Bernanke gives a reality check on systemwide regulation

Bernanke in his speech at Kansas Fed Symposium raises number of issues on financial stability and regulation. It is a pretty good speech highlighting issues related to the subject.

First, Fed’s response to the crisis:

The Federal Reserve’s response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year.

The second element of our response has been to offer liquidity support to the financial markets through a variety of collateralized lending program

The third element of our strategy encompasses a range of activities and initiatives undertaken in our role as financial regulator and supervisor

As first two have been discussed at numerous forums, Bernanke focuses on third as that is also the topic of the conference.

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe “financial infrastructure” very broadly, to include not only the “hardware” components of that infrastructure–the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions–but also the associated “software,” including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction.

This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the “hardware” and the “software” components

Financial regulation has always been scoffed at and this is dfficult to understand as regulation has been pretty effectivein other markets. Financial markets need better regualtion as information asymmetry is much higher here compared to other markets. Bernanke then discusses how to strengthen the finacnial infrastructure.

One suggestion which has emerged from the crisis is that regualtors need to look at systemwide risk and not just a  firm specific risk. So far, regulators just look at individual firms and act only if individual firms are in trouble.

The integration of financial markets imply though individually firms may be fine but when analyses from a systemwide perspective they could pose high risks. This has been suggested by BIS for quite some time now but has been ignored. In the subprime crisis it was felt that Banks were in good shape as they had adequate capital cushions but we still had a systemwide crisis. Hence the focus on systemwide implications (also called macroprudential regulations) is increasing.

Bernanke says:

Going forward, a critical question for regulators and supervisors is what their appropriate “field of vision” should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

At least informally, financial regulation and supervision in the United States already include some macroprudential elements. …..For example, following lengthy comment periods, in 2006, the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending

And then he provides a reality check:

 Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise. It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions. International regulatory coordination, already quite extensive, would need to be expanded further.

Macroprudential supervision also presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, as such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that financial crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more, rather than less, likely.

This is pretty useful reality check by Bernanke. I had not really thought about the costs and difficulty associated with assessing systemwide risks. Though, regulation is needed we have a number of issues to be sorted out. This area of financial regulation requires urgent attention. 

For long we have discussed financial regulation from a design perspective – principles based vs rules based or single regulators vs multiple regulators. What is needed now is to understand it from a functional perspective and get the basics right. Otherwise, either we would stifle financial innovation (markets) or would have too many crisis.