The World's Most Boring Question

What exactly should financial regulators regulate?  A boring question, indeed.  A collorary, not the same question but not quite different, is: what precisely is the role of a central banker?

Stan Fischer, formerly at the World Bank and the IMF and currently Governor of the Central Bank of Israel, takes a crack at answering these two boring but critical questions in an insightful paper entitled "Preparing for Future Crises", delivered to the Club of Central Bankers which met at Jackson Hole last week (see previous post). 

(See papers at http://www.kc.frb.org/home/subwebnav.cfmlevel=3&theID=11163&SubWeb=10660)


Stan, born in Northern Rhodesia (now Zambia), is one of the most insightful central bankers around, albeit quite high on the orthdoxy scale.  His paper gives a pretty good summary of his views, and therefore those of the fiscally orthodox, on these questions. 

Conceptually, financial sector supervision covers two areas: regulation and control of risk ("prudential" regulation); and investor/consumer protection ("conduct of business) regulation. Prudential regulation is further divided into systemic -- or macroprudential -- regulation, which considers risks to the financial system as a whole; and microprudential regulation, which considers risks to individual banks and other financial institutions, and the impact of on investors, depositors and consumers.
 
The tools for prudential regulation are primarily the central bank interest rate, and the those that target the overall riskiness of the financial system -- credit creation in particular -- such as capital and leverage ratios.  There is nothing new under the sun and so there is a return following the crisis to more specific tools such as maximum loan-to-value ratios (in particular for real estate), margin requirements for purchases of securities, and other relics of the Great Depression which have fallen out of use.
 
All of this is useful, but pretty boring.  So OK, what do central bankers do?  Or more specifically, is it the role of central bankers to pop bubbles, or simply clean up the mess once they have burst on their own?  Even more specifically, is Alan Greenspan -- and by extension, Ben Bernanke -- responsible for the financial crisis by not targeting asset price inflation?  They saw the boom in real estate prices.  Was it their job to rein it in?  Should they have closed the open bar and turned off the music when the party-goers started to get rowdy?
 
Stephan Roach, Chairman of Morgan Stanley Asia, believes Alan and Ben guilty.  He thinks that they drew the wrong conclusion from the post-bubble strategies put in place following the bursting of the dot.com equity bubble in 2000.  As Stephan puts it in an article in the FT of today (August 26, 2009): "...In retrospect, the Fed's injection of excess liquidity in 2001-2003, which Mr. Bernanke endorsed with fervour, played a key role in setting the stage for the lethal mix of property and credit bubbles."
 

Stephan, you're a bit rich on this.  Hindsight is a marvelous thing, but let's face it -- if Greenspan had burst the bubble (how exactly?  The Fed doesn't have the authority to set loan-to-value ratios), he would have been excoriated, tarred, feathered, and marched out of this Federal capital of ours on a pole.  His options were limited.  (And probably post-dated, but that's another thing.)

 

Damned if you do, damned if you don't.

 
So in closing, congratulations to Mr. Bernanke for having been nominated for a second term as Chairman of the Federal Reserve Bank by President Obama.  Ben, we need you to work now on getting a coherent regulatory framework in place in the US, one that extends beyond banks to insurance companies, equity and hedge funds, and all the other hybrid animals that have made it a sport to regulatory-shop across the nation.

Good luck, Ben.  We're counting on you.