The writer is former Chair of the FDIC and former Assistant Secretary of the U.S. Treasury for Financial Institutions.
Federal Reserve Board Chairman Jay Powell delivered a masterful speech on Friday to the annual Economic Policy Symposium sponsored by the Federal Reserve Bank of Kansas City. He focused almost exclusively on the Fed’s inflation outlook and when it might start slowing its asset purchases.
He did not mention bubbly conditions in financial, commodity, and real estate markets, nor the dangerous buildup of leverage in the business and corporate sector as potential threats to system stability. He did not discuss the use of the Fed’s regulatory authorities to address them.
These omissions were not surprising. Financial stability regulation is not typically an area of focus for Fed chairs. One would have to go back to Paul Volcker to find a chair who really saw financial regulation as core to their responsibilities. Volcker’s successor, Alan Greenspan, began an era when the Fed focused primarily on interest rate policy — using cheap credit, not regulation, to smooth out financial market turmoil. This inattention to financial stability was one reason why the Fed missed the great financial crisis until it was on our doorstep. That crisis helped make the Fed a better regulator, particularly under Janet Yellen, but the current debate over Powell’s re-appointment suggests that regulation still takes a back seat to monetary policy.
Powell’s record on regulation has come under scrutiny from Senate Banking Committee Chair Sherrod Brown (D-Ohio) and Subcommittee Chair Elizabeth Warren (D-Mass.) They have expressed concerns about a number of regulatory moves during Powell’s tenure. Powell’s main challenger for the job — fellow Fed Governor Lael Brainard — has repeatedly dissented from those measures. Powell’s supporters whisper that this criticism is “politically motivated." Others have suggested that Brown’s and Warren’s concerns could be better addressed by selecting Brainard as vice chair of supervision (replacing incumbent Randy Quarles, whose term is up in October).
Federal Reserve Chairman Jerome Powell speaks with Fed Governor Lael Brainard (L) at the Federal Reserve Bank of Chicago, in Chicago, Illinois, U.S., June 4, 2019. REUTERS/Ann Saphir ·Ann Saphir / reuters
The problem with this whole discussion is that it assumes financial stability regulation can somehow be segmented from monetary policy and relegated to a subordinate governor (while the chair pre-occupies himself with more important monetary matters). They cannot be separated.
The Fed does not like to admit that its aggressive monetary interventions create system instability — but they do. People can disagree on whether the benefits outweigh risks, but there can be no debate that the risks are there. Financial crises, when they occur, result from a buildup of leverage and sudden correction in inflated asset valuations. Both conditions prevail today and risk triggering deep, prolonged recessions that hit the poor and lower income families the hardest.
Under Powell, regulatory oversight has become less stringent. Stress test assumptions have been eased and key hurdles to passing the tests have been removed. Up until the pandemic, the Fed consistently let big banks make shareholder distributions exceeding earnings (meaning they were depleting, not building, capital). About $600 billion in assets held by big banks were removed from the Volcker Rule’s prohibition on risky proprietary trading. Rules requiring securities affiliates of FDIC-insured banks to post collateral protecting against uncleared derivatives exposures were eliminated.
It is absurd to suggest criticism of these measures is “political.” I hardly think “enhanced supplemental leverage ratios” and “inter-affiliate margin requirements” are the stuff of campaign literature or donation solicitations. People can disagree on the magnitude of their impact, but directionally, they have all been to loosen, not strengthen, post-crisis reforms.
Powell has kept himself at arms-length from most of these measures, leaving it to Vice Chairman Quarles to defend them. But Powell brought them to a vote — and supported them.
Randal K. Quarles, vice chairman of the Federal Reserve Board of Governors, testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on "Oversight of Financial Regulators" on Capitol Hill in Washington, U.S., December 5, 2019. REUTERS/Erin Scott ·Erin Scott / reuters
If Powell lacks a strong commitment to financial stability and oversight, coupling his re-appointment with Brainard as vice-chair for supervision will not be sufficient.
“Vice chair of supervision” is a nice title, but not much more than that. Importantly, the Fed’s powerful staff report to the chair, not the vice chair. Unless a strong tone and commitment comes from the very top of the house, it will not matter who holds the vice chair role.
Any Federal Reserve chair who ignores financial regulation is robbing himself of a tool for financial stability — as well as a tool for cooling an overheated economy (should current inflation prove less than transitory). Countercyclical capital buffers, targeted tightening of credit standards, increased margin requirements, and more rigorous stress tests are all tools at the Fed’s disposal that could tap the brakes on deteriorating credit standards and reckless market speculation.
Wall Street lobbyists and executives might not like them, but they are certainly better than the brute force of an interest rate hike. If the Fed is forced to raise rates, they would give banks larger capital buffers to protect against the inevitable losses that will occur as inflated markets correct.
Paul Volcker understood this. In 2018, a few years before his death, he penned an insightful op-ed about the intersection of the Fed’s regulatory and monetary responsibilities, critiquing the Fed’s dominant preoccupation with increasing inflation. He observed that our economy has always been sufficiently resilient to recover quickly from recessions, except the two that resulted from financial breakdowns: the Great Depression of the 1930s and the Great Recession following the financial crisis of 2008.
Former U.S. Federal Reserve Board Chairman Paul A. Volcker speaks at a news conference in New York, June 8, 2015. REUTERS/Mike Segar ·Mike Segar / Reuters
He wrote: “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk-taking, in effect, standing by while bubbles and excesses threaten financial markets.”
Volcker concluded: “That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of these requirements inexorably lead to the responsibilities of a central bank.” (emphasis added)
With increasingly fragile and unpredictable financial markets, we cannot afford a Federal Reserve Board chair simply “standing by” with regard to financial stability.
This issue goes to the culture of the Fed as an institution and transcends any particular candidate. Jay Powell is an intelligent, thoughtful leader, much admired in the financial industry and media. Lael Brainard is also smart and highly regarded. But any serious candidate to be the next Fed chair should be asked by the White House — and Congress — their views on system stability, their understanding of regulatory and supervisory tools, and their willingness to use them to protect Main Street America from another financial crisis.
