Federal Reserve Governor Kevin Warsh has recently delivered a masterfully rhetorical speech to support the Fed’s public case to keep and expand its regulatory powers over the financial sector as if doing so is a lessons-learned logical extension to the recent interventions by the Fed. He very cleverly weaves, as if a quilt, striking the right notes on principle while couching the Fed’s case in it by implication. Because the Fed’s case is non-sequitur with the principle he is so well articulating, it is necessary to reweave it.
The canvas of his speech is Ronald Reagan. The Fed governor acknowledges that regulations need repair. If Reagan was correct on regulation, then why do we need the repair? After all, it is Ronald Reagan’s regulatory ethos that has caused the current crisis in many ways because it has mutated into an ideology in Washington, even during the presidency of Bill Clinton. The Reagan recovery can be attributed more to defense spending and the tax overhaul than to deregulation whose positives and negatives cancel out when the crises are factored in, from savings and loan to junk bonds and all else that followed to today.
The unjustifiable purpose of the Volcker Rule to return to the pre-Gramm-Leach-Bliley (GLB) days has been motivated because GLB happened under the watch and encouragement of the Democrats in Washington. And now the chastened Democrats, once again in power, want to move left to rediscover their roots. What had not happened was the expansion of the reach of financial regulation to catch up with the new architecture of finance that had resulted from the GLB deregulation. Therefore, a new financial architecture is not necessary, but a new regulatory architecture is. Meaning, the issue is not the repair of regulation (its lax implementation does not mean it was inadequate), but its new construction. This is the problem at hand.
In the construction of consolidating and streamlining existing regulations with new regulations, the what is just as important as the who. The discounting of the who on the basis of the need for international coordination is not material to the discussion of reforming financial regulations in the United States. The U.S economy is large enough to lead the world independently. International implications, policy coordination being premature, of U.S reforms would fall in the domain of multilateral institutions. To reform financial regulations, the United States must understand the problem from its perspective, while being cognizant of its implications abroad, because doing so will suffice for its geopolitical context in contrast to, for example, the context of the United Kingdom or the multitude of separate countries that make up the European Union.
The complementarity of market discipline and regulatory discipline is the burden of regulatory discipline. Private participants cannot be expected to be enlightened in the pursuit of their self-interest. The government is obligated to. Therefore, the execution of regulatory discipline is intricately tied to the institutional structure of government in a democracy of checks and balances: the regulator cannot also be the lender of last resort if moral hazard is to be mitigated.
Small is not necessarily more dynamic and big is not necessarily more inertial. Elephants can dance, and elephants are not big in a world that is large enough for elephants and dinosaurs to coexist. As much as the Fed governor’s sentiment that creative destruction ought to be supported in the marketplace, such was not the case during the recent crisis. The creative destruction was engineered and the government picked the winners and losers. If political circumstances for the losers were different, they could just as well have been the winners.
All government resolution mechanisms are by nature normatively engineered, but the issue is if the financial institutions have been treated fairly in the resolution process. Certainly the expedited resolution of Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup and AIG, for example, even if one were to give the benefit of the doubt to the government given the nature of the crisis, reveals the underlying faults in the regulatory structure which can lead to arbitrages among competing firms in the market to skew the resolution process in favor of some and not in favor of the others. Therefore, it becomes necessary to insulate firms, both large and small, from each other as a first resort before any resolution by the government becomes necessary as a last resort. Financial institutions must be required to maintain minimum capital cushions, determined progressively on a revenue basis, with the government, in lieu of the Basel framework which is more lenient to the large firms.
What the government chooses to regulate and how it regulates can sometimes be overlapping choices. For example, fiscal policy can regulate through incentives the choices the financial institutions make to structure their assets on the balance sheets without necessarily directing the specific operational aspects of their business conduct, besides of course ensuring that there is no collusion or fraud taking place. For example, the government can and sometimes must indeed regulate through the tax structure the availability of credit for targeted purposes and interest groups. It is up to the financial institutions to decide if they wish to take advantage of it or not.
It may also become necessary to invoke the extraordinary provisions of the Federal Reserve Act (FRA) through the resolution process and the last resort lender function to complement such fiscal policies to guide where firms ought to invest without necessarily forcing them to invest. Still, it is the choice of the financial institutions in duress to decide whether to be resolved subject to the conditionality of the government’s resolution processes. If, for example, the Fed could do this with its recent Term Asset-Backed Securities Loan Facility (TALF) it can also do the same with the discount window to create sufficient demand for both loans as well as securities. This can guard against any potential misallocation of excess reserves leading to inflation should the Fed decide to stop paying interest on them.
A house would be a farce if each room is a standalone and so it is with financial holding companies. What is important is to know where to place the walls without separating the room from the house, unless some financial market activities are being intended for the dog house. Architectures, by definition, are frameworks. And economic frameworks are incentive structures by design. The purpose of the rules which make up the trusses and beams of the frameworks is to ensure the structural integrity of the system.
Even if there is only one very large bank monopoly in the United States, it is not too big to fail as long as the rules make sense.