Economic View: Fed’s Moves Offer a Shield Against Europe — Economic View

With such dangers at hand, it’s time for a spot-check on whether financial regulation in the United States has left us prepared. So far — with one notable exception — it’s not looking good.

A core problem in finance is that banks and other intermediaries can take on too much risk, not caring enough that their potential failures may throw people out of work, burden taxpayers and damage the broader economy. The solution — if it can be managed — is to ensure that banks have enough safe, liquid capital so that A) they are betting a lot of their own money, thereby inducing some caution, and that B) they have a large-enough cushion to limit the risk of failure. “Lots of capital, not too much leverage” is the basic formula for a safe financial system.

Such a general approach is needed because it’s again become clear that regulators can’t predict the specifics of the next crisis. Less than two years ago, our government enacted the Dodd-Frank law, the most complex financial regulation bill of all time, based on the work of hundreds of economic and legal experts, all hyper-aware of the issues of risk. Neither this bill nor our government, however, foresaw that we were already living in the onset of the next potential financial crisis, namely the spillover from the euro zone.

Dodd-Frank left questions of capital and leverage largely to the Basel III international banking agreements, the second piece of the new financial regulatory architecture. Basel III, like its predecessors Basel I and Basel II, encourages banks to hold sovereign debt. This has been revealed as a mistake, just as it was wrong for the earlier Basel regulations to encourage banks to hold mortgage securities.

Most fundamentally, Basel III seems obsolete even before it can formally take effect over the next few years. Its standards imply that European banks will have to raise more capital, possibly in the hundreds of billions of dollars. At this point, that’s like wishing a poor man were a millionaire. The question will sooner be one of survival. In lieu of raising new capital, many European banks will stretch the capital they already have and meet minimum capital standards by shrinking, thereby cutting back on lending and damaging economic growth.

The standards may eventually be tossed out or revised, even though they looked good on paper not that long ago. If nothing else, after recent downgrades, there are no longer enough triple-A securities to carry out the requirements.

Despite these problems, the United States may oddly enough be facing this new financial turmoil in a relatively safe position, though whether it’s safe enough remains to be seen. The Federal Reserve took the lead on future capital requirements just last week, but for the shorter run there is a more important Fed policy move. Starting in late 2008, as a response to our financial crisis, the Fed bought government and mortgage securities from banks on a very large scale.

Bank reserves at the Fed rose from virtually nothing to more than $1.6 trillion. Then the Fed paid interest on those reserves to help keep them on bank balance sheets.

It is estimated by Moody’s that America’s biggest banks now have liquid assets that are 3 to 11 times their short-term borrowings. In other words, it’s the cushion we’ve been seeking. Furthermore, a lot of those reserves sit in the American subsidiaries of large foreign-owned banks, protecting the European system, too.

This new safety comes not from regulatory micromanagement but rather from the creation of additional safe interest-bearing assets. While European economies have been losing safe assets through debt downgrades, the United States financial system has been gaining them.

THE Fed’s stockpiled liquid reserves have met some heavy criticism. Hard-money advocates contend that they are a prelude to hyperinflation — although market forecasts and bond yields don’t bear this out — while proponents of monetary expansion have wished that banks would more actively lend out those reserves to stimulate the economy. That second view assumes that the financial crisis is essentially over, but maybe it’s not. As the euro zone crisis continues, it seems that Ben S. Bernanke has been a smarter central banker than we had realized.

The final lessons are scary, but also powerful.

First, don’t assume that the first wave of a financial crisis is the final act. Circa 1931, many people thought that the global economy was recovering, until an additional wave of financial crises caught fire in Europe and later damaged the United States. Mr. Bernanke is a scholar of exactly this period.

Second, no matter what laws are written, good central banking is the most powerful and most influential financial regulator, if only through the broad management of liquidity and safety. The euro zone has put too much responsibility on national governments and too little on its central bank.

Third, good regulation should take account of our rather extreme ignorance. That means emphasizing the more general protections, as embodied in a ready supply of safe liquid assets, rather than obsessing over the regulatory micromanagement of particular bank activities.

On the whole, we still haven’t learned that last lesson. Nonetheless, this time around we may just squeak by, largely because of the prudence of our central bank.

Tyler Cowen is a professor of economics at George Mason University.

Article source: http://www.nytimes.com/2011/12/25/business/feds-moves-offer-a-shield-against-europe-economic-view.html?partner=rss&emc=rss