ACTION MEMORANDUMTO: Timothy Geithner, Secretary of the Treasury Lawrence Summers, Director, National Economic Council CC: Ben Bernanke, Chairman, U.S. Federal Reserve Board of Governors FROM: Thomas H. Stanton DATE: August 10, 2009 SUBJECT: Creating a Financial System Safety Board
As the dust settles around our fallen financial system, it is increasingly apparent that, with better information and judgment, we might have avoided at least some of the worst aspects of the financial debacle. To borrow a phrase from former Federal Reserve Chairman William McChesney Martin, the Fed and other financial regulators failed in their responsibility “to take away the punch bowl just as the party gets going.” The Obama Administration is certainly aware of the problem. In June, after six months of internal study and debate, it formally proposed a solution that would: (1) increase the supervisory authority of the Federal Reserve over large, complex financial institutions; (2) give authority to the Federal Deposit Insurance Corporation to take over and deal with a broad range of failing financial institutions; (3) create a new Consumer Financial Protection Agency; and (4) create a Financial Services Oversight Council composed of financial regulators to help improve interagency coordination and identify emerging systemic risks. It has been widely and credibly reported that, given the acknowledged political power of vested interests, the Administration crafted its proposed reform package to protect and preserve what it considers the most essential elements. Nonetheless, the chances for effective supervision of the financial system may well diminish further as legislators work their will. New draconian provisions may emerge, such as compensation caps that Congress added to the TARP legislation earlier this year, that play to popular sentiment but do not address the subtleties of truly effective oversight and regulation of the financial system. Those who know how the Capitol Hill sausage factory works also suspect that congressional desire to preserve the ornate committee and subcommittee structure that oversees the U.S. banking and financial industry will further affect the result. In the delicate phrasing of the June 18 Washington Post, the committee chairmen who will shepherd the legislation through—Barney Frank (D-MA) in the House and Christopher Dodd (D-CT) in the Senate—suggested that the President’s proposals “needed to be discussed and modified, and that some were unlikely to survive.” As the political process grinds on, however, one thing at least is certain: No matter which branch of government proposes and which disposes, the search for effective solutions will be complicated by a dynamic I call Stanton’s Law: Risk migrates to the place where government is least equipped to deal with it. Stanton’s Law
Stanton’s Law has been much on display in recent years. Nearly two decades ago, I appeared before the Senate Banking Committee in the wake of the savings and loan debacle. In my testimony, I pointed out that increases in stringency of capital requirements and government supervision for thrift institutions would drive many billions of dollars of mortgages from the portfolios of savings and loan associations to Fannie Mae and Freddie Mac because their capital standards and government oversight were much weaker.1 (That, of course, turned out to be true.) In the lead-up to the current debacle, the capital markets found numerous places where government could not effectively manage risk, not least in the vast “shadow” banking system: Structured investment vehicles of commercial banks, private securitization conduits and collateralized debt obligations went virtually unregulated, except by the vagaries of the rating agencies and exuberance of the market during the housing bubble. Huge volumes of subprime, Alt-A, interest-only and other toxic mortgages went to these parts of the market. Major financial institutions, including Fannie Mae and Freddie Mac, major investment bank holding companies, and commercial banks all figured out ways to reduce their capital requirements through a set of loopholes and preferential laws or regulations. Indeed, they often did so by working in concert with their own regulators or, in the case of Fannie Mae and Freddie Mac, with Congress itself.Enacting laws and regulations is technically cumbersome and invariably time-consuming, especially when powerful institutions have a stake in how those laws and regulations read. By contrast, markets are fluid, so they can arbitrage smoothly across regulatory boundaries and requirements. This means that a combination of regulatory remedies is likely to be more effective than any easily dodged single prescription. For example, besides improving the capacity and expanding the authority of Federal regulators to wind up troubled major institutions, Congress and the Obama Administration should institute improved and more uniform capital and supervisory requirements across multiple types of financial organizations—requirements that would take account of unquantifiable risk, require issuance of debt obligations that convert to equity in the event of insolvency, strengthen consumer and investor protections and bankruptcy provisions, and discourage institutions from shopping for the most lax regulator. The Obama Administration’s proposals would achieve some of these goals, if Congress helps them become law. The Administration could achieve even more, however, by adding another modest proposal, one that would both contribute to effective financial supervision and also take account of political realities: Let’s create a Financial System Safety Board (FSSB), an agency that would be the financial system’s equivalent of the National Transportation Safety Board (NTSB). The FSSB: An Independent Risk Monitor
The NTSB is a uniquely designed organization within the Federal government. Established in 1967, it is composed of five board members, appointed by the President and confirmed by the Senate, with authority to obtain information about transportation accidents, but without authority to compel adoption of its recommendations. It supplements the Federal Aviation Administration (FAA), which is responsible for regulating and supervising airline safety, and other Federal, state and local transportation agencies. The NTSB submits reports to the Secretary of Transportation, who is required to respond in writing within ninety days. It also publishes reports on nationally significant issues of transportation safety. While the Department of Transportation and Congress have resisted making many improvements urged by the NTSB, they also have adopted, or at least been forced to address, many of its recommendations.The NSTB works by dint of its technical competence, high prestige and reputation for truth-telling. Its organizational design relies on a simple idea: The problem of regulatory capture—the process by which regulators come to identify with the goals of the regulated—is less likely to impede an agency that exercises no regulatory authority. Willem Buiter convincingly argues that “cognitive regulatory capture” in government is not a product of corruption in any simple sense, but rather a process by which the regulator or relevant congressional actors internalize “as if by osmosis, the objectives, interests, and perception of reality of the vested interests they are meant to regulate and supervise.”2 How would the FSSB work? Similar to the NTSB, it would obtain information from financial regulators and financial institutions and make recommendations, but not enforce them. The theory here is that, regardless of the form of systemic supervision that Congress ultimately adopts, there must be a Federal oversight body with the mandate, authority and capacity to raise and monitor issues of systemic risk throughout the U.S. and global financial systems, including those related to emerging financial innovations. While a systemic risk monitor might not be able to predict the risk implications of each new development, its capacity to anticipate many of them could be honed over time by its specialized responsibilities.3 The idea of an FSSB based on the NSTB model is different in character from the Administration’s proposed Financial Services Oversight Council, which would also be charged with identifying emerging systemic risks.4 The Council seems at first glance like a good idea until you realize that it will tend to represent the interests of the particular financial regulators and their constituencies. There could be reluctance to explore regulatory shortcomings and propose solutions that might put some or all of them at a disadvantage. Spreading vested interests within an organization can dilute them, but it doesn’t eliminate them. Stanton’s Law, or the tendency for risk to seep through the cracks of any rigid regulatory system, means that we will always need a more independent analytical voice to point out those cracks.5 Even without authority to implement its recommendations, a new independent agency could provide a clear voice as to emerging issues and regulatory actions needed to address them. Had an FSSB been active in recent years, for example, it might have warned us of: the high leverage of investment banks subject to the Consolidated Supervised Entity (CSE) program of the Securities and Exchange Commission (SEC);
the high leverage of Fannie Mae and Freddie Mac compared to other financial institutions serving the residential mortgage market;
the flawed standards of credit rating agencies in assigning credit ratings to mortgage securities;
the failure of regulators to deal in time with risky mortgages like “option adjustable-rate” mortgages, which allowed numerous homebuyers to assume mortgages they couldn’t afford;
and the potential problems of trying to apply loss mitigation to delinquent mortgages that had been securitized in private-label securities.
From this list alone one can see the potential limitations of the Administration’s Financial Services Oversight Council: The council would be less likely to investigate topics that would affect particular regulators sitting on the council. It would still be susceptible to cognitive regulatory capture. Avoiding this problem defined the logic of earlier proposals to create functional regulators, each with authority over a broad range of institutions and institutional types. The Administration chose instead to preserve most of today’s specialized regulatory fiefdoms. The FSSB, a systemic risk monitor, would restore the key virtue of the earlier proposals. It would possess authority to review the gamut of financial institutions, much as the National Transportation Safety Board monitors safety issues and makes recommendations concerning air, sea, road and rail transportation. The broad scope of the FSSB’s responsibilities would both reduce the chance of regulatory capture and address the dynamic of Stanton’s Law by requiring the monitor to follow risk wherever it may shift within the financial system. Operating as a systemic risk monitor, the FSSB could require other government agencies to produce information in a timely fashion. At other times, it would assist financial regulators by recommending improvements in their statutory authority, capacity or mandate. Without having to worry about enforcing its recommendations, it would be in a position to tell politically unpalatable truths to those in power. It could not intervene to correct the weaknesses it discovers, but the relevant Federal regulatory agencies would be required to respond to the FSSB’s reports promptly in writing, just as the Secretary of Transportation must respond to the NTSB. The FSSB should also be authorized to publish data relating to its systemic risk mission.6 It should analyze information and periodically report to the President, Congress, the relevant government regulatory agencies and the general public on areas of systemic risk and supervisory vulnerability. With the current financial debacle fresh in the public mind, the FSSB’s reports would likely find an attentive and extensive audience. One way to set up a Financial System Safety Board would be to follow the NTSB model—that is, create an independent agency run by a board of Federal officials who are appointed by the President (and confirmed by the Senate) for five-year terms, with a chairman approved for a two-year term, and with a stipulation that no more than three of the five officials be from any one political party. Creating the FSSB as an independent agency, free of other responsibilities, can help the agency to preserve its voice. There are at least two cases on record where the Treasury Department reportedly acceded to pressure to make its reported views more congenial to Fannie Mae and Freddie Mac.7 Treasury is a very powerful Federal department. One would have expected that it could express unfettered opinions about the safety and soundness of the financial system. Its inability to do so shows why we need new safeguards to ensure the ability of at least one monitor of the financial system to speak plainly about matters that affect powerful organizations in both government and the private sector. Organizing the FSSB as an independent agency rather than as part of a cabinet department would be one such safeguard. Another would be to subject the new agency to the authority and protection of a powerful congressional committee like the House Ways and Means Committee. Unlike authorizing committees, which potentially have more parochial interests, the Ways and Means Committee is responsible for both taxation and the public debt.8 In the aftermath of the savings and loan debacle, the House Ways and Means Committee was the key body driving reform of the regulatory structure of government-sponsored enterprises. It also helped to protect the integrity of the work of a small Federal agency, the Administrative Conference of the United States, when it sought to develop careful policy proposals as to the most appropriate form of safety-and-soundness regulation for Fannie Mae and Freddie Mac and other government-sponsored enterprises. In any event, the FSSB must be independent of the appropriations process so that it cannot be pressured in that way—a tactic that Fannie Mae and Freddie Mac were especially accomplished in employing. Policymakers may fear giving such independence to a new Federal agency. That fear should be allayed by the fact that the FSSB would have the authority only to issue reports and make recommendations, not implement them. We need to create and protect sources of high-quality feedback to policymakers about the state of our financial system. The systemic risk monitor represented by the FSSB could provide expert, accurate and disinterested guidance on risks posed by major financial institutions and the most appropriate ways to address them. With the protections suggested here, the new agency might be able to warn about systemic weaknesses in advance of a crisis. Then it will be up to policymakers to take heed and remove the punch bowl in time.
1See Senate Banking Committee hearing on The Safety and Soundness of Government-Sponsored Enterprises, October 31, 1989, p. 41.
2Willem H. Buiter, “Lessons from the North Atlantic Financial Crisis”, prepared for the conference The Role of Money Markets, Columbia Business School and the Federal Reserve Bank of New York, May 29–30, 2008.
3Just before press time, I learned that MIT professor Andrew Lo proposed a similar idea in November with a slightly different focus. See Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008”, testimony presented to the Committee on Government Reform and Oversight, U.S. House of Representatives, November 13, 2008. Lo emphasized the new agency’s role in investigating financial failures and deriving larger lessons for the financial system. My proposal focuses more directly on systemic risk. Banks and other institutions often fail for reasons unrelated to systemic issues, and these failures are properly the province of relevant government regulators. The new agency should concern itself with problems, such as the size and complexity of financial institutions and their linkages to the larger financial system, that could rise to the level of a systemic threat. For a useful distinction between the two sets of issues, see Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin, The Fundamental Principles of Financial Regulation: Geneva Reports on the World Economy 11, Preliminary Conference Draft (Center for Economic Policy Research, January 2009).
4Department of the Treasury, Financial Regulatory Reform: A New Foundation, June 17, 2009, p. 3.
5Aficionados of organizational design may want to consider structural parallels between the Financial
Services Oversight Council and the Joint Chiefs of Staff (JCS) before enactment of the Goldwater-Nichols Act in 1986. The JCS, too, was a political compromise reflecting the power of divergent government departments and agencies. Only with enactment of Goldwater-Nichols, decades after the JCS was created, did the JCS gain much of the independence it needed. See Amy Zegart, Flawed by Design: The Evolution of the CIA, JCS, and NSC (Stanford University Press, 1999).
6In this function the systemic risk monitor could resemble the idea of a National Institute of Finance that some have recommended. See Allen I. Mendelowitz and John C. Leichty, “Financial Regulators Need Better Data”, American Banker, March 25, 2009.
7On the weakening of a 1996 Treasury report on the desirability and feasibility of removing government sponsorship from Fannie Mae and Freddie Mac, see Jackie Calmes, “Federal Mortgage Firm Is Facing New Assault to Privileged Status: But Fannie Has Clout to Counter the Agencies that Seek to Privatize It”, Wall Street Journal, May 14, 1986; and Subcommittee on Capital Markets, Securities, and Government-Sponsored Enterprises, Committee on Banking and Financial Services, U.S. House of Representatives, “Oversight of the Federal National Mortgage Association [Fannie Mae] and the Federal Home Loan Mortgage Corporation [Freddie Mac]”, July 24, 1996, pp. 136–41 (comments of Chairman Richard Baker). For discussion of possible pressure in 1991 on the Treasury Department to state that HUD would be an appropriate regulator of Fannie Mae and Freddie Mac, see Thomas H. Stanton, “Increasing the Accountability of Government-Sponsored Enterprises: Next Steps”, Public Administration Review (November/December 1991) and articles cited.
8Similarly, the House Ways and Means Committee successfully asserted jurisdiction over government-sponsored enterprise matters as a part of its public debt responsibilities. See, for example, Title XIII of the Revenue Act of 1992, Conference Report, 102 session, Report 102-1084, October 5, 1992, pp. 669–71. That act passed both houses of Congress and then was vetoed at the end of the session.