The Federal Reserve's Power to Act as Lender-Of-Last-Resort Is Necessary for a Stable Financial System
March 5, 2015
Once the 2008 crisis abated, there was growing public concern about "moral hazard" - that government backstops and guarantees incentivized risky behavior in financial markets. The Dodd-Frank Act (July 2010) pulled back the Federal Reserve Bank's (FED) lender-of-last-resort powers for non-banks. In addition, the Federal Deposit Insurance Company(FDIC) cannot expand guarantees to bank depositors without congressional approval, and the Treasury cannot do the same to money-market funds without new legislative authority. These changes could make it difficult for the Fed and other regulatory bodies to act effectively in the next crisis, according to Glen Hubbard and Hal Scott in the Wall Street Journal.
Some claim there is nothing to worry about because of new regulations to prevent another crisis: enhance capital requirements, new liquidity requirements and new resolution procedures.
- Capital requirements apply to three systematically important financial institutions (SIFIs) - GE Capital, Prudential, and American Insurance Group. Regulators envision regulatory capital for the most important U.S. banks will max out at 8% to 11.5% of risk-weighted assets.
- New liquidity rules assuring banks have sufficient "liquid" assets to cover withdrawals. These rules are based on assumptions that assets such as U.S. Treasury or foreign-government debt have low creditrisk and assume certain rates of withdrawal from different types of funding.
- Dodd-Frank restrictions allow the FDIC to step in only if a financial institution on the brink of insolvency is designated by the Treasury secretary, in consultation with the president, as threatening financial stability. By the time that determination is made, and even afterward, other institutions may be attacked by runs causing their own insolvency.
Even though the Treasury secretary can approve using the FED's lender-of-last-resort powers and approve the design of a broad program, markets cannot know they will act, and with such bailouts now in disrepute, runs are more likely in a future crisis, say Hubbard and Scott.
Source: Glenn Hubbard and Hal Scott, "A Financial System Still Dangerously Vulnerable to a Panic," The Wall Street Journal, March 2, 2015.
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