Saturday, March 13, 2010

Who wants to be the next systemic risk regulator?

Systemic Risk Oversight

It is amusing to think that people in Washington are fighting over who should be responsible for systemic risk oversight. Talk about a thankless task. Nothing could better demonstrate just how power hungry people get when they inhale the DC air.

Think about it for a minute. Let’s say excessive risk is being created by too much leverage. Can the systemic risk regulator really rein it in? Keep in mind the government can and has raised its debt ceiling whenever it has a mind to spend money it doesn’t have. Aside from the potentially expansionary impact of the debt, what if sovereign risk is the most pressing risk? Can the systemic risk regulator stop it? No.

One doesn’t even have to go that far. Again, sticking with the risk of over-leverage, all that is needed is for someone to exempt a few organizations from the systemic risk regulator’s control: say, Fannie and Freddie or the FHLBs. It is easy to see how this could develop into a situation where the systemic risk regulator can’t control total leverage. At best, the regulator can only influence the form of the risk, (i.e., what assets are used as collateral). However, even that influence is limited. Credit, like money, is fungible. Credit secured by a house can be used as a substitute for other credit. It could be used to buy an SUV, a big flat screen, a night on the town, or whatever. It could also be used to buy income-producing assets. Money will go where it wants to go.

Similarly, on the flip side, lending is fungible. There was a time when regardless of who was lending, the funds came through a bank or from an individual lender. People with money then realized that they could cut out the middle man and lend the funds themselves. Borrowers found it annoying to have to depend on bankers who may or may not like the cut of the borrower’s jib. So, they were glad to cut the banker out of the action.

With securitization almost any form of loan is available to any lenders and any borrower. The systemic regulator can at best exert influence on the intermediaries (i.e., the channels). Controlling the amount of leverage in the channels will help, but it is na├»ve to think borrowers and lenders won’t look for or invent alternative channels. No regulator can cover all channels. Sub-prime mortgages are a good example. In this instance the market disappeared, but the government stepped in with FHA to replace it.

The example above involved excessive leverage. If the risk is too little leverage, potential responses are even more constrained. Economist talk about “pushing on a straw,” liquidity traps, aggregate demand, etc. Much of the literature focuses on the issue. It is so pervasive in the discipline that even with negative savings rates and large and growing debts, there are invariably a raft of economists that see too little leverage. So, let it suffice to point out two none-technical constraints. First, it is hard to force people to lend or borrow if they don’t want to. Second, even if they can be forced into borrowing and lending, the total amount of capital available presents a constraint.

Keep in mind the question in the title involves the NEXT systemic risk regulator. We already have one: the Federal Reserve System. As argued above, controlling systemic risk is only possible on a good day, and we just had a string of bad days. So, the Fed has only two options. Either it can argue that it just needs a little more authority which is probably true, or it can argue that it has an impossible task and should be phased out which is clearly not true on a good day. Since requesting more power is the DC default and there will never be enough centralized power to eliminate systemic risk, more power to the Fed follows.

But here’s the rub. The closer any institution gets to being able to control systemic risk, the closer it gets to really constraining government options. Everyone in government wants to run the show. From a populist perspective, a systemic risk regulator could constrain the populist’s ability to act in ways that create systemic risk. “Power to the people!” Let us be free to mortgage our future. We’re good at it. Keep it out of the hands of anyone who might actually do it.

Someone will be given systemic oversight. Despite the limitation, net-net, it makes sense. On a good day it will help. Besides, we will need a fall guy the next time systemic risk shows its ugly face.


  1. Well thought out post, but I'm not sure how much I believe in the concept of a systematic risk regulator. I do know though that a ton of it is rhetoric. Saying something like, "We could have stopped the crisis if only we had the authority to... yada yada yada," is just too tempting.

  2. Your point is well taken. The limitations on what can realistically be expected of a systemic risk regulator will be the subject of my post on Monday or Tuesday. I apologize for not responding here, but the issue you raise is sufficiently important that I already planned a post on the topic. I plan to address it from two perspectives: would it have helped with recent experience and how likely is it to help in the future.

    You’re right about two things: the Washington default is always “we just need more authority”, and with hindsight people can always create a scenario where they would have saved the world if given the chance.