Fed Governor Dudley part 2

The other part of NY Federal Bank President Dudley's remarks dealt with the causes of the current recession and steps being taken to ensure it doesn't happen again. It is only mildly interesting to note that while in the same speech he praised the new Fed tool of paying interest on excess reserves (IOR) as being powerfully contractionary, he did not mention its introduction and use as one of the issues currently facing the economy. What I gather from his talk was that the Fed instead views IOR as a means of lowering the expected cost of quantitative easing, so tightening policy makes it less costly to loosen it again later. ... What am I missing here? Since we were encouraged to not have video or audio recording equipment, I apologize if any of my notes and conclusions misrepresent the position of Governor Dudley or the Fed. From my notes:

The recession has taught the Fed that they needed to elevate their "financial stability" hobby to a level on par and equal to their inflation-and-unemployment fighting role. This is seen in the 5 causes of financial instability: lousy incentives (traders receive bonuses for risky behavior that pays off and no penalty for failure), lack of transparency (Wall Street firms said it would take over three weeks to find out the worth of a particular asset), inadequate liquidity and low quality capital, interconnectedness (Banks had long claimed they were not on a contractual hook for paying any debts in the shadow banking sector, but they were on a reputational hook; when credit ratings fell, it made it harder to raise capital, which lowered their ratings further in a vicious cycle), and the Fed lacked a resolution mechanism for liquidating large financial institutions like Lehman. Put the points together and Dudley said the consequences for letting Lehman fall were more vicious than they had imagined. He also noted later that AIG just happened to have run out of liquidity at about the same time which was the worst possible timing of events.

So what are we doing? Bankers are meeting in Basel, Switzerland, to construct new capital standards for international banking. Large, international firms will have to be able to prove they have a 30 day liquidity buffer so they won't have to rely on financial markets for up to a month should it come to it. That way investors can be assured they will be solvent even in a crisis.

He was largely positive about the Dodd-Frank bill's oversight council, whose main purpose he characterized as watching for systemic risk in macro/environmental factors, products and practices, institutions, and a fourth "bucket" he didn't name. Subprime lending with poor underwriting was the "Ground Zero" for the recession. There is also a push in the bill to standardize and regulate over the counter derivatives. The more controversial rule in the bill is the Volcker rule.

The bill only lists the requirements of what needs to be done rather than spelling out how. That means the Fed is going to be writing the regulations and laws on how. The Fed in that way will be acting a lot like the courts or the IRS, not "writing" the law but yes they are (as Sotomayor mentioned) [and that's entirely my own analogy, not Dudley's]. When asked if the Fed's new responsibilities and powers would compromise its independence, Dudley said that he had every hope of maintaining the Fed's independence in setting monetary policy but expected that the Fed would and should not maintain it in writing the regulations. If it is to be the servant of Congress, Congress should have some say.

Also from the Q&A session, he mentioned that they would not be directly regulating the credit agencies, but the bill forbids the Fed from using the credit agencies' ratings. So they are going to have to do it or figure out another system. He said this goes rather farther than the Fed Board thinks is ideal. They would rather see a modest fix to the incentive problem of letting the agencies be paid by the people they are rating.

He is bullish on changing the rules for traders. The banks are actually pretty happy about a changing landscape: none of them can individually change the incentive rules (the good traders will go where they can be paid more) so it needs to be coordinated by the Fed. But changing the rules will be a work of years done in consultation with the banks and financial firms. When he speaks with businesses, the thing he hears over and over again is that politicains are creating more uncertainty. There needs to be a less adversarial and more partnership atmosphere.