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Friday, June 26, 2009

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Let's get it right this time

Guest column

By Andrew T. Hook

As the politicians get together with the financial community to decide what to do about the financial sector, we should be clear both about what went wrong and how to prevent it from happening again. Many mistakes were made, by many people, from the purchasers of new homes, the spinners of mortgages, those who pumped the all-too-risky assets into the domestic and world markets, and those who were responsible for the oversight and supervision of the financial sector. Also, we should be clear, without the failure of the financial sector, both the banks, and other financial institutions, and the bank supervisors, including first and foremost the Federal Reserve Board, we would not have had the financial and economic crisis that we are now living through. While some debate is possible, if the financial regulators had been alert and had taken action to slow down the build up of toxic assets, we can be sure that the high unemployment we now face, moving toward 10 percent would not have happened. To do nothing now to address this weakness would be totally irresponsible.

Turning to public policy, as that is where the debate is currently being held in regards to the financial sector, it should be clear that there were two principal reasons for the failure of the financial regulators, with one reason being foremost: 1) the lack of responsibility and accountability of the top officials of the Federal Reserve Board and 2) the inability o the front line regulators and supervisors to identify and/or pass on their concerns to the senior officials. The Federal Reserve Board has been aware of the issue and problems of systemic risk for a long time, but the chairman at the time closed his eyes and his mind to the possibility of such a systemic crisis building up. If he had taken responsibility for the good operation of the financial sector, as he was implicitly for systemic risk as he should have, the problems would have been contained. His assumption that the markets would take care of everything was irresponsible as well as being incorrect. They will take care of matters, but only at a high cost of systemic failures.

We know that there were Federal Reserve officials who recognized the building problems and raised the issues, but they were ignored. This underlines the other weakness that we must address; the bureaucracy that dominates financial regulation. To some extent this is unavoidable, as financial regulation is an on-going task that must be thorough, and that depends on routine in order to maintain standards and continuity. However, the characteristics that make a good bureaucracy are also those that will blind people to new problems and to the unusual. And, naturally enough, the latter are what cause the financial crises.

There must be room in the new financial oversight structure for independently minded officials who can and do question the on-going work of the institution. An internal GAO that has leeway to bring up issues to the highest levels of the regulators is necessary, to catch the inevitable new developments early enough to respond constructively. This will not be comfortable, as it will mean internal challenges, but without such independent intelligence the financial officials are likely to miss once again the coming storm.

This will mean that the chairman of the Federal Reserve Board must recognize his or her responsibilities, not only for monetary policy but also for the stability of the financial sector. As we have seen, the central role of the United States means that the stability of the world' financial sector is also at stake. Yes, this will be additional to the current responsibilities, but unless this is recognized explicitly, we risk missing any early warning of the next financial storm. Thus, explicit responsibility at the highest level of the Federal Reserve Board for financial stability and openness to new information from within the community of financial regulators and an independent body within the Federal Reserve System that can questions and bring Issues and risks to the highest level are necessary to build a sound and robust financial sector. The country deserves no less.

ANDREW T. HOOK, who owns a cabin in the Crosby area, is professor of economics and business at the newly formed American University of Afghanistan. He has 30 years of experience in banking, finance and economic development throughout the world and has worked for the World Bank, the International Monetary Fund and the Federal Reserve Bank of New York.

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