The Federal Reserve: A Study in Soft Constraints

In response to the greatest financial crisis since the Great Depression, the Federal Reserve (the Fed) took a number of unprecedented steps to try to minimize the adverse economic consequences that would follow. From providing liquidity injections to save companies like Bear Stearns and American International Group (AIG) to committing to a prolonged period of exceptionally low interest rates and buying massive quantities of longer-term securities to further reduce borrowing costs, the Fed\u27s response to the 2007 through 2009 financial crisis (the Crisis) has been creative and aggressive. These actions demonstrated that the Fed is uniquely powerful among federal agencies, and its authority is even greater than most had previously appreciated. They also made clear that the Fed\u27s actions can have significant distributional consequences, in addition to affecting the health of the overall economy. These developments have led many to suggest that the Fed should be far more accountable, or less powerful, than it currently is. Attacks on the Fed\u27s power are not new. Vesting so much power in the hands of an unelected few inevitably raises questions about legitimacy, for which there are no easy answers. Using traditional mechanisms to make the Fed more politically accountable could substantially impede the Fed\u27s capacity to achieve the aims assigned to it. Yet, as reflected in the demise of the First and Second Banks of the United States, ignoring these concerns can prove even more detrimental. In the United States, the outer limits of independence are delineated by the Constitution, but important questions regarding legitimacy and accountability arise far shy of the Constitution\u27s outer bounds. Many of these issues are not specific to the Fed, and there is a robust body of literature examining these dynamics. Nonetheless, this article suggests that many of the forces that influence the degree of independence that the Fed enjoys in practice are largely overlooked in much of this literature. Those overlooked forces are soft constraints, a range of forces that are not legally binding and that can even be a little fuzzy in application, but that nonetheless impose meaningful limits on how the Fed exercises its seemingly vast authority. This article illustrates the power of soft constraints by examining the role that two particular soft constraints – principled norms and the Fed Chair\u27s concern with her reputation – have played in shaping Fed action over the last hundred years

The Importance of Money

What types of financial instruments get treated as “money”? What are the implications for financial regulation? These two questions animate The Money Problem: Rethinking Financial Regulation by Morgan Ricks and my review of his thought-provoking new book. The backbone of The Money Problem is a reform agenda that aims to give the government complete control over the creation of money equivalents. According to Ricks, the government should insure all bank deposits, no matter how large, and prohibit any other entity from issuing short-term debt. I question the efficacy, benefits, and costs of the proposed reforms. Both theory and history suggest that so expanding the government’s formal safety would engender massive moral hazard while likely failing to achieve the purported aim of “panic-proofing” the financial system. I also worry about the foregone credit creation and other costs of eliminating money market mutual funds, sale and repurchase agreements (repos), commercial paper, and other arrangements that are pervasive today and would be outlawed under the proposed reforms. Nonetheless, The Money Problem could – and should – transform the ongoing debate about how best to promote financial stability. Ricks’s core insight is that financial crises routinely emanate from changes in the types of instruments that market participants are willing to treat like money. The range of instruments accorded that status expands during periods of financial stability and contracts rapidly when the boom turns to bust, magnifying the adverse consequences of that change. His claim that government guarantees are the most effective way to staunch runs in the face of such a change is also persuasive. Combining these insights with a heightened appreciation of the inevitable dynamism of financial markets lays the groundwork for a different set of reforms. I argue that the government should be prepared to act as an “insurer-of-last-resort” to stem the spread of a budding financial crisis. This type of support, however, should be reserved for periods of systemic distress. More broadly, history suggests that the rise of private money, as embodied in the growth of shadow banking before the recent crisis, is endemic to finance. Rather than fooling ourselves into believing that a broad ex ante regime can eliminate private money creation, we should recognize its development as inevitable and devise a regime that is capable of responding as markets evolve

If It Ain\u27t Broke, Don\u27t Fix It

A prescription is only as good as the diagnosis on which it is based. This is just as true in finance as it is in medicine. And, in Hal Scott\u27s assessment, the reforms adopted in the wake of the 2007-09 financial crisis ( Crisis ) are based on a fundamental misunderstanding of the reasons for that crisis. The future is accordingly bleak

Fragmentation Nodes: A Study in Financial Innovation, Complexity, and Systemic Risk

This Article resents a case study in how complexity arising from the evolution and proliferation of a financial innovation can increase systemic risk. The subject of the case study is the securitization of home loans, an innovation which played a critical and still not fully understood role in the 2007-2009 financial crisis. The Article introduces the term fragmentation node for these transaction structures, and it shows how specific sources of complexity inherent in fragmentation nodes limited transparency and flexibility in ways that undermined the stability of the financial system. In addition to shedding new light on the processes through which financial innovations become so complex and how that complexity contributes to new sources of systemic risk, the Article considers the tools regulators will need to tackle these sources of systemic risk. The policy analysis shows that disclosure, a tool commonly used in financial regulation, will not suffice. At times, regulators should target these new sources of systemic risk directly by seeking to reduce the length and complexity of the chain connecting investor and investment. The Article suggests some modest steps regulators could have taken prior to the 2007-2009 financial crisis, such as a transaction tax targeting serial fragmentation nodes, to illustrate how such reforms might work in practice. It also explains why the dynamics revealed in this case study are almost certain to arise again, even if in slightly different form

Interbank Discipline

As banking has evolved over the last three decades, banks have become increasingly interconnected. This Article draws attention to an effect of this development that has important policy ramifications yet remains largely unexamined – a dramatic rise in interbank discipline. The Article demonstrates that today\u27s large, complex banks have financial incentives to monitor risk taking at other banks, They also have the infrastructure, competence, and information required to be fairly effective monitors and mechanisms through which they can respond when a bank changes its risk profile. Interbank discipline thus affects bank risk taking, discouraging banks from taking some types of risk while potentially encouraging the assumption of others. Given its influence, ignoring the phenomenon can lead to inefficiencies and gaps in bank regulation. The rise of interbank discipline has positive and negative ramifications from a social welfare perspective. \u27The good news is that self-interested banks may be expected to penalize a bank when it takes excessive risks, thereby deterring such risk taking. he bad news is that the interests of banks and society are not always so well aligned. Other banks, for example, may be expected to reward a bank when it changes its risk profile in a way that increases the probability that the government would bail the bank out rather than allowing it to fail. This is because a bailout protects a bank\u27s counterparties and other creditors, even though socially costly. Interbank discipline ma thus encourage barks to alter their activities in ways that increase systemic fragility. In drawing attention to the powerful yet mixed effects of interbank discipline on bank activity, this Article contributes to a new generation of scholarship on market discipline. Its aim is not to question whether we need regulation, but to address the pressing issue of how we should allocate inherently finite regulatory resources. By reducing the regulatory resources devoted to activities that other banks are performing relatively well, increasing the resources devoted to activities that regulators are uniquely situated or incented to address and seeking to counteract the adverse effects of interbank discipline, bank oversight could be redesigned to more effectively promote the stability of the financial system