The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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March 05, 2010

In the beginning, there was a lender of last resort

Steven Pearlstein, business columnist for the Washington Post, asks and answers the question "should the Fed stay out of the bank supervision business?"

"As the Senate begins to focus on how to fix financial regulation, one of the remaining unresolved issues is what role the Federal Reserve should have in supervising banks.

"The correct answer? None at all."

One of the centerpieces of the Pearlstein argument is this:

"The reality is that the Fed's primary focus is and will always be on monetary policy. Bank supervision will continue, as it has been, as a secondary activity that not only receives less attention from the top but will be sacrificed at those rare but crucial moments when the two missions might conflict. Indeed, by arguing that the Fed needs the insights gleaned from bank supervision to be more effective in making monetary policy, the Fed essentially acknowledges this hierarchy in its priorities. Bank supervision is important enough that it ought to be somebody else's top priority."

If you might allow me a moment of personal indulgence, there was a time when I had some sympathy with the sentiment that the "Fed's primary focus is and always will be on monetary policy." I, of course, knew the story of the creation of the Fed, motivated by the need to provide an elastic currency to avoid disruptive fluctuations in prices and a lender of last resort to stop liquidity stress from becoming a full-blown financial crisis. But that was a story from the past. The modern world began in 1935 with the statutory creation of the Federal Open Market Committee, which would eventually evolve, with its central bank brethren in the rest of the world, into the institution described by Pearlstein as being primarily focused on monetary policy.

I felt that way until Sept. 11, 2001. On an average day in the week ending Sept. 5 of that year, the Federal Reserve extended $21 million in discount loans to banks, a reasonably representative volume. On Sept. 12, discount loans amounted to over $45 billion. As a result, the U.S. financial system did not collapse.

The horrible circumstances of 9/11 have been thankfully unique, but there is a case to be made for the proposition that the most important role of the central bank in the recent financial crisis was not in the realm of traditional monetary policy but in the exercise of variations on the lender-of-last-resort function. In fact, in times of acute financial stress, this role must always be so. Witness this remark by Alan Greenspan on Oct. 20, 1987:

"… in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos."

Which brings us to the question of the Fed's role in bank supervision. More precisely, it brings us to comments from Atlanta Fed President Dennis Lockhart, who delivered remarks on Wednesday to the New York Association for Business Economics:

"… the Fed must play a central role in a defense structure designed to prevent or manage future crises. My key argument is the indivisibility of monetary authority, the lender-of-last-resort role, and a substantial direct role in bank supervision. Only the Fed can act as lender of last resort because only the monetary authority can print money in an emergency. To make sound decisions, the lender of last resort needs intimate hard and qualitative knowledge of individual financial institutions, their connectedness to counterparties, and the capacity of management.

"There is sentiment in Washington that would separate these tightly linked functions that are so critical in responding to a financial crisis. Removing the central bank from a supervision role designed to provide totally current, firsthand knowledge and information will weaken defenses against recurrence of financial instability. Flawed defenses could be calamitous in a future we cannot see."

If this advice goes unheeded, I fear we might discover its wisdom in the worst possible circumstances.

By Dave Altig, senior vice president and research director at the Atlanta Fed

March 5, 2010 in Federal Reserve and Monetary Policy , Financial System , Monetary Policy , Regulation | Permalink


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Dave, is the Federal Reserve taking action to strengthen its level of expertise in banking and financial intermediation and risk management ? The argument has been made that its academic staff were very good at doing 1001 variations on the Taylor rule but lacked the human capital necessary to understand financial developments. I don't know if that was true, but it would explain the Fed's dereliction of duty in the latter years of Greenspan tenure.

Posted by: PE | March 05, 2010 at 06:08 PM

The best banking system in the world (Canada) separates the two functions.

Posted by: JKH | March 06, 2010 at 11:11 AM

Indeed, if this crisis demonstrates nothing else, it is that monetary policy is indivisible from regulation. Loose regulation is a form of loose monetary policy.

Since virtually all innovation has eventually come around to the Fed to backstop, one would wish the Fed would get out in front to decide what it can and cannot defend. We suspect it is too late.

Posted by: Alan Harvey | March 06, 2010 at 06:13 PM

What of the argument that it was the Fed's failed supervision and regulation that in part caused the crisis? If the Fed hadn't failed in S&R, then maybe we wouldn't have needed all the new liquidity facilities in the first place. Perhaps a somehow more effective regulatory body could have avoided the current crisis? The question seems to come down to "who can do it better?" Perhaps the answer is noone.

Also, for 9/11, I wonder what the counterfactual would have been if the Fed didn't have bank regulatory powers. That is, would the Fed still have opened the liquidity spigot without the "hard and qualitative knowledge of individual financial institutions..."?

Posted by: MH | March 09, 2010 at 10:45 AM

The best banking system in the world (Australia) separates the two functions.

Nevertheless, this rule is necessary but not sufficient.

Posted by: Thomas Esmond Knox | March 15, 2010 at 03:26 AM

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