

Thus,
in the fall of 2008, regulators and policymakers found themselves
facing the prospect of the total collapse of a complex and
interconnected system. It was these circumstances, and the
prospect they created for an even deeper and more protracted downturn
in real economic activity and employment, that required truly
extraordinary actions on the part of the Federal Reserve, as well as
the Treasury and many other agencies. This is a situation in which the
United States must never again find itself.

For its part, the
Federal Reserve is hard at work on developing and implementing new
regulations and policy guidance that take on broad lessons of the
recent crisis. We are working with other banking regulators in the
United States and overseas to strengthen bank capital standards, both
by raising the required level of capital where appropriate and
improving the risk capture of our standards. We are issuing new
guidelines on compensation practices so that financial sector employees
are rewarded for long-term performance and discouraged from excessive
risk-taking. And we are working with foreign regulators to develop more
robust international standards for bank liquidity. We are working to
make the tri-party repo system more robust and reducing settlement risk
by facilitating the settlement of over-the-counter derivatives trades
on central counterparties (CCPs). But more needs to be done and much of
this requires action by Congress.

Congress is now considering
several proposals for comprehensive regulatory reform, proposals that
merit careful study and debate. Let me offer some general thoughts on
the principles that should guide how we approach reform.

First,
it's important to take a clear-eyed and comprehensive view of the
financial system we have today. As I've already suggested, if there is
one overriding lesson to be drawn from the events of the past 18
months, it is that the financial system is just that: a system, and a very complex one at that.
The operational, liquidity and credit interdependencies that
characterize contemporary financial markets and institutions mean that
the well-being of any one segment of the system is inextricably linked
to the well-being of the system as a whole. Because of this, our
approach to reform must be guided by a coherent sense of the system as
a whole, not merely by a focus on some of its component parts, as
important as they may be.

We need a new regulatory structure that
provides for comprehensive and consistent oversight of all elements of
the financial system. This includes effective consolidated oversight of
all our largest and interconnected financial institutions and oversight
of payment and settlement systems. We must make sure that the people
doing the regulation have the power and expertise to ferret out and
bring to heel regulatory evasion as it occurs to prevent abuse and
excess from building up in the financial system. In the end, the gaps,
not the overlaps, have been the main shortcoming of our existing
regulatory framework.

A second fundamental point is that
regulatory reform has to ensure that the financial system will be
robust and resilient even when it comes under stress so that it will
not fail in its critical role in supporting economic activity. No
economy can prosper without a well-functioning financial system—one
that efficiently channels savings to the businesses that can make the
most productive use of those savings, and to consumers that need credit
to buy a home and support a family. The fact that our financial system
isn't functioning well right now is part and parcel of our current
economic difficulties. This critical link between the “real” and the
“financial” is why we care so much about the systemic risks inherent in
banking and finance.

One critical element of systemic risk is
what is known as the “too big to fail” problem. Without sufficiently
high capital and liquidity standards, and, as a backstop, a resolution
mechanism that is credible, regulators are faced with a Hobson’s Choice
when a large, systemically important financial firm encounters
difficulties. On the one hand, if authorities step in to respond to
prevent failure, contagion and collapse of the broader system, that
action rewards the imprudent and can create moral hazard—that is,
encouraging others to act irresponsibly or recklessly in the future in
the belief that they will also be rescued or “bailed out.” On the other
hand, if authorities do nothing and let market discipline run its
course, they run the risk that the problem will spread and unleash a
chain reaction of collapse, with severe and lasting damage to markets,
to households and to businesses.

So what can we do about the “too
big to fail” problem? It is clear that we must develop a truly robust
resolution mechanism that allows for the orderly wind-down of a failing
institution and that limits the contagion to the broader financial
system. This will require not only legislative action domestically but
intensive work internationally to address a range of legal issues
involved in winding down a major global firm. Second, we need to ensure
that the payments and settlement systems are robust and resilient. By
strengthening financial market infrastructures, we can reduce the risk
that shocks in one part of the system will spread elsewhere. Third, we
need to reduce the likelihood that systemically important institutions
will come close to failure in the first place. This can be done by
mandating more robust capital requirements and greater liquidity
buffers, as well as aligning compensation with the risks that are taken
by the firm’s employees. In addition, instruments such as contingent
capital–debt that would automatically convert to equity in adverse
environments–need to be considered. Such instruments would enable
equity capital to be replenished automatically during stress
environments, dampening shocks rather than exacerbating them.

I
would now like to take some time to discuss some of the proposals that
Congress is debating regarding regulatory reform. As Congress and the
Administration consider what legislative changes are warranted, the
Federal Reserve's actions before and during the crisis have been
getting close inspection. Given the Federal Reserve's key role in our
financial system, and the scale of the damage caused by the financial
crisis, this careful scrutiny is necessary, appropriate and welcome.

Not
surprisingly, there are legislative proposals that would significantly
alter the Federal Reserve's powers and responsibilities, particularly
with respect to supervision of bank holding companies. Again, that's
entirely within Congress's purview: the Federal Reserve only has the
powers and responsibilities that Congress has entrusted to us. But in
drawing up new legislation, it's important not to throw the baby out
with the bathwater—we should preserve what has worked and fix what
hasn’t. A dispassionate analysis of what is needed will almost
certainly lead to better decisions and a more effective regulatory
framework.

The legislative proposals concerning the Federal
Reserve are not limited to the Federal Reserve’s role in supervision.
Consider, for example, one proposal that calls for what it terms
"audits" of the Federal Reserve by the U.S. Government Accountability
Office (GAO), an arm of Congress. These wouldn't be audits at all in
the commonly understood sense of the term. The Federal Reserve's
financial books and transactions are already audited by wide
range of professionals internal and external to the institution.
Rather, these new audits would involve ex-post review of Federal
Reserve monetary policy decisions, a potential first step
toward the politicization of a process that Congress has carefully
sought to insulate from political pressures.

The notion that the
Federal Reserve's financial dealings are somehow kept hidden from the
public is a surprisingly widely held view—and it is simply incorrect.
An independent outside audit of the Federal Reserve's books is
conducted annually. You can find the results online, including a
detailed accounting of the Federal Reserve's income and operating
expenses in its annual report. The financial books of the regional
Federal Reserve Banks also undergo independent outside audits, also
available online. In addition, the GAO is empowered to review almost
all Federal Reserve activities other than the conduct of monetary
policy, including the Federal Reserve's financial operations, which the
GAO has done so frequently. The Federal Reserve's balance sheet is
posted online weekly, with considerable detail, in what's called the
H.4.1 report. Finally, an additional accounting of the Federal
Reserve's emergency lending programs created over the last two years is
available online in a monthly report.

But my objection that GAO
oversight would be broadened to include a review of monetary policy
decisions is not based just on the fact that the Fed is already subject
to considerable oversight. My principal concern is the damage that
could potentially result to the Fed’s ability to achieve its mandate of
price stability and maximum sustainable employment. The effectiveness
of monetary policy depends most of all on the Federal Reserve’s
credibility with market participants and investors. In particular, both
groups need to know that the Fed will always act to keep inflation in
check. That's why Fed Chairman William McChesney Martin famously joked
that the Fed would sometimes need "to take the punchbowl away just as
the party gets going." As you can well imagine, this may not always
enhance our popularity, especially among those who were enjoying the
party. But, the fact that markets know that the Federal Reserve will
tighten monetary policy when needed helps keep inflation expectations
in check. This, in turn, helps keep inflation low since inflation
expectations affect actual inflation. The consequence is credibility
with respect to the conduct of monetary policy. This gives the Fed more
latitude not to tighten when inflation rises for transient reasons—say,
due to a short-lived spike in oil prices—and more scope to ease credit
to support the economy during economic downturns.

Recognizing
these benefits, Congress wisely acted many years ago to exempt monetary
policy decisions from the GAO's wide powers to review Federal Reserve
activities. Congress' decision to bolster the Fed's monetary policy
independence has been followed by similar actions around the
world—substantial independence for the central bank in the conduct of
monetary policy is now widely regarded as international best practice.
Policy independence does not absolve the Federal Reserve from
accountability for its monetary policy decisions and the need to
clearly explain why they were taken. But it avoids the politicization
of monetary policy decision-making. And this is good because
politicized central banks generally do not have enviable records with
regard to inflation, economic growth or currency stability. Risk premia
on financial assets are typically much higher in countries with
politicized central banks.

Of course, a reversal of Congress's earlier decision would not amount to legislative control
over monetary policy decisions. That's not the issue. The issue is that
a reversal of Congress’ earlier decision could create the appearance
that the legislature seeks to influence monetary policy
decisions by establishing a mechanism to publicly second guess those
decisions. Such a move would blur what has been a careful separation of
monetary policy from politics. Market confidence here and abroad in the
Federal Reserve would be undermined. Asset prices could quickly build
in an added risk premium, which might lead to tighter credit
conditions. These unintended consequences would undermine the
legislation’s intent.

I’m also concerned about those proposals
under consideration that would move the regulatory and supervisory
functions now held by the Federal Reserve to other agencies, new or
existing. At present, the Federal Reserve is the consolidated
supervisor for bank holding companies, a group that has expanded
recently as investment banks and other companies formerly outside the
Federal Reserve's purview have been brought under Federal Reserve
oversight. In my view, further disaggregation or fragmentation
of regulatory oversight responsibility is not the appropriate response
to our increasingly interconnected, interdependent financial system.
Funneling information streams into diverse institutional silos leads to
communication breakdowns and too often to failure to "connect the dots."

In
addition, there are clear synergies between the supervisory process and
the Federal Reserve's monetary policy and financial stability missions.
The information we collect as part of the supervisory process gives us
a front-line, real-time view of the state of the financial industry and
broader economy. Monetary policy is more informed as a result. Only
with this knowledge can a central bank understand how the monetary
policy impulse will be propagated through the financial system and
affect the real economy.

Similarly, involvement in the
supervisory process gives us critical information in fulfilling our
lender-of-last-resort responsibilities. Information sharing with other
agencies is simply not as good as the intimate knowledge and
understanding of markets and institutions that is gathered from
first-hand supervision. Indeed, many institutions at the center of the
crisis and arguably the most troubled—Bear Stearns, Lehman Brothers,
Merrill Lynch, AIG and the GSEs—were not supervised by the Federal
Reserve. Consequently, when those institutions came under stress, the
Federal Reserve had poorer quality and far less timely information
about the condition of these institutions than would have been the case
if we had had the benefit of direct supervisory oversight.

In fact, some of the hardest choices the Federal Reserve had to make
during the most chaotic weeks of the crisis concerned systemically
important firms we did not regulate. It is not surprising
that, in the wake of the crisis, some countries that had separated bank
supervision from the central bank monetary policy role are now
reconsidering that division of labor. That is mainly because
coordination problems created difficulties in responding quickly and
effectively in the crisis. Separation made it more difficult to
communicate in a timely way and to understand the broader implications
of what was transpiring. It is critical that we not introduce new
inefficiencies and impediments. No matter what steps are taken to
improve our regulatory system and strengthen market discipline, history
tells us that there will inevitably be circumstances in which an
informed and effective lender of last resort will play a critical role
in preventing shocks and strains in financial markets and institutions
from generating a broader collapse of the financial system.

Of course, there are legitimate questions as to how broad the
Federal Reserve's regulatory and supervisory responsibilities should
be. That question is up to Congress, and should be decided on the
merits. What is fundamentally at issue here is not “turf,” but
rather how we as a nation can best ensure that we never again re-live
the events of the past few years—that the legitimate public interests
associated with a safe, efficient and impartial banking and financial
system are well served.

In the end, it is critical that financial
reform be decided on the basis of the merits. If objective and careful
policymaking prevails, we will all be the better off for it. In
contrast, if we fail in this endeavor, that would truly be tragic. We
must act informed by the important lessons that we have learned from
this crisis.

Thank you for your kind attention.