The Financial Stability Oversight Council’s Fatal Flaw
Saturday, October 27, 2012
Consider the prospects for the Financial Stability Oversight Council (FSOC) set up by the Dodd-Frank Act. Can a big, cumbersome committee made up of representatives of numerous regulatory bureaucracies, each driven to defend its jurisdictional turf, actually produce new insights into the unknowable financial future? In particular, can such a committee have insights into the future “systemic risks” of complex, interacting systems, in which the members of the committee are themselves creators of such risks?
It seems unlikely.
As described by Vern McKinley in Financing Failure: A Century of Bailouts, the formation of such a committee is an expected political phase in the wake of a financial crisis. “The chosen solution from Washington after a financial panic is to create a panel of wise people in Washington that, so it is alleged, will smooth out the process of booms and busts in the financial cycle that periodically occur.” Forming such a group is something politicians can do when they feel they must Do Something. “Are we,” McKinley asks, “talking about the creation of the Federal Reserve in 1913, the Working Group on Financial Markets in 1988, or the Financial Stability Oversight Council in 2010?” All indeed reflect the same hope, always before disappointed. Is this time different? That also seems unlikely.
In his reflections on risk and uncertainty, Peter Bernstein wrote in 1998 that “The past seldom obliges by revealing to us when wildness will break out in the future,” and “Surprise is endemic above all in the world of finance.” The experience of a decade later showed how right he was.
“No regulator had the foresight to predict the financial crisis,” Andrew Haldane of the Bank of England recently wrote, “although some have since exhibited supernatural powers of hindsight.” This is consistent with common sense and with Bernstein’s observation that “After the fact … we have a hard time understanding how people on the scene were oblivious to what lay in wait for them.”
There is no doubt that the FSOC will display excellent future hindsight, although it will not wish to fasten any blame on its own members. But will it display the foresight so lacking in historical financial experience up to now?
The Federal Reserve itself has taken on enormous amounts of additional leverage risk and duration risk, and its own balance sheet is highly vulnerable. FSOC does not mention this.
The FSOC’s 2012 annual report is more than 200 pages. On page 124, the report mentions “the current economic environment in which structural change has elevated the level of uncertainty.” A better statement would have been that change in every economic environment makes it one of uncertainty (although sometimes we convince ourselves otherwise). As Frank Knight tried to get us to understand in 1921, “Uncertainty is one of the fundamental facts of life. It is … ineradicable.” In other words, a period of uncertainty, like now, is a period between two periods of uncertainty.
One key source of current uncertainty is what will be the behavioral results of a long period of close-to-zero interest rates, negative real interest rates, and the manipulation of long-term interest rates to low levels heretofore not experienced. As the FSOC says, “An unusually low rate environment, such as that currently in place, is prone to several behavioral vulnerabilities. Market participants may have an incentive to take on additional leverage, credit risk, and duration risk.” This “could leave many participants with portfolios that are more vulnerable to adverse market moves” — or adverse central bank moves.
FSOC is required to identify “potential emerging threats to the financial stability of the United States.” Regarding the risks and uncertainty induced by unusually low interest rates, the source of the threat is the behavior of the Federal Reserve, a principal member of the FSOC. Also, the Federal Reserve itself has taken on enormous amounts of additional leverage risk and duration risk, and its own balance sheet is highly vulnerable. FSOC does not mention this.
Knight articulated what is in fact an essential dilemma of central bank interventions: “the use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all.” As a consequence, it does seem that trying to reduce instability through monetary manipulation creates other forms of instability. These in turn seem to call for more interventions, and so ad infinitum.
Real insight into the future risks and uncertainties of financial markets at a systemic level requires the ability to analyze and criticize the actions not only of private financial actors but also government agencies and central banks, which are key sources of systemic risk. In its ability to generate worldwide volatility in interest rates, present values, prices, and exchange rates, the Federal Reserve is obviously the biggest “Systemically Important Financial Institution” in the world. Other government actors are also very important — for example, in their ability to constrict credit or promote its risky, politically inspired expansion.
Can the FSOC point out that its own members are creating potential instability and systemic risk? If it cannot, it is constitutionally incapable of carrying out its statutory assignment.
It may well be that nobody can consistently generate successful insight into the unknowable future. Nonetheless, a truly independent “systemic risk adviser,” as I have proposed, would have a better chance of doing so than what we’ve got.
Alex J. Pollock is a resident fellow at the American Enterprise Institute.
FURTHER READING: Pollock also writes “The Tragic Demise of Fannie Mae,” “Geithner’s View from the Top of the Bubble,” and “Who Will Guarantee This Guarantor? Part Two.” Blake Hurst explains “The High High Cost of Low Low Rates.” Peter J. Wallison contributes “Magical Thinking: The Latest Regulation from the Financial Stability Oversight Council” and “The Election and Dodd-Frank.”
Image by Darren Wamboldt / Bergman Group