I want to be very clear: too big to fail is one of the biggest problems we face in this country, and we must take action to eliminate too big to fail.
~Ben Bernanke, Interview in Time Magazine, Page 78, Dec 28 2009-Jan 4 2010 Issue.
~Ben Bernanke, Interview in Time Magazine, Page 78, Dec 28 2009-Jan 4 2010 Issue.
Among the most prominent policy questions currently under debate is how to restructure the architecture of the financial system and its regulatory infrastructure so as to minimize the risk of a future financial meltdown. The core of this discussion focuses on the fact that several of the large financial institutions that were on the brink of collapse, such as Bear Stearns, Bank of America, Citibank and AIG, were considered “too big to fail.” In the opinion of some experts, it was the collapse of Lehman Brothers that triggered the most severe phase of the financial crisis that still continues to course through the economy. In this view, the decision not to bail out Lehman Brothers may have been a mistake. It is in this context that the Chairman of the Federal Reserve, Ben Bernanke, seeks expanded regulatory authority over the nation’s financial system from Congress. At the same time however, there is also a proposal under consideration in Congress to subject the Federal Reserve’s decisions to increased Congressional oversight.
The rationale for these two opposing policy proposals are quite different. From the Fed's point of view, the argument runs as follows. The financial system, by necessity is, and always will be, highly interlinked in the form of interbank borrowing and other reciprocal financial contracts. In a densely interconnected financial network, if a few firms end up with a disproportionate share of the links, then the collapse of one of these "large" firms can set off a cascade of failures that reverberates through the entire network, becoming amplified in the process and ultimately jeopardizing the entire system. Such a systemic failure can have catastrophic consquences. In order to avert this scenario, it is important to reform the financial system so that the distribution of financial interlinkages is more decentralized and less lop-sided. The Federal Reserve seeks the authority to oversee and regulate the system to prevent such a configuration from arising. A more uniform market organization should be more robust to occasional bank failures, so the thinking goes.
The opposing point of view is that the Federal Reserve already wields tremendous power of the financial system. This is manifested in its independent ability to set interest rates, as well as engage in the kind of unorthodox crisis management that we've seen over the last year, such as participating directly in the market for mortgage-backed securities, commercial paper, and coordinating closely with the treasury in bank bailouts. Shouldn't an organization with so much power be more readily answerable to Congress?
This argument sounds logical and persuasive, save for one very big caveat. Precisely because the Federal Reserve wields inordinate power over the economy via its control of monetary policy, it is important for it to be politically independent. This is a central tenet of effective Central Banking. The moment it is perceived that a nation's central bank is driven by political motivations, it becomes much less effective at monetary policy.
The rationale for these two opposing policy proposals are quite different. From the Fed's point of view, the argument runs as follows. The financial system, by necessity is, and always will be, highly interlinked in the form of interbank borrowing and other reciprocal financial contracts. In a densely interconnected financial network, if a few firms end up with a disproportionate share of the links, then the collapse of one of these "large" firms can set off a cascade of failures that reverberates through the entire network, becoming amplified in the process and ultimately jeopardizing the entire system. Such a systemic failure can have catastrophic consquences. In order to avert this scenario, it is important to reform the financial system so that the distribution of financial interlinkages is more decentralized and less lop-sided. The Federal Reserve seeks the authority to oversee and regulate the system to prevent such a configuration from arising. A more uniform market organization should be more robust to occasional bank failures, so the thinking goes.
The opposing point of view is that the Federal Reserve already wields tremendous power of the financial system. This is manifested in its independent ability to set interest rates, as well as engage in the kind of unorthodox crisis management that we've seen over the last year, such as participating directly in the market for mortgage-backed securities, commercial paper, and coordinating closely with the treasury in bank bailouts. Shouldn't an organization with so much power be more readily answerable to Congress?
This argument sounds logical and persuasive, save for one very big caveat. Precisely because the Federal Reserve wields inordinate power over the economy via its control of monetary policy, it is important for it to be politically independent. This is a central tenet of effective Central Banking. The moment it is perceived that a nation's central bank is driven by political motivations, it becomes much less effective at monetary policy.
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