Financial Regulatory Forum

Systemic regulator plan right approach-NY Fed head

July 3, 2009

dudley    By Kristina Cooke
   NEW YORK, July 3 (Reuters) – The U.S. proposal for a systemic risk regulator to ensure firms are not taking the type of excessive risks that could destabilize the economy is the right approach but it will be difficult to execute, the president of the New York Federal Reserve said.
   William Dudley’s remarks, delivered on June 26 in Basel, Switzerland at a Bank of International Settlements (BIS) conference, were released on the New York Fed’s Web site on Friday.
   Under the Obama administration plan the Fed would have the power to monitor the financial system for potential problems that could lead to cascading failures.
   “Supervisory practices need to be revamped. They need to be coordinated and multi-disciplinary,” said Dudley, who heads the Fed’s operations on Wall Street.
   A New York Fed spokeswoman declined to comment on why there was a one-week delay in posting the speech on the Web site.
   “I think the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan, but it we shouldn’t kid ourselves about how difficult this will be to execute,” Dudley said in his remarks at the BIS conference.
   The systemic risk regulator would need “flexible and dynamic governance” to identify the important elements of systemic risk and then act on their concerns in a timely manner, he added.
   The Obama administration’s plan aims to fix flaws that allowed risky practices to escape scrutiny and resulted in the collapse of companies such as investment bank Lehman Brothers and insurer American International Group last year.
   Top Republicans and Democrats in Congress are questioning whether the proposal vests too much authority in the Fed, which has already drawn ire for its role in costly bailouts.
   Dudley said supervision should not just be firm by firm or region by region, but looking across banks, securities firms, markets and geographies.
   He said it was also important to look at how different parts of the financial system interact, as some mechanisms can reinforce a shock.
   These include collateral tied to credit ratings — as ratings downgrades can lead to collateral calls, further weakening a firm — as well as compensation tied to short-term gains which provide an incentive for employees to take on too much risk.
   A systemic risk regulator, Dudley said, could be given the authority to establish overall leverage limits or collateral requirements across the system.
  “This would give the financial authorities the ability to limit leverage and more directly influence risk premia and this might prove useful in limiting the size of future asset bubbles,” Dudley said.
   The common view among central bankers has been that asset bubbles are hard to identify and monetary policy is not the best way to stop bubbles from being created. Dudley said he hoped the crisis would lead to a reevaluation of that view.
   “I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier,” he said.
   Asset bubbles may not be that hard to identify, said Dudley, a former Goldman Sachs economist. The housing bubble in the United States — in which house prices rose much faster than income — had been identified by many in 2005, he noted. 
   While short-term interest rates aren’t well-suited to deal with asset bubbles, other tools exist, he said.
   “It might be better for central bankers to examine the efficacy of other instruments in their toolbox, rather than simply ignoring asset bubbles,” Dudley said.
   “If existing tools are judged inadequate, then central banks should work on developing additional policy instruments.”

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