NEW YORK – The financial world is too complex for “siloed regulators” to monitor all that goes on, and the recent financial crisis is proof that systemic oversight is needed, Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley said today.
“In my opinion, this crisis demonstrated that a systemic risk oversight framework is needed to foster financial stability,” Dudley told the Partnership for New York City, according to prepared text of the speech, which was released by the Fed. “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.”
To oversee such a complex system, Dudley suggested evaluating the financial system in its entirety since “developments in one area can often have devastating consequences elsewhere.” Continuously evaluation of large systemically important financial institutions, payments and settlement systems and the capital markets, are essential, with connections understood and monitored on a real-time basis.
To be effective, systemic overseers must have a broad range of expertise, and Dudley suggested the Federal Reserve have an essential role, since it has experience and expertise in all three areas: overseeing the largest U.S. financial institutions; operating a major payments system and supervising others; and operating in the capital markets 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,” Dudley said.
Turning to the economy, Dudley said the financial markets have stabilized, and the financial system no longer seems like it could collapse, and a second Great Depression “now seems extremely remote.”
However, credit remains tight, especially for small businesses and households. While the economy grows, 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.”
While calling the Fed’s actions “extraordinary,” Dudley noted, “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.”
The gaps, he said, include “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.”
Calling the regulatory system “obsolete,” Dudley explained it was not prepared to regulate “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.”
Regulators, including the Fed, he said, did not appreciate the importance of some of these changes. “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,” he said.
“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,” he said.
While these gaps existed for years, it wasn’t until they broke down that their consequences became apparent. Stresses 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,” he added. Likewise, regulators lacked tools to deal with these deficiencies.
Dudley also called for “a large-firm resolution process that would allow for the orderly failure even of a systemically important institution.”
Assailing Congressional efforts to take power away from the Fed, Dudley said, giving regulatory power the different agencies “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.’"
He added, “The information [the Fed] collect[s] 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.”
Involvement in supervision provides the Fed critical data for its 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,” he said.
The Fed did not supervise Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and the GSEs, so when those institutions had problems “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,” Dudley noted. “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.”
Concluding, Dudley said, “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.”
