By Steven K. Beckner
PHILADELPHIA (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser said Wednesday that the economy is “gradually emerging”
from the financial and economic crisis but warned that the raft of new
regulations that will be written to enforce provisions of the financial
reform legislation could inadvertently lead to another crisis at some
point.
Plosser, in remarks prepared for the Union League Club, hammered
government sponsored enterprises Fannie Mae and Freddie Mac for the role
they played in bringing about the crisis and called it “unfortunate”
that the problems of the GSEs have yet to be addressed.
Plosser will be a voting member of the Fed’s policymaking Federal
Open Market Committee next year, but he refrained from commenting on the
economic and monetary policy issues that will be facing the FOMC when it
meets Nov. 2-3. He dwelt instead on financial regulatory matters.
A central theme of his prepared remarks was that the crisis was not
primarily a failure of markets or the capitalist system, but a result of
bad incentives built into government policies.
“We are gradually emerging from the depths of the recent economic
crisis,” said Plosser, who noted that in response “we now have a massive
financial reform law that will generate many new regulations.”
While the goal of Dodd-Frank is “to substantially reduce the
chances of another financial crisis and to lower the costs of financial
disruptions when they do occur,” Plosser suggested that probably won’t
be the result.
“When the next crisis inevitably arises, the cycle will likely
repeat itself, with more laws, more stringent regulations, and more
assurances that — this time — we have eliminated the possibility of
bad economic outcomes and have prevented reckless behavior from
disrupting the economy,” he said.
“New rules and regulations, often made with good intentions, can
create bad incentives, which, in turn, yield ugly results,” he said.
“The ugly results could include another, but perhaps different, crisis
or a reduction in the vibrant and dynamic growth of our economy.”
Plosser cited a number of government policies which contributed to
the crisis, including tax code incentives favoring debt finance over
equity and bankruptcy code incentives that encourage firms to borrow
short and lend long.
On the latter, he took aim at policies which he said subsidize
investment banks’ use of repurchase agreements (repos) to finance their
activities.
“While these overnight loans to the investment banks are not
explicitly guaranteed by the government, the bankruptcy code says that
should the borrower get into financial distress and file for bankruptcy,
these overnight, or very short-term, lenders can immediately receive
their collateral and do not have to wait in line with other creditors,”
he explained.
“Thus, market discipline is undermined as these overnight lenders
have little incentive to monitor the risk-taking of these institutions,
since they will almost certainly get paid,” he continued. “This means
that overnight funding was cheaper because creditors did not have to
incorporate the risk of default.”
“So the bankruptcy code effectively provided incentives for these
nonbank financial institutions to borrow very short and lend long,” he
went on. “When liquidity became scarce, this proved a debilitating
strategy for these firms and contributed significantly to the financial
crisis.”
Plosser also faulted the whole government policy of treating some
firms as “too big to fail.”
“Moral hazard problems are an inevitable outcome of the government
safety net,” he said. “It has only been worsened by government rescues
of large, complex financial firms that find themselves in financial
distress.”
“Financial firms that are considered too big to fail do not bear
the full costs of the risks they take on,” he said. “This is because
their creditors — like depositors — believe they will be bailed out if
the firm fails and so they have no incentive to monitor the firms’
risk-taking. Market discipline breaks down because of the government’s
policy to bail out big banks rather than allowing them to fail.”
“This is not a failure of markets; it is the response of market
participants to policies and incentives created by government actions,”
he added.
Privately owned but federally subsidized Fannie and Freddie are
particularly egregious examples of bad government incentives, according
to Plosser.
Not only did the GSEs enjoy an implicit government guarantee, which
enabled them to borrow cheaply, but they were insufficiently capitalized
and regulated, but highly leveraged, he said.
Fannie and Freddie were put into conservatorship in September 2008,
and Plosser predicted “the costs of rescuing them will exceed that of
any other financial institution that has received taxpayer support.”
“The costs of the government subsidies to Fannie and Freddie go
beyond the direct cost to the taxpayer for their rescue,” Plosser went
on. “The fact that they had implicit government backing meant that
ordinary banks found it hard to compete with them on conventional
mortgages.”
“Thus, banks found other ways to compete in the residential
mortgage area by taking on more jumbo, sub-prime and alt-A mortgages
than they otherwise would have – which exacerbated problems at
commercial banks,” he elaborated.
“It is unfortunate that financial reform has yet to address the
problems created by these government created and sponsored entities,”
Plosser added.
Plosser’s lesson from the crisis was that “we need better-designed
regulation that recognizes incentives and tries to address moral hazard
so that market discipline can work. Overly proscriptive regulation is
counterproductive – it increases the incentives to evade it, which
ultimately defeats it.”
“This requires scaling back some of the safety net subsidies that
have risen over the years and increasing capital requirements,” he said.
** Market News International **
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