Wednesday, November 18, 2015

The move by Congress to limit Federal Reserve powers is a mistake

There is apparently bipartisan support in Congress for limiting the ability of the Fed to avert a severe financial crisis.  The coming move will not allow the Fed to address the problems of a single company, such as AIG during the 2008 financial crisis. The Fed will only be allowed to take broad actions to create liquidity under the new regulation.  This is a mistake.

When there is an in your face and severe financial crisis, there is no time.  Actions must address problems directly and immediately.  What if a major financial institution has a rogue trader or operating systems manager who creates, unbeknownst to management, a devastating trade or a crippling insider hack?  Or what if terrorists find a way to attack one institution in multiple places around the world, attacking their people, entering their systems, and bombing their buildings?  There are lots of "what ifs" that suggest what a bad idea this is. Giving more liquidity to the system will not address the failure of counterparties around the world related to one institution.  That institution will need to be dealt with fast, fast and furious one could say, and there will be zero time to go back to Congress and get this law amended.

Elizabeth Warren and others on the right and left feel that allowing the Fed the ability to address individual institutions gives those institutions the incentive to take more risk.  They will expect to be bailed out, so why not take more risk than is reasonable.  Do the legislators not know that deferred compensation, stock options, and outright stock grants that have at least three year vesting periods, more in many cases,  represent the great majority of compensation in these institutions.  Many top executives own significant amounts of stock as they are required to report their market activity, and most do not want to seem as if they are voting against their company.  The losses that employees will have in a market damaging loss would be devastating.  This is a major reason financial institutions are incented, in an overwhelming way, to control risk.  Admittedly, really bad actors sometimes cause problems in all endeavors, not just finance.

The bias against financial institutions by many can be understood.  It is misguided to some extent and exploited by politicians, but it has a rationale.  That does not mean that it should lead to legislation that ties the hands of the Fed and the Treasury in a severe crisis.  Dodd Frank has already drastically cut into the liquidity of the fixed income markets by limiting securities trading by the large institutions.  Those institutions created significant liquidity through their market making activity and, truth be told, market making is rarely a risk taking exercise of any significance.  With the Dodd Frank limits on bank trading activity, there is already a significantly higher level of risk in fixed income markets should there be a financial crisis.  This new move by Congress will decrease flexibility and add to rather than alleviate risk during a crisis.

At some recent point, there was talk by many about how to roll back or alter the Dodd Frank trading limits so it did not impact systemic liquidity.  Somehow, in this political season, that is off the table and this new restriction on the Fed is front and center and about to be done.  Ugh.  It is frustrating to see how little politicians understand, other than what is easy to sell to their constituents.

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