The Agency for Financial Stability

Aswath Damodaran on The Agency for Financial Stability? A Good Idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
http://online.wsj.com/article/SB125786789140341325.html
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed

There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk

The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.