Fed’s Kohn’s systemic risk testimony to House panel

July 9, 2009

Vice Chairman of the Board of Governors of the Federal Reserve System Donald Kohn     WASHINGTON, July 9 (Reuters) – Following is the full text of Federal
Reserve Vice Chairman Donald Kohn’s testimony delivered on Thursday before a
House Financial Services subscommittee hearing on systemic risk regulation: 
    “Chairman Watt, Ranking Member Paul, and other members of the Subcommittee,
I appreciate the opportunity to discuss with you the important public policy
reasons why the Congress has long given the Federal Reserve a substantial
degree of independence to conduct monetary policy while ensuring that we remain
accountable to the Congress and to the American people. In addition, I will
explain why an extension of the Federal Reserve’s supervisory and regulatory
responsibilities as part of a broader initiative to address systemic risks
would be compatible with the pursuit of our statutory monetary policy
objectives. I also will discuss the significant steps the Federal Reserve has
taken recently to improve our transparency and maintain accountability.
Independence and Accountability
    A well-designed framework for monetary policy includes a careful balance
between independence and accountability. A balance of this type conforms to our
general inclination as a nation to have clearly drawn lines of authority,
limited powers, and appropriate checks and balances within our government; such
a balance also is conducive to sound monetary policy.
    The Federal Reserve derives much of the authority under which it operates
from the Federal Reserve Act. The act specifies and limits the Federal
Reserve’s powers. In 1977, the Congress amended the act by establishing maximum
employment and price stability as our monetary policy objectives; the Federal
Reserve has no authority to establish different objectives. At the same time,
the Congress has–correctly, in my view–given the Federal Reserve considerable
scope to design and implement the best approaches to achieving those statutory
objectives. Moreover, as I will discuss in detail later, the independence that
is granted to the Federal Reserve is subject to a well-calibrated system of
checks and balances in the form of transparency and accountability to the
public and the Congress.
    The latitude for the Federal Reserve to pursue its statutory objectives is
expressed in several important ways. For example, the Congress determined that
Federal Reserve policymakers cannot be removed from their positions merely
because others in the government disagree with their views on policy issues. In
addition, to guard against indirect pressures, the Federal Reserve determines
its budget and staff, subject to congressional oversight. Thus, the system has
three essential components: broad objectives set by the Congress, independence
to pursue those legislated objectives as efficiently and effectively as
possible, and accountability to the Congress through a range of vehicles.
Benefits of Independence to Conduct Policy in Pursuit of Legislated Objectives
    The insulation from short-term political pressures–within a framework of
legislated objectives and accountability and transparency–that the Congress
has established for the Federal Reserve has come to be widely emulated around
the world. Considerable experience shows that this type of approach tends to
yield a monetary policy that best promotes economic growth and price stability.
Operational independence–that is, independence to pursue legislated
goals–reduces the odds on two types of policy errors that result in inflation
and economic instability. First, it prevents governments from succumbing to the
temptation to use the central bank to fund budget deficits. Second, it enables
policymakers to look beyond the short term as they weigh the effects of their
monetary policy actions on price stability and employment.
    History provides numerous examples of non-independent central banks being
forced to finance large government budget deficits. Such episodes invariably
lead to high inflation. Given the current outlook for large federal budget
deficits in the United States, this consideration is especially important. Any
substantial erosion of the Federal Reserve’s monetary independence likely would
lead to higher long-term interest rates as investors begin to fear future
inflation. Moreover, the bond rating agencies view operational independence of
a country’s central bank as an important factor in determining sovereign credit
ratings, suggesting that a threat to the Federal Reserve’s independence could
lower the Treasury’s debt rating and thus raise its cost of borrowing.1 Higher
long-term interest rates would further increase the burden of the national debt
on current and future generations.2
    The second way in which political interference with monetary policy can
damage the economy is by promoting an undue focus on the short term. Because
excessively easy monetary policy tends to boost economic activity temporarily
before the destabilizing effects of higher inflation are felt, policymakers
with a relatively short-term outlook may be tempted to ease monetary policy too
much. The eventual result is higher inflation without any permanent benefit in
terms of employment, an outcome that is inconsistent with the dual mandate for
maximum employment and price stability. Thus the increase in inflation must be
followed by policies to bring inflation back down–policies that have the side
effect of temporarily reducing output and employment. The fixed, lengthy, and
overlapping terms of Federal Reserve Board members, in combination with the
other elements of operational independence, help ensure that the Federal
Reserve appropriately considers both the short-term and long-term effects of
its policy decisions.
    Statistical studies have confirmed that countries with more independent
central banks experience lower and more stable rates of inflation with no
sacrifice of jobs or income.3 Moreover, low and stable rates of inflation help
to deliver strong economic growth and high rates of employment. The benefits of
central bank independence appear to be a major explanation for the trend I
mentioned earlier of countries moving to establish or to enhance the
independence of their central banks. It is surely no coincidence that countries
around the world have experienced sustained declines in the level and
variability of inflation as they have moved to grant their central banks
greater operational independence.
Monetary Policy Independence and the Mitigation of Systemic Risk
    Is monetary policy independence threatened by giving a central bank other
responsibilities, such as supervisory and regulatory authority for some parts
of the financial system? Are there potential conflicts between a high degree of
independence for monetary policy and accountability in supervisory and
regulatory policy? I believe that U.S. and foreign experience shows that
monetary policy independence and supervisory and regulatory authority are
mutually compatible and even have beneficial synergies.
    The current financial crisis has clearly demonstrated the need for the
United States to have a comprehensive and multifaceted approach to containing
systemic risk. The Administration recently released a proposal for
strengthening the financial system that would provide new or enhanced
responsibilities to a number of federal agencies, including the Securities and
Exchange Commission (SEC) and the Commodity Futures Trading Commission with
respect to over-the-counter derivatives, the SEC with respect to hedge funds
and their advisers, and several agencies, including the Treasury, the Federal
Deposit Insurance Corporation, the Federal Reserve Board, and the SEC with
respect to the resolution of systemically important failing nonbank financial
institutions. In addition, the proposal would provide the Federal Reserve
certain new responsibilities for overseeing systemically important financial
institutions and payment, clearing, and settlement arrangements.
    These incremental new responsibilities are a natural outgrowth of the
Federal Reserve’s existing supervisory and regulatory responsibilities. Through
our role as consolidated supervisor of all bank holding companies (BHCs), the
Federal Reserve has long been responsible for supervising many of the most
important U.S. financial organizations, and in the current crisis several more
large complex financial firms–including Goldman Sachs, Morgan Stanley, and
American Express–have become bank holding companies. And the expanded
regulatory authority of the Federal Reserve with respect to payment and
settlement systems builds upon our existing responsibilities for supervising
certain critical payment, clearing, and settlement systems, such as the
Depository Trust Company and CLS Bank, as well as our historical efforts to
reduce risk in such systems through, for example, our Payment System Risk
    The authorities that the Administration’s proposal would provide the
Federal Reserve with respect to systemically important non-BHC financial firms
and payment, clearing and settlement systems also are similar in many respects
to the authorities that the Federal Reserve currently has with respect to bank
holding companies and payment, clearing, and settlement systems under our
supervision. The Administration’s proposal does call for a more
macro-prudential approach to the supervision and regulation of systemically
important financial firms and payment, clearing, and settlement systems,
including the establishment of higher capital, liquidity, and risk-management
requirements for systemically important firms. The Federal Reserve already has
been moving to incorporate a more macro-prudential approach to our supervisory
and regulatory programs, as evidenced by the recently completed Supervisory   
Capital Assessment Program. The Federal Reserve has also long been a leader in
the development of strong international risk-management standards for payment,
clearing, and settlement systems and has implemented these standards for the
systems it supervises.
    In our supervision of bank holding companies and our oversight of some
payment systems, we already work closely with other federal and state agencies
and participate in groups of regulators and supervisors such as the Federal
Financial Institutions Examination Council and the President’s Working Group on
Financial Markets. These responsibilities and close working relationships have
not impinged on our monetary policy independence, and we do not believe that
the enhancements proposed by the Administration to the Federal Reserve’s
supervisory and regulatory authority would undermine the Federal Reserve’s
ability to pursue our monetary policy objectives effectively and
    Indeed, these enhancements would complement the Federal Reserve’s monetary
policy responsibilities. The Federal Reserve and other central banks have
always been involved in issues of systemic risk, most notably because central
banks act as lenders of last resort. Central banks, which operate in markets
daily and have macroeconomic responsibilities, bring a broad and unique
perspective to analysis of developments in the financial system. And, as we
have seen over the past two years, threats to the stability of the financial
system can have major implications for employment and price stability. Thus,
the Federal Reserve’s monetary policy objectives are closely aligned with those
of minimizing systemic risk. To the extent that the proposed new regulatory
framework would contribute to greater financial stability, it should improve
the ability of monetary policy to achieve maximum employment and stable
Accountability and Transparency
    In a democracy, any significant degree of independence by a government
agency must be accompanied by substantial accountability and transparency. The
Congress and the Federal Reserve have established a number of policies and
procedures to ensure that the Federal Reserve continues to use its operational
independence in a manner that promotes the nation’s well-being. The Federal
Reserve reports on its experience toward achieving its statutory objectives in
the semiannual Monetary Policy Reports and associated congressional testimony.
The Federal Open Market Committee (FOMC) releases a statement immediately after
each regularly scheduled meeting and detailed minutes of each meeting on a
timely basis. We also publish summaries of the economic forecasts of FOMC
participants four times a year. In addition, Federal Reserve officials
frequently testify before the Congress and deliver speeches to the public on a
wide range of topics, including economic and financial conditions and monetary
and regulatory policy.
    Our financial controls are examined by an external auditor, and Reserve
Bank operations and controls are reviewed by each Reserve Bank’s independent
internal audit function and by Board staff who oversee Reserve Bank activities.
We provide the public and the Congress with detailed annual reports on the
consolidated financial activities of the Federal Reserve System that are
audited by an independent public accounting firm. We also publish a detailed
balance sheet on a weekly basis.
    The Federal Reserve recognizes that the new programs we have instituted to
combat the financial crisis must be accompanied by additional transparency.
Americans have a right to know how the Federal Reserve is using taxpayer
resources and they need to be assured that we are acting in a responsible
manner that minimizes risk and maintains the integrity of our operations. We
have increased the transparency of our actions while safeguarding our ability
to achieve our public policy goals of fostering financial and economic
stability. This year we expanded our website to include considerable background
information on our financial condition and our policy programs. Recently, we
initiated a monthly report to the Congress and the public on Federal Reserve
liquidity programs that provides even more information on our lending, the
associated collateral, and other facets of programs established to address the
financial crisis. These steps should help the public understand the
considerable efforts we have taken to minimize the risk of loss as we provide
liquidity to the financial system in our role as lender of last resort.
Altogether, we now provide a higher degree of transparency than at any other
time in the history of the Federal Reserve System. Because of the large volume
of information we publish, the Federal Reserve is among the most transparent
central banks in the world.
    Federal Reserve policymakers are highly accountable and answerable to the
government of the United States and to the American people. The seven members
of the Board of Governors of the Federal Reserve System are appointed by the
President and confirmed by the Senate after a thorough process of public
examination. The key positions of Chairman and Vice Chairman are subject to
presidential and congressional review every four years, a separate and shorter
schedule than the 14-year terms of Board members. The members of the Board of
Governors account for seven seats on the FOMC. By statute, the other five
members of the FOMC are drawn from the presidents of the 12 Federal Reserve
Banks. District presidents are appointed through a process involving a broad
search of qualified individuals by local boards of directors; the choice must
then be approved by the Board of Governors. In creating the Federal Reserve
System, the Congress combined a Washington-based Board with strong regional
representation to carefully balance the variety of interests of a diverse
nation. The Federal Reserve Banks strengthen our policy deliberations by
bringing real-time information about the economy from their district contacts
and by their diverse perspectives.
Oversight by the Government Accountability Office
    On the topic of Federal Reserve accountability and transparency, the
possibility of expanding the audit authority of the Government Accountability
Office (GAO) over the Federal Reserve has recently been discussed. As you know,
the Federal Reserve is subject to frequent audits by the GAO on a broad range
of our functions.
    For example, the supervisory and regulatory functions of the Federal
Reserve are subject to audit by the GAO to the same extent as the supervisory
and regulatory functions of the other federal banking agencies. Thus, the GAO
has full authority to–and does in fact–audit the manner in which the Federal
Reserve supervises and regulates bank holding companies on a consolidated
basis. Moreover, if the Congress were to provide the Federal Reserve with
responsibility for serving as the consolidated supervisor of systemically
important financial firms that are not bank holding companies, the GAO would,
under existing law, have full authority to audit the Federal Reserve’s
supervision and regulation of such firms as well. We would expect the GAO to
actively use that authority, as it does today. Indeed, as of June 29, 2009, the
GAO had 19 engagements under way involving the Federal Reserve, including 14
that were initiated at the request of the Congress. In addition, since the
beginning of 2008, the GAO has completed 26 engagements involving the Federal
Reserve, including engagements related to the Basel II capital framework,
risk-management oversight, the Bank Secrecy Act, and the Board’s Regulation B,
which implements the Equal Credit Opportunity Act.
    The Congress also recently clarified the GAO’s ability to audit the Term
Asset-Backed Securities Loan Facility (TALF), a joint Treasury-Federal Reserve
initiative, in conjunction with the GAO’s reviews of the performance of
Treasury’s Troubled Asset Relief Program (TARP). The Federal Reserve has been
working closely with the GAO to provide that agency with access to information
and personnel to permit it to fully understand the terms, conditions, and
operations of the TALF so that the TARP can be properly audited. At the same
time, the Congress granted the GAO new authority to conduct audits of the
credit facilities extended by the Federal Reserve to “single and specific”
companies under the authority provided by section 13(3) of the Federal Reserve
Act, including the loan facilities provided to, or created for, American
International Group and Bear Stearns. These facilities are markedly different
from the widely available credit facilities–such as the discount window access
for depository institutions, the Primary Dealer Credit Facility, and the
Commercial Paper Funding Facility–that the Federal Reserve either has
historically used or has recently established to address broad credit and
liquidity issues in the financial system. For this reason, the Federal Reserve
did not object to granting the GAO audit authority over these
institution-specific, emergency credit facilities.
    The Congress, however, has purposefully–and for good reason–excluded from
the scope of potential GAO audits monetary policy deliberations and operations,
including open market and discount window operations, and transactions with or
for foreign central banks, foreign governments, and public international
financing organizations. By excluding these areas, the Congress has carefully
balanced the need for public accountability with the strong public policy
benefits that flow from maintaining the independence of the central bank’s
monetary policy functions and avoiding disruption to the nation’s foreign and
international relationships.
    The same public policy reasons that supported the creation of these
exclusions in 1978 remain valid today. The Federal Reserve strongly believes
that removing the statutory limits on GAO audits of monetary policy matters
would be contrary to the public interest by tending to undermine the
independence and efficacy of monetary policy in several ways. First, the GAO
serves as the investigative arm of the Congress and, by law, must conduct an
investigation and prepare a report whenever requested by the House or Senate or
a committee with jurisdiction of either body. Through its investigations and
audits, the GAO typically makes its own judgments about policy actions and the
manner in which they are implemented, as well as recommendations to the audited
agency and to the Congress for changes or future actions. Accordingly,
financial markets likely would see the grant of audit authority with respect to
monetary policy to the GAO as undermining monetary independence–with the
adverse consequences discussed previously–particularly because GAO audits, or
the threat of a GAO audit, could be used to try to influence monetary policy
    Permitting GAO audits of monetary policy also could cast a chill on
monetary policy deliberations through another channel. Although Federal Reserve
officials regularly explain the rationale for their policy decisions in public
venues, the process of vetting ideas and proposals, many of which are never
incorporated into policy decisions, could suffer from the threat of public
disclosure. If policymakers believed that GAO audits would result in published
analyses of their policy discussions, they might be less willing to engage in
the unfettered and wide-ranging internal debates that are essential to
identifying the best possible policy options. Moreover, the publication of the
results of GAO audits related to monetary policy actions and deliberations
could complicate and interfere with the communication of the FOMC’s intentions
regarding monetary policy to financial markets and the public more broadly.
Households, firms, and financial market participants might be uncertain about
the implications of the GAO’s findings for future decisions of the FOMC,
thereby increasing market volatility and weakening the ability of monetary
policy actions to achieve their desired effects.
    These concerns extend to the policy decisions to implement the discount
window and broadly available credit facilities. These facilities are extensions
of our responsibility for promoting financial stability, maximum employment and
price stability. Indeed, unlike the institution-specific loans that the Federal
Reserve has made that now are subject to GAO audit, these broader market
facilities are designed to unfreeze financial markets and lower interest rate
spreads in concert with our other monetary policy actions. It is important
that, like other monetary policy decisions, the Federal Reserve remain
independent in making policy decisions regarding these facilities.
    An additional concern is that permitting GAO audits of the broad liquidity
facilities the Federal Reserve uses to affect credit conditions could reduce
the effectiveness of these facilities in helping promote financial stability,
maximum employment, and price stability. For example, even if strong
confidentiality restrictions were established, individual banks might be more
reluctant to borrow from the discount window if they knew that their identity
and other sensitive information about their borrowings could be disclosed to
the GAO. Rumors that a bank may have used the discount window can cause a
damaging loss of confidence even to a fundamentally sound institution.
Experience, including experience in the current financial crisis, shows that
banks’ unwillingness to use the discount window can result in high and volatile
short-term interest rates and limit the effectiveness of the discount window as
a tool to enhance financial stability.
    Overall, the Federal Reserve believes that removing the remaining statutory
limits on GAO audits of monetary policy and discount window functions would
tend to undermine public and investor confidence in monetary policy by raising
concerns that monetary policy judgments in pursuit of our legislated objectives
would become subject to political considerations. As a result, such an action
would increase inflation fears and market interest rates and, ultimately,
damage economic stability and job creation.
    Thank you for inviting me to present the Board’s views on this very
important subject. I look forward to answering any questions you may have.”
1 Standard & Poor’s (2004), “Sovereign Credit Ratings: A Primer,” March 15,
2 The beneficial effects of central bank independence on a government’s
borrowing costs have been observed even when budget deficits are not unusually
large. For example, on May 6, 1997, the U.K. government announced that the Bank
of England would be given considerable operational independence. The yield on
10-year U.K. government bonds fell 30 basis points that day, even though the
government made no change to the Bank of England’s policy objectives and there
was no other prominent economic or policy news. Market participants widely
attributed the decline in long-term interest rates to the surprise announcement
of independence and the consequent increased confidence in future price
3 See, for example, the survey in Alex Cukierman (2008), “Central Bank
Independence and Monetary Policymaking Institutions–Past, Present, and
Future,” European Journal of Political Economy, vol. 24 (December), pp.
4 The Federal Reserve’s Payment System Risk Policy can be found at
  ((Reuters Washington Newsroom, 202 898 8310))
Keywords: USA FED/KOHN TEXT =4

Thursday, 09 July 2009 18:25:45RTRS [nN09458743] {EN}ENDS

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