RECOMMENDATIONS OF THE ISSING COMMITTEE
After the November meeting of the international grouping known as the G-20, the German government appointed a committee chaired by Professor Dr. Otmar Issing to recommend changes in policies, regulations, and supervision that would reduce the chance of future crises. The Issing committee identified three major causes of incentive misalignment: structured finance, rating agencies, and management compensation. It found that the crisis was a consequence of “massive liquidity and low interest rates” (Issing, 2008, 2) in an “environment of inadequate regulation and important gaps in supervisory oversight [and] inappropriate incentive structures” (ibid.). Unlike most comments on regulation, the report of the Issing committee emphasized incentives. This section summarizes some of its main proposals.
The committee recommended that the accuracy of rating agencies should be monitored and reported to the public. Rating fees should be linked to the accuracy of past ratings.
Many of the main proposals concern increases in transparency by specifying rules of disclosure that improve incentives by buyers and sellers of financial instruments. Securitization transactions should disclose the allocation of loss to the tranche that receives the first loss. Disclosure should be mandatory to permit the market to price risk more accurately.
The Issing committee did not propose legal limits on compensation as such rules “are expected to backfire” (ibid., 3). Instead they favored full disclosure and the development by rating agencies and auditors of a metric that reports on management incentives.
The committee also proposed a global credit register to show exposure by lenders and their counterparties. The report recognized that the register would be incomplete in real time.
CONCLUSION
The credit crisis should be used to recognize and correct errors on several sides, not to look for scapegoats and evildoers. This is a first step to market reforms that reduce the risk of repetition. We cannot avoid all risk and should not try. We can reduce risk by better policy choices.
Public and private actions contributed to the crisis. Congress and several administrations encouraged public agencies to accept much greater risk to promote home ownership. The Federal Reserve failed to develop a lender- of-last-resort policy. This failure increased uncertainty. Many banks and financial institutions reward risk taking, thereby increasing incentives for actions that later produced losses. Rating agencies erred.
This epilogue suggests some changes to respond to these failings. Unlike the claim that more regulation is needed, I argue that regulation works well only if it takes account of the incentives it induces. Good regulation aligns public and private interests where there is evidence of market failure. Bad regulation usually requires strong enforcement.
To prevent future crises, Treasury Secretary Geithner proposed creation of a new super-regulator responsible for monitoring risk throughout the financial system. His proposal has major problems. First, there is no evidence that anyone can succeed at that task. The Federal Reserve’s record in the savings and loan, Latin American debt, and recent mortgage and banking crises strongly suggests that they would fail. The Securities and Exchange Commission failed totally to prevent the Madoff scandal despite receiving evidence of Madoff’s fraud. Also, the proposal ignores the pressures from Congress and others to support failing institutions important to the members. Second, the proposal increases regulators’ responsibility with errors being paid for by taxpayers. A much better alternative is to strengthen bankers’ responsibility by ending too big to fail and making managements and stockholders responsible for losses. This encourages bankers to hold collateral, monitor risks, and remain vigilant about the risks they accept. And it removes the risk of losses falling on taxpayers and the public.
One consequence of the credit and economic crisis is the aggressive response by governments and central banks to restore stability and growth. Eventually the excessive liquidity they created must be eliminated, a task that will not be easily accomplished. The Federal Reserve has not given much thought to how it will avoid inflation after the recovery is under way. And the greatly expanded role of governments and central banks must not become a precedent. A main lesson of this crisis is that societies must reinvent individual responsibility for avoiding excessive risk. This will be neither easy nor popular with many, but the survival and prosperity of a free society requires greater acceptance of individual responsibility for mistakes. We cannot expect a private system to survive if the profits go to the bankers and the losses go to the taxpayers.
We cannot know what the future consequence of the crisis and the policy response will be. We should recognize, however, that despite the severity of the crisis, regulators have not announced a policy or encouraged financial markets to believe that they have abandoned “too big to fail.” In fact, mergers have made the largest firms larger.
The broader lesson of this experience should be that policy misjudgments by Congress and the Federal Reserve helped to bring on the crisis. Discretionary policy failed in 1929–33, in 1965–80, and now. The Federal Reserve should announce and follow a rule for its lender-of-last-resort actions. For monetary policy, the lesson should be less discretion and more rule-like behavior. For several years, I have proposed a multilateral arrangement under which major currencies—the dollar, the euro, and the yen— would agree to maintain a common rate of inflation. That would work to increase both expected price stability and greater nominal exchange rate stability. To implement the policy, the Federal Reserve should commit to the Taylor rule. For the monetary policy to work well, the Congress and the Treasury should agree to limit the budget deficit to a narrow range. A rule of this kind increases stability of both domestic and global economies. And Congress should put its housing subsidies on budget and close Fannie Mae and Freddie Mac. As the Issing committee showed, the route to less risky financial markets starts with stabilizing incentives.
The current crisis calls for reopening long-settled issues about Federal Reserve governance and independence. The 1913 Federal Reserve Act and all subsequent legislation made the Federal Reserve independent but never defined independence. Under the gold standard, that was not much of a problem, but this history shows that Federal Reserve chairs often gave up independence. The Volcker and Greenspan eras restored independence, but Chairman Bernanke has acted frequently as a financing arm of the Treasury.
The purpose of independence is to prevent government from using the central bank to finance its spending and budget deficit. Independence should not be left to the decision of the chair or the members of the Board of Governors. To protect the public, it should be defined in law. At the same time, the position of the presidents of the reserve banks should be clearly defined. Questions about their role arose many times in the past, and it has come up again. The presidents have an important role. They talk to people in their districts, and they have been a source of valid criticism of the Board’s procedures for controlling inflation or analyzing the economy. Also, as the system developed, the Board chair became the dominant spokesperson. This too seems an unwise development.
A History of the Federal Reserve, Volume 2 Page 81
