NEW YORK – Preaching patience, Federal Reserve Bank of Philadelphia President and CEO Charles I. Plosser warned that while the economy is recovering many challenges lie ahead, the nation should not rush to make changes to prevent future crises.
“The race to reform will not serve the nation well if haste makes for faulty or misguided policies,” Plosser said at the Philadelphia Fed Policy Forum today, according to prepared text of his speech. He said policymakers need to “lower the odds of a future crisis while ensuring that we are better prepared to handle one when it arises.”
Not all the facts about the recent crisis have been collected, Plosser said, adding, “I believe that it is too soon to say with any confidence that we fully understand the current crisis. We are still in the learning phase, positing a wide range of hypotheses about the role of market failures as well as regulatory failures, and formulating some rough estimates of the relative weights to place on various contributing factors. I think it will take more forums like this one and more careful and dispassionate analysis before we fully understand what happened and why.”
Therefore, Plosser urged moving “deliberately in designing major regulatory reforms, certainly more deliberately than the current legislative calendar suggests. Making major policy reform based on anecdotes and narratives that have not yet met the test of more rigorous analysis is misguided. Rushing major policy reforms in the immediate aftermath of a crisis risks adopting policies that have unintended consequences.”
Realism is needed about what reform can achieve. “We should not assume that regulators have some crystal ball and thus can see the future with more clarity than market participants,” Plosser said. “We also should not assume that markets will stand still, nor should we want them to.”
Plosser said he learned two major lessons from the crisis, but acknowledged that other people may have learned other lessons. “The first lesson I would like to highlight is that moral hazard and the too-big-to-fail problem loom large and have contributed to the crisis in fundamental ways. If reforms do not adequately address these problems, then reform efforts will be a failure. The second lesson is that regulators are not perfect, and using regulations that excessively stifle the markets will also fail, because private interests will always seek to escape regulation. Thus, for reform to improve financial stability, it must rely heavily on making market discipline more effective and not simply rely on government rules and regulations.”
Too big to fail, he noted, showed “how easy it is for discretionary policy choices to exacerbate moral hazard and the problem of firms deemed too big to fail. In my view, policy actions — before and during this crisis — vastly expanded the safety net for financial institutions.”
Plosser added that government-sponsored enterprises — and Fannie Mae and Freddie Mac, in particular — “were rife with long-standing moral hazard problems.” These entities operated “for private profit but with essentially a government debt guarantee.”
“Unfortunately, rather than limiting moral hazard and the too-big-to-fail problem, we have made them worse during the crisis,” Plosser said. “In trying to stabilize the financial system, we have led creditors of large financial institutions to expect that the government will protect them from losses, which in turn means they need not monitor risk-taking by these firms.”
The policy responses to too big to fail “from the rescue of Bear Stearns, to the failure of Lehman, and to the bailout of AIG, have aggravated the too-big-to fail problem,” Plosser said.
“In the case of these nonbank financial institutions, we faced added challenges because we were extremely limited in our ability to permit failure in an orderly manner,” he added. “The lack of an acceptable mechanism to fail these large interconnected financial firms clearly put policymakers between a rock and a hard place — either run the risk of creating potentially large, unknown risks to financial and macroeconomic stability or take the unpalatable step of increasing moral hazard. The Fed chose the latter, but we must now face the consequences of these actions and develop a better regime to rein in the moral hazard created. Doing so requires that policymakers articulate a transparent, consistent, and predictable policy regarding bailouts, and, perhaps a more difficult task, policymakers must commit to follow the policy. Indeed, the regulatory regime must be designed with built-in commitment mechanisms that make it difficult for policymakers not to implement the policy. Failing to develop such a new regime will risk sowing the seeds for the next crisis and ever more frequent, and perhaps costly, taxpayer bailouts.”
A policy must be developed that allows a safe failure of large and interconnected financial firms, he said.
“As I said, no firm should be too big to fail. A resolution mechanism would encourage greater market discipline on the decisions made by systemically important firms,” Plosser said. “But we need to think carefully about the various options for resolution. If Congress merely expands the safety net by enlarging the list of firms that have access to government resources or increases the opportunities for the government to take over firms, we will have failed to solve the problem. In my mind, a resolution mechanism is a bankruptcy mechanism. That is, shareholders are wiped out, unsecured creditors face losses, and the firm is either liquidated or sold to other private parties rather than becoming a ward of the state.”
He suggested changing “bankruptcy law to take into account the special needs of financial institutions, or to create a specialized bankruptcy court to handle financial firms. This might be a more credible way of permitting systemically important financial firms to fail than current proposals to create an expanded resolution authority on the model of the FDIC’s existing authority to operate bridge banks. Of course, this type of solution also raises questions. How will bank regulators interact with the court? How will the court maintain its expertise, given that financial crises are infrequent? Who assigns firms to this special court?”
The recent crisis also taught that passage from well-capitalized to undercapitalized “can happen in a heartbeat — making the prompt in prompt corrective action difficult to achieve. So, regulatory reform must enhance market discipline and regulators’ use of market signals to guide interventions.”
Plosser said he believes the crisis showed “regulations did too little to promote market discipline and in some cases actually discouraged market discipline.”
