Federal Reserve officials, academics and central bankers from abroad are gathering for Ben Bernanke’s annual confab in Jackson Hole Wyoming to discuss the management of financial crises. A better topic might be: Is the Fed Still a Central Bank?
Essentially, national monetary authorities do two things. Central banks manage liquidity in their national capital markets—the supply of credit to finance businesses, new homes and consumer spending. Central banks and banking authorities regulate commercial banks and other depository institutions to ensure their solvency and the adequate availability of credit to businesses and consumers.
The Fed manages liquidity by regulating federal funds rate—the rate banks charge one another to borrow reserves that back up loans. Historically, by varying the federal funds rate, the Fed could influence the interest rates charged on loans of various maturities ranging from the prime rate on business loans to 30 year mortgages and corporate bonds.
In this decade, the United States has run large and growing trade deficits on imports of oil and consumer goods from Asia. Essentially, Saudi Arabia and other oil exporters cannot spend all they charge for oil and invest the rest—much of it in U.S. Treasury securities and other U.S. debt instruments. Also, the People’s Bank of China and several other foreign monetary authorities intervene in foreign exchange markets—selling their own currencies for dollars—to keep their currencies and exports inexpensive in U.S. markets. In turn, foreign central banks and sovereign wealth funds have huge quantities of dollars they invest in U.S. securities.
Consequently, the Fed has lost its ability to manage interest rates charged on loans with longer maturities, like mortgages and corporate bonds, and can no longer effectively manage liquidity by raising and lowering the federal funds rate.
The Fed has general supervisory responsibility for the major money center banks, and an assortment of federal and state agencies regulate the day-to-day activities of commercial banks and other depository institutions.
In recent years, the Fed’s responsibility for the large monetary center banks and its knowledge of large investment bank activities that function as primary securities dealers in open market operations has become more critical. Since the Savings and Loan Crisis of the 1980s, banks throughout the country have adopted the securitization model of banking. Instead of relying on deposits to fund loans, they sell loans to money center commercial and investment banks who bundle these into bonds for sale to pension funds, insurance companies and large investors like foreign central banks and sovereign wealth funds.
The money center banks and securities companies have incentivized managers to take high risks in accepting mortgages to bundle into bonds, and in turn, this encouraged regional banks and mortgage companies to write increasingly dodgy loans. Through credit default swaps and various financial structures, the banks and securities companies sought to lay off risk but this proved impractical, investors got burned with bad bonds, and the banks got stuck with a lot of bad paper on their books.
The banks and securities companies had to take large losses on bonds they could not unload, and this created a big drain on their capital and solvency. Ultimately, Bear Stearns failed, and the stock market values of big banks and securities companies have fallen dramatically.
To avert crisis the Fed has loaned the money center banks and primary securities dealers hundreds of billions of dollars through the discount window—some of those loans are collateralized by bonds of highly questionable value.
These special assistance programs were supposed to be temporary but now the deadline has been extended to January 2009. The fact is it may be extended again and again, because the banks and securities dealers may not have the liquidity to redeem their paper and still have adequate reserves. Hence, the Fed does not regulate the banks to ensure their banks solvency, it just props them up.
The Fed’s mistake was not stepping in, within a very short period, and imposing conditions on its loans–namely forcing the money center banks and securities companies to reform their management practices, abandon incentive schemes that encourage high risk taking for big bonuses, and obtain a commitment from the large financial institutions to fully function as commercial banks, in addition to pursuing their other more healthy businesses. That would have required them to underwrite soundly written business loans and mortgages, and offer plain vanilla bonds to investors, who could understand and accept the bonds they were being offered. This would reopen the bond market to securitized mortgages and business loans.
By imposing these conditions, the Fed would have become the large money center bank regulator, in full, until the “crisis” passed. That is until its special loans to the banks and securities dealers were repaid, if not longer.
Instead, by giving the big banks and securities companies revolving short-term loans against questionable paper, it has become hostage to their actions. If they all behave more or less the same, the Fed can’t pull the rug out from under all of them without crashing the financial system. Neither the Fed nor the other Federal regulatory agencies can effectively regulate the bank.
The banks have not altered their incentive structures for executives. Instead, they are abandoning the securitization of mortgages and other loans for sale to fixed income investors, and encouraging executives to focus on their most profitable business lines. However, if the Fed is going to guarantee the solvency of these enterprises, it should require they engage in commercial banking.
Although fixed income investors and foreign central banks have vast pools of capital to invest in the United States, many sound businesses and homebuyers cannot access it, and the Fed has failed to ensure the adequate availability of credit to businesses and consumers.
If the Fed is not effectively managing liquidity, regulating banks to ensure their solvency and the adequate availability of credit to businesses and consumers, I am not sure the Fed is functioning as a central bank.
I do know Ben and his friends will enjoy some good food and fine conversation in Jackson Hole.
PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.