One of the larger mistakes in the Obama financial regulatory reform package was its attempt to give the Federal Reserve additional powers so that it could in theory protect the economy from risks such as the housing bubble that could endanger the entire financial system.
As we have argued in the past, the entire concept of minimizing systemic risk is a thankless task that is probably impossible. A key question is how much power such a regulator would have. As we said in June, “Congress could grant it such wide powers that the agency could intervene in just about any aspect of the financial industry, thus causing even more chaos and uncertainty than it prevents. It could also hinder the development of new products and other innovations if the agency develops an attitude that anything new may be risky.”
However, if there is to be a systemic risk regulator, it would be far better to give that responsibility to a council of regulators than to the Federal Reserve or any other single agency.
Now, Federal Reserve Chairman Ben Bernanke has endorsed the council approach even though it could cost his agency additional powers and resources. Testifying before the House Financial Services Committee this morning, Bernanke said that:
…the broader task of monitoring and addressing systemic risks that might arise from the interaction of different types of financial institutions and markets–both regulated and unregulated–may exceed the capacity of any individual supervisor. Instead, we should seek to marshal the collective expertise and information of all financial supervisors to identify and respond to developments that threaten the stability of the system as a whole. This objective can be accomplished by modifying the regulatory architecture in two important ways.
First, an oversight council–composed of representatives of the agencies and departments involved in the oversight of the financial sector–should be established to monitor and identify emerging systemic risks across the full range of financial institutions and markets. Examples of such potential risks include rising and correlated risk exposures across firms and markets; significant increases in leverage that could result in systemic fragility; and gaps in regulatory coverage that arise in the course of financial change and innovation, including the development of new practices, products, and institutions. A council could also play useful roles in coordinating responses by member agencies to mitigate emerging systemic risks, in recommending actions to reduce procyclicality in regulatory and supervisory practices, and in identifying financial firms that may deserve designation as systemically important. To fulfill its responsibilities, a council would need access to a broad range of information from its member agencies regarding the institutions and markets they supervise and, when the necessary information is not available through that source, the authority to collect such information directly from financial institutions and markets.
Perhaps the most important part of the testimony is that while Bernanke calls for the ability to gather information, a necessary part of any effort to identify systemic risk, he does not call for the council to have any new powers. Congress should heed this part of Bernanke’s testimony at least as much as any other part. If a council of combined regulators cannot prevent systemic risk using the wide powers that they already have, it has no chance of stopping it anyway.
Bernanke has proposed the right solution to a thankless task; gather the combined expertise of the various federal financial regulatory agencies in a council. This solution is far more likely to identify systemic threats to the financial system, and equally important, their combined voices are much more likely to get Congress to listen.