In March 2007, Federal Reserve chairman Ben Bernanke infamously told Congress that the “impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.” The U.S.’s top bank watchdog was, of course, embarrassingly wrong. Yet, Bernanke was not alone. As his predecessor Alan Greenspan later recounted, “Everybody missed [the coming crash] — academia, the Federal Reserve, all regulators.”
Ah, but now Congress thinks it has a better scheme for spotting and heading off disaster. Tucked into the Dodd-Frank financial reform bill was establishment of the Financial Stability Oversight Council. The new agency’s crucial task is to detect risks to the financial system and take prompt corrective action.
FSOC can call for more risk capital or limits on leverage. It even has the clout to advise big banks or Wall Street firms to sell off assets. Bizarrely, however, the agency lacks the authority to force banks or firms into liquidation. Under Dodd-Frank, that ultimate capital punishment resides with a cascading congeries of authorities: the Fed’s board of governors, the Treasury secretary and, last, a panel of judges. Purported überregulator FSOC will surely lack the savvy, the maneuverability or, most important, the political will to stave off the next calamity.
Not surprisingly, it all comes down to politics. FSOC will have ten members: the secretary of the Treasury; the Fed chairman; the heads of the SEC, FDIC and CFTC; the chiefs of four other financial agencies; and an insurance expert appointed by the president. All decisions must be made by a two-thirds-majority vote of these turf-guarding, sector-fixated senior officials.
Moreover, the majority vote must include that of the Treasury secretary, who will chair the council. A political appointee thus has an all-powerful veto and could block a major campaign contributor like, say, Citigroup from being named a systemic risk and ultimately broken up.
“It is a problem that political appointees say what they have to say to get elected,” muses Yale economist Robert Shiller, who had joined with other academics in calling for the chairman of the Fed to be the chief systemic-risk regulator.
And even if the FSOC members manage to rise above the political fray, will they be able to spot a financial crisis brewing before it is too late? Brian Gardner, an expert on financial regulation at investment bank Keefe, Bruyette & Woods, says an oversight council is unlikely to be better at this than the financial markets themselves. “I don’t know that it’s possible to avert another meltdown,” he says. “A regulatory agency is as susceptible to human emotion as market participants.”
The reform legislation also creates an Office of Financial Research at Treasury to gather data to alert the council when a problem is developing. (Meeting just once a quarter, FSOC is unlikely to spot many trends on its own.) Closer market scrutiny could be a positive development, but the new law does not specify the agency’s budget or the size of its staff. And what kind of telltale information will the new office be able to collect that the Fed, the Comptroller of the Currency and a half dozen other agencies don’t gather now?
Ross Levine, an economics professor at Brown University, says it was a mistake to put the research office at Treasury. “Its view of the world will be dictated by what’s expedient,” he says, adding that Treasury pays such miserly salaries that quality people who understand complex financial enterprises won’t stick around. “The attraction of where these people can eventually end up is going to distort to some degree what they see,” Levine says.
The council also faces two huge hurdles. First, it must determine whether to increase capital requirements and impose stricter leverage limits — issues currently under negotiation by 27 countries. The Obama team can’t upstage the Basel III talks without infuriating the U.S.’s trading partners. And Wall Street will scream if the U.S. unilaterally imposes harsher capital requirements than, say, the U.K.
Second, Congress has authorized FSOC to promote market discipline “by eliminating expectations on the part of shareholders, creditors and counterparties of such companies that the government will shield them from losses in the event of failure.” This is the too-big-to-fail problem writ billboard-size. But as Albert Savastano, banking analyst at Macquarie Capital, points out, no one seriously believes that the U.S. government is going to let a big bank fail — it is just not politically feasible, especially after the fallout from Lehman’s collapse.
