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Financial firms don't need an inside job to get favorable Fed treatment

- September 30, 2014

Henry Paulson, Ben Bernanke and Timothy Geithner in the documentary “Inside Job.” (Sony Pictures)
Last week “This American Life” and ProPublica reported on the close relationship between the U.S. Federal Reserve (Fed) and major Wall Street banks, particularly Goldman Sachs. These reports suggest that the Fed is “captured” by the firms it is tasked with regulating, meaning that banks strongly influence the Fed’s application of the rules governing the banking sector.  While the claim itself is certainly not new, these reports approach the topic in a fairly unique manner. Unlike most regulatory capture arguments that emphasize the “revolving door” between regulators and the private sector or even outright corruption, the TAF/ProPublica story focuses instead on the organizational culture within the Fed, which appears to be deferential to major banks. The Fed is not so much corrupted as “wimpy,” as Justin Fox wrote in the Harvard Business Review blog.
In a new article in International Studies Quarterly, I examine the problematic relationship between central banks and financial firms in a number of countries. The article shows that even if the Fed is not captured and firms like Goldman Sachs are fully in compliance with their statutory obligations, the relationship between the Fed and the financial sector is such that systemic stability may be jeopardized. That is because banks may interpret the Fed’s mandate to maintain financial stability as a signal that the Fed will pursue bank-friendly monetary policies. If they believe the Fed will support them, then banks may behave more riskily than they otherwise would, which can actually make the financial system less stable.
The argument rests on a simple logic. Monetary policy goals are countercyclical – expansionary policies are pursued when economies are weak, while inflationary conditions are met with monetary contraction. By contrast, regulatory goals are procyclical – banks are encouraged (and often required) to limit lending and raise additional capital if economic weakness damages their balance sheets, but when the economy is performing well and loan defaults are rare, then banks are able to lend more freely. This can exacerbate economies’ tendency towards boom-and-bust periods, which is precisely what wise monetary management is intended to prevent. The fact that monetary and regulatory principles are at odds presents a challenge for policymakers, particularly during recessions.
One possible way to alleviate this tension is to give authority over monetary and regulatory policies to the same institution and rely on them to find the proper balance. Many countries have done this, including the United States, by tasking their central banks with preserving financial stability in addition to managing the macroeconomy. A healthy financial sector is a prerequisite for an effective monetary policy, after all, so why not locate policy authority in the place where it can achieve both goals? It is the financial stability mandate that allowed the Fed to lend so extensively to financial institutions during the subprime crisis, and they justified these programs not only because they helped to restore financial stability but also because they were necessary to return the U.S. economy to growth.
The problem is that one policy goal – countercyclical monetary policy or procyclical regulatory policy – must take priority over the other. Prior research has found that central banks that regulate their financial sectors tend to pursue more bank-friendly monetary policies than nonregulatory central banks. Why? Because if they preside over a financial collapse, they risk the loss of their authority.
I show that banks observe the policy bias that favors them and alter their behaviors accordingly. Banks in systems where monetary and regulatory authority are unified in a central bank hold less capital – the buffer against declines in the value of banks’ asset portfolios – than banks that cannot count on preferential monetary policies. This is important because inadequate capital reserves is a major contributing factor in all financial crises, and many regulatory reforms since the crises have focused on boosting bank capital. If institutional arrangements are encouraging banks to hold less capital against risk then political systems are working against themselves in a way that could increase the probability of experiencing a crisis.
To demonstrate this claim, I aggregated capital-to-assets ratios by country for each wealthy OECD economy. I coded situations in which the assignation of regulatory or monetary authority changed, and compared the capital ratios of that country’s banks before and after the switch. A number of countries reassigned regulatory authority over their banks during the sample period (1992-2009), usually in the wake of a financial crisis. The location of monetary authority usually does not change, but the creation of the European Central Bank – which did not regulate the European financial sector during the years I examined – provided another way to examine how banks change their behaviors in response to changed institutional arrangements.
The main statistical finding is that there is a difference in bank behaviors when monetary and regulatory authority are unified in central banks, particularly when that central bank is given monetary flexibility (i.e. is not tasked with defending a fixed exchange rate). The effect is large, too: there are a variety of ways to measure capital, but the statistical models show that these buffers are about 15-35 percent lower when central banks have both regulatory and monetary authority. This behavior is exacerbated when financial sectors are large, as financial firms rely on the importance of their stability to expect even greater privileges.
As I wrote above, this result conforms to a simple logic: if you task central banks with financial stability, they will partially tailor monetary policy to make it so. If banks know that their central bankers have their interests in mind, they will behave with less prudence. It makes perfect sense why this would be the case. So long as banks do not violate their statutory capital requirements there is little that central banks can do to prevent this behavior even if they wished to do so. Economists refer to situations in which actors are able to shift the risk generated by their actions onto others as “moral hazard.” It is one of the greatest economic problems, which can cause entire markets to fail. Isn’t that what’s happening in this situation?
As a result of the TAF/ProPublica reports, several senators have called for hearings on the Fed’s relationship with Wall Street, and Goldman Sachs has revised its conflict-of-interest policy. Both the Federal Reserve and Goldman Sachs have issued statements denying the allegations of capture and non-compliance in the report. My research suggests that even if they are telling the truth, one source of bias that can contribute to financial instability is likely to remain in the financial system. The Fed officials may be wimps, but if they are, it is because our government has effectively asked them to be.
 Kindred Winecoff is an assistant professor in the Department of Political Science, Indiana University. You can follow him on twitter @whinecough