William Poole*
President, Federal Reserve Bank of St. Louis

Panel Discussion

Cato Institute - 24th Annual Monetary Conference
Washington, D.C.
Nov. 16, 2006

*I appreciate comments provided by my colleagues at the Federal Reserve Bank of St. Louis, especially Robert H. Rasche, senior vice president and director of research, and William R. Emmons, senior economist.  I take full responsibility for errors.  The views expressed are mine and do not necessarily reflect official positions of the Federal Reserve System.

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Responding to Financial Crises: What Role for the Fed?

I am delighted to return to Cato, an organization with which I feel a natural affinity, especially through Bill Niskanen with whom I served as a member of the Council of Economic Advisers a quarter century ago. That sounds like a long time ago, and I guess it was. However, when it comes to the subject of this panel, I do not think much has changed. The key issue then, as today, is time inconsistency. It seems to make sense in the middle of a financial crisis for someone to bail out a failing firm or firms. However, the inconsistency is that, however sensible a bailout seems in the heat of crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too little capital and take too many risks. As every economist understands, a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts. Along the way, the policy also encourages inefficient risk-management decisions by firms.

In writing the previous paragraph, I at first began by saying, “Everyone knows that a policy of bailouts will increase their number.” But here we are in Washington, and a cursory examination of federal policy proves that not everyone knows. Federal disaster relief policy is exhibit A, but every company, financial or otherwise, knows that if it gets into trouble it is at least worth a major effort to attempt to secure a bailout because there is always a significant probability of success. Given this state of affairs, in place for many decades despite economists’ pleadings, I think the most important issue is not reflected in the title of this panel—what to do in the event of financial crisis—but instead how to avoid financial crisis in the first place.

Before proceeding, I want to emphasize that the views I express here are mine and do not necessarily reflect official positions of the Federal Reserve System. I thank my colleagues at the Federal Reserve Bank of St. Louis for their comments, especially Robert H. Rasche, senior vice president and director of research and William R. Emmons, senior economist. However, I retain full responsibility for errors.

Avoiding Financial Crisis

Deposit insurance and a broader, fuzzy, safety net for financial firms creates an incentive for firms to take too much risk and hold too little capital. That is a fact of life. I believe that we should continue to seek reforms to the deposit insurance system. I am particularly fond of proposals that would establish a formal policy of “haircutting” the insurance coverage to, say, 90 percent of insured liabilities and/or requiring that insured financial institutions issue explicitly uninsured long-term subordinated debt. Such reforms would administer a healthy dose of market discipline to financial firms. But until such reforms are put in place, I do not see any other option than maintaining substantial supervisory oversight of large, systemically important financial institutions. The supervisors need to have the authority to require adequate capital and maintenance of robust risk-management policies in financial firms.

I believe that supervisory oversight is in pretty good shape, with one glaring exception. Government-sponsored enterprises are not adequately capitalized and the supervisory powers of the Office of Federal Housing Enterprise Oversight (OHFEO) are inadequate. I’ll concentrate on the housing GSEs—Fannie Mae and Freddie Mac. This is a topic I’ve addressed several times in the past (Poole, 2003 and 2004) and I’ll not repeat those arguments in any detail here. Although the GSEs are not formally insured by the federal government, the market clearly believes that they are effectively backstopped. As I’ve emphasized before, the Federal Reserve does not have the legal authority to bail out a troubled GSE. The Fed can provide liquidity support through its discount window, but only indirectly through collateralized loans to banks that would then bear the credit risk of making loans to a troubled firm. Under emergency conditions, the Fed does have the authority to make loans directly to a GSE, but the loans must be fully collateralized. The Fed is obviously disinclined to use its emergency powers to lend to firms other than banks; despite numerous financial upsets over the years, the Fed has not used this authority since the 1930s.

Given the obvious moral hazard facing the GSEs, the first best solution would be to turn the GSEs into fully private firms subject to normal market disciplines and with no special connection to the federal government. Absent that step, what supervisory policy actions could reduce the threat they pose to financial stability? The two items of highest priority are, first, that the GSEs’ portfolios should be limited in both scope and scale to assets with a clear public purpose; and, second, capital at the GSEs should be higher—substantially higher. As I have argued before, the capital standards applied to the GSEs are simply inconsistent with the interest rate risks the firms have assumed. It does not make sense for public policy to permit GSEs to hold far less capital than required in large banks given that GSEs have substantially similar or even greater risks than large banks.

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