By Neil Irwin
Washington Post Staff Writer
Saturday, August 23, 2008
JACKSON HOLE, Wyo., Aug. 22 -- Federal Reserve Chairman Ben S. Bernanke on Friday laid out his views of how the central bank should position itself to try to prevent or ease future financial crises. But he acknowledged that any such changes are fraught with new risks of their own.
Bernanke wants the Fed to have a more explicit role overseeing the plumbing of the financial system -- the computer systems, contractual arrangements and such by which financial institutions conduct transactions. And he would like for bank regulation to focus more on ensuring that the financial system as a whole is in sound shape, not just on the risks facing any given bank.
"An expectation by financial market participants that financial crises will never occur would create its own form of moral hazard," Bernanke said, "and encourage behavior that would make financial crises more, rather than less, likely."
Bernanke's speech here came at a conference of many of the world's top central bankers and economists on financial stability -- in the same ballroom where one year ago he indicated that the Fed would respond aggressively to a "financial storm that reached gale force some weeks before."
That storm "has not yet subsided," Bernanke said Friday, as he offered his broadest analysis to date of the regulatory failures that contributed to the problems, and said that "many challenges remain."
Since the crisis began in August 2007, the Fed has taken unprecedented steps to try to prevent the financial crisis from spilling over into the broader economy -- with limited success. One year in, Bernanke and his colleagues have begun drawing conclusions about how the financial system should be remade to prevent a repeat of this experience.
Treasury Secretary Henry M. Paulson Jr. has proposed giving the Fed broad authority over the financial system as a whole, but taking away some of its day-to-day role overseeing the soundness of bank holding companies. Congress will take up that possibility next year.
But Bernanke shows no desire to give up the Fed's responsibility for day-to-day supervision of the nation's banks, even as it takes over broad new responsibilities overseeing investment banks and other kinds of financial institutions. That concerns some experts.
"No other industrial country has the central bank also doing prudential supervision," said Charles Calomiris, a Columbia University finance professor, in presenting a paper analyzing the crisis.
The March collapse of investment bank Bear Stearns convinced Bernanke that one key to ensuring financial stability is more-intensive regulation of the nation's financial infrastructure, such as the systems that banks use to pay each other.
"This experience has led me to believe that one of the best ways to protect the financial system against future shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure," he said, including both the physical computers used to conduct trades and the various contractual arrangements and processes behind them.
The Fed felt the need to intervene to arrange the sale of Bear Stearns then because failing to do so could have caused a cascading series of failures through complex and obscure markets.
He also urged the creation of a formal procedure, likely overseen by the Treasury Department, for dissolving failed companies whose rapid collapse creates risks to the economy as a whole. In the absence of such procedures, the Fed and Treasury had to engineer the buyout of Bear Stearns in the middle of the night, using emergency authority.
Bernanke described a worry, shared by many economists outside the Fed, that if no new legislation is passed, the Bear Stearns action will create a perception that many financial firms are "too big to fail," which could lead firms to take too much risk, anticipating a government bailout if things turn sour.
However, as the Fed takes on a broader range of responsibilities, some worry that it could lose its focus on managing the nation's money supply.
"When you wake up in the morning as a Fed chairman, you're thinking about banks, about growth, about inflation," Martin Feldstein, a Harvard economist and chairman of the symposium sponsored by the Federal Reserve Bank of Kansas City, said in an interview. "It's a lot to have on your mind."
Bernanke also laid out his thinking about the recent drop in prices of oil and other commodities, making clear that he takes some solace from that shift despite data showing that the prices consumers pay spiked in July.
"The recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging," Bernanke said. Barring a reversal, they should "lead inflation to moderate later this year and next year."
He did, however, say that the Fed will "act as necessary" to achieve price stability in the medium run, which means that the Fed could raise the interest rate it controls to combat inflation if there is a big bump up in commodity prices or a significant drop in the dollar.
However, by emphasizing the drop in oil and other commodity prices, he was signaling that the central bank is likely to leave rates unchanged in the near future.