Kansas City Fed President Urges Caution in Federal Reserve Board Being Financial Stability Regulator of Investment Banks

As the debate intensifies over the Federal Reserve Board’s role as financial stability regulator with enhanced power over investment banks, Kansas City Fed President Thomas Hoenig raised some caution flags to the Fed assuming such a role. Noting that the Fed enters uncharted waters as a financial stability regulator, he said that such a role would raise a host of difficult decisions during a crisis and potentially put the Fed in the uncomfortable position of having to pick winners and losers from a broad range of financial institutions and investors.

Moreover, the Bear Stearns experience shows that these decisions would have to be made in a hurry and with limited information. He advised the Board to carefully weigh the consequences of being a market stability regulator before embarking on a course of action outside its mandate of price stability. At the same time, the regional CEO recognizes that the importance of financial stability and addressing systemic risks justifies the federal safety net and the need for prudential supervision. The question is how far the framework of financial stability should be extended.

The senior official’s remarks came against the backdrop of recent congressional testimony of Fed Chair Ben Bernanke Citing the Bear Stearns experience, Federal Reserve Board Chair Ben Bernanke asked Congress to adopt a regulatory macro-prudential regime capable of dealing with systemic risk to the financial markets. In remarks at the Fed’s annual economic symposium, he also asked Congress to give the Treasury the duty and resources to intervene in cases in which an impending default by a major investment firm is judged to carry significant systemic risks.

The regional Fed CEO cautioned that providing assistance to market participants who have made unwise decisions risks magnifies the moral hazard problem in financial markets. The most prominent example of the moral hazard problem is the too big to fail doctrine, which the official described as a ``very intractable issue’’ of regulators. In his view, individual financial institutions must be permitted to fail if the Fed is to find the proper balance between financial stability and market stability.

If the Fed extends a safety net and bank-like supervision to investment banks and an ever larger class of ``too big to fail institutions, he warned, it could destabilize the financial system. More broadly, assuming the role of market stability regulator would force the Fed to make difficult decisions on what segments of the financial system would be regulated and how extensive such regulation should be.

If the Fed holds back from overseeing market stability, he continued, the Board must direct more focus on the market interdependencies among commercial banks and institute better mechanisms to unwind failing investment banks and non-bank financial institutions and their counterparty exposures. Further, the Fed should work with the private sector to increase transparency, enhance corporate governance, and strengthen settlement systems and the securitization markets. And it must be made clear that any investment bank seeking discount window assistance will immediately come under Fed oversight directed at ascertaining the firm’s viability and exposures.

The regional officer then posed a series of questions involving what the Fed’s role as market stability regulator would entail. He asked if principles can be defined to guide the Fed’s mandate for financial stability, such as when it should act and when it should refrain from acting. A more basic question is whether the Fed has the ability and the policy tools to pursue financial stability along with its more established mandates. There is also the question of how the Fed would deal with potentially conflicting objectives under its different mandates. Similarly, the official wonders how a central bank can implement a financial stability mandate while maintaining the independence needed to pursue its other mandates. There could be difficult trade-off decisions between price stability and market stability.