Ben and his Avatar

I can’t help noting the coincidence of Bernanke’s nomination as both “Man of the Year” and “The Definition of Moral Hazard” in the same week as the release of Avatar… And while Ben has probably settled on which “body” he belongs to, representatives of the voting public have yet to make up their mind.

The recent Senate Banking Committee hearing on his reappointment is evidence of Congress’ dilemma: While his re-election as Fed Chairman is coming closer to materializing in recognition of his multibillion dollar rescue(/bailout) of the entire economy, Congress has doubts about the Fed’s future role as financial regulator and supervisor.

In fact, under the current draft financial regulatory reform bill, financial supervision and regulation responsibilities (including those of the Fed) would be consolidated under a single federal bank regulator (other than the Fed).

Given the obvious turf issues, Ben is already fighting back, using every occasion to make the case for maintaining and indeed enhancing the Fed’s supervisory authority. But turf matters aside, the proposed reform may be actually doing the Fed a favor.

The starting point here is that international experience does not offer paradigms of an “optimal” institutional structure for financial supervision and regulation. For example, countries with very different institutional frameworks (e.g. the UK, the eurozone or Japan) have all experienced a major financial crisis recently or in the past.

Then, the case for assigning the roles of both monetary policy and financial supervision/regulation to one and the same institution (the central bank) has to be made at a conceptual level, based on arguments of efficiency and effectiveness:

1) Does the Fed have a comparative advantage in supervising financial institutions? 2) Does the Fed’s role as banking supervisor help inform monetary policy and make the latter more effective? 3) Is the mandate of banking supervision critical for the Fed’s effective execution of its non-monetary policy roles, notably its role as a lender of last resort (LoLR)?

So let’s take these one by one. The weakest argument in support of the Fed as banking supervisor is, in my view, that the Fed has a comparative advantage in fulfilling that role. At the Senate Banking Committee hearing, Bernanke argued that Fed staff have “unparalleled expertise”, being trained economists with a deep grasp of monetary issues. In his view, these skills would become even more valuable as banking supervision expands to include a macro-prudential/systemic perspective.

Sorry Ben, but we don’t buy that. To start with, the Fed staff’s “unparalleled expertise” failed abysmally to grasp the scale of banks’ problems at both the micro and macro level, not just before but also well into the crisis. Aside from that, the “right expertise” can always be hired by the institution that needs it. It’s no sexier for a bank supervision expert, or a macroeconomist for that matter, to work for the Fed than for another institution, if the latter is the one with the lead authority in his/her area of expertise.

A stronger argument is that the Fed’s role as banking supervisor can help inform its monetary policy decisions and make the latter more effective. Existing academic literature is inconclusive on this topic, though I personally think that current research efforts (exploring the links between monetary policy and the behavior of financial institutions) will provide more solid support. Nonetheless, the argument is made controversial by the Fed’s own practice and by Bernanke’s view that the best tool to address “excessive” risk taking in the financial sector is not monetary policy.

Re. the former, Ben admitted at the hearing that “in normal times”, FOMC meetings (on monetary policy) spend very little time, if any, on the state of the financial sector. Of course we all know now (with the benefit of hindsight) that what the FOMC viewed as “normal times” were not normal at all.

Aside from that, this de facto separation of monetary policy decisions from financial stability issues is revealing of the Chairman’s intellectual belief (which he has stated time and again) that financial sector “excesses” should be addressed by appropriate regulation instead of interest rate policy. If Ben insists on that view, the case for uniting the authority for monetary policy and banking supervision/regulation under the Fed is pretty tenuous, at least on the grounds of making monetary policy more effective.

Bernanke’s strongest case in support of the Fed’s role as supervisor is based on the critical role it can play (not in preventing but) in managing financial crises—i.e. once they happen! The argument has a number of dimensions including, inter alia:

First, when a financial institution is under distress, the Fed can benefit immensely by its own in-house supervisors, who can assess the state of the institution, evaluate its collateral against which it might lend to it (under its LoLR function) and, thus, protect the taxpayer.

Second, the Fed’s role as banking supervisor, in conjunction with its mandate as overseer of the payments system, is critical for allowing it to understand the systemic implications of the distress in an individual institution, and therefore assess the tradeoffs between providing support to a failing institution or letting it fail.

These arguments have merit but do not necessarily make the Fed’s supervisory role absolutely essential. For example, provided that there are officially-established communication links between the Fed and the supervisory agency, the Fed would have access to all the information it needs to assess the situation. Indeed, the distressed institution itself would cooperate in the provision of information, as it happened when Bear Stearns went under.

But what is more important here is to weigh the benefits of the Fed having its own people managing the nitty-gritty details of a bailout with the political costs (to the Fed) associated with that role. The backlash from (what was inevitably seen as) the Fed’s gross failure to protect the taxpayer in the AIG bailout (legal excuses notwithstanding) highlights the political risks of too direct an involvement by the Fed with decisions that ultimately belong to the fiscal authority.

In my view, this political risk is a cost sufficiently large to tilt the balance against granting the Fed the lead role as financial supervisor, notwithstanding the benefits mentioned above. Mistakes, or actions perceived as inequitable and unfair, will always be made, especially in a crisis situation, so an arm’s length involvement by the Fed can actually help safeguard its monetary policy independence—an independence that should remain sacrosanct.

As a result of the bailout mess, the Fed has now found itself engaged in a PR exercise to defend not only the details of its bailout actions but also the rationale and soundness of its monetary policy decisions. It’s still unclear whether it’s winning. But, maybe a cleaner way to go is to avoid altogether the public’s confusion between “Ben: Man of the year” and his “Moral Hazard” avatar.

Originally published at Models & Agents and reproduced here with the author’s permission.