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Minneapolis Fed president blasts financial reform proposal in Senate

Saying that “stripping the Federal Reserve of its supervisory role would needlessly put a Great Depression on the menu of possibilities for our country,” Minneapolis Federal Reserve Bank President Narayana R. Kocherlakota took aim at a financial reform proposal before Congress in an address to state bankers.

In published remarks delivered Feb. 16 to the Minnesota Bankers Association, Kocherlakota criticized a proposal by Sen. Chris Dodd, D-Conn.,  that would create a new federal agency — the Financial Institutions Regulatory Administration – to supplant the Fed’s supervisory authority over banks. Dodd’s banking committee is expected to prepare a new draft of the bill to be introduced later this week.

Kocherlakota pointed to actions the Fed took in the fall of 2008 and spring of 2009 to inject liquidity into the financial system and to remove uncertainty about the soundness of 19 of the largest bank holding companies. He said those actions were critical to restoring stability and avoiding a financial panic similar to the Great Depression.

He told the bankers that Fed’s ability to move quickly after the financial collapse in the fall of 2008 was due to “expertise and information that it had acquired as a supervisor of the nation’s banks.”

In terms of liquidity, Kocherlakota pointed out that the Fed increased lending to financial institutions by 200,000 percent from July 2007 to the end of 2008. Loans outstanding from a variety of Fed sources rose from $246 million to a combined total of $540 billion over that period, keeping a badly shaken financial system afloat.

Kocherlakota told the bankers that in a financial panic the Fed’s role is “to ensure that illiquid but solvent firms survive and … to make sure that truly insolvent firms do in fact fail.”

He argued that a shrunken role for the Fed could limit its ability to act in that dual role in the future. “In the politically charged circumstances of a financial panic…the Federal Reserve would have no way to obtain reliable information… and would have no way to make appropriately targeted loans” to threatened banks, Kocherlakota said in his first public speech as the new head of the Fed in Minneapolis.

In the spring of 2009, the Fed also evaluated the 19 largest bank holding companies’ financial soundness. The so-called stress tests were crucial to get banks to lend to one another again. The central bank’s role “was an intrinsic outgrowth of the Federal Reserve’s multitasking role in the economy,” he said. Without supervisory authority, Kocherlakota speculated “that the stress test would never have taken place.”

When asked if Kocherlakota intended to push his views within the Fed or Congress, Fed Public Affairs Director Dave Fettig said that Kocherlakota was speaking as an individual and not representing the views of the Fed. He said the new president will “let the published remarks stand as they are.”

Kocherlakota also offered the bankers some short term economic projections. Describing inflation as “relatively tame,” Kocherlakota forecast 3 percent growth in the economy over the next two years, while the official Fed projection is for 3 percent next year followed by 4 percent in 2012.

Uncertainty over congressional action on health care and financial reform as well as risky commercial real estate portfolios on many bank balance sheets could slow any economic recovery, he said.

Saying “the outlook for unemployment is not comforting,” Kocherlakota would be “highly surprised if unemployment were below 9 percent by the end of 2010 or below 8 percent by the end of 2011.”

Kocherlakota became the 12th president of the Minneapolis Fed on Oct. 8, 2009. Before that he was a professor of economics at the University of Minnesota, where he chaired the economics department. He also served as a consultant to the Federal Reserve Bank of Minneapolis, was a research associate at the National Bureau of Economic Research, and from 1996 to 1998, worked as a research staff member at the Minneapolis Fed.

Correction

An earlier version of this article incorrectly reported the year the Fed evaluated the 19 largest bank holding companies’ financial soundness. The so-called stress tests were done in 2009.

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Comments (2)

  1. Submitted by Joel Jensen on 02/23/2010 - 02:28 pm.

    I’d be interested to know what supervisory responsibility Mr. Kocherlakota believes the Fed had ‘before’ the financial collapse, to prevent the financial collapse and avoid the destruction it brought on our economy and our lives.

    To the extent he believes the Fed had any such responsibility, I’d be interested in knowing how well he thinks they did in that regard.

  2. Submitted by Joel Jensen on 02/23/2010 - 02:55 pm.

    Actually, in general terms, he did speak on that point, but not till the end of his remarks:

    “Indeed, one could go further. Suppose that the Federal Reserve had had responsibilities for systemic risk regulation, as has been proposed in the House financial regulation bill. My belief is that under this proposed regulatory structure, the stress test would have been better in terms of both its form and its timing.”
    He goes on to conclude:
    “My remarks have focused on the Federal Reserve’s ability to stop a financial crisis from creating a Great Depression. I’ve done so because I believe that this ability is critical. Don’t get me wrong—we can and should do a better job of financial regulation so that we minimize the likelihood of a financial crisis ever taking place. In the 2000s, the Federal Reserve made some significant mistakes along these lines—as did the FDIC, the OCC, the OTS, and regulators in many other countries. As the Minneapolis Federal Reserve has been urging for over 30 years, politicians and regulators need to create incentives that will lead financial firms to avoid risks that end up costing taxpayers.”

    http://www.minneapolisfed.org/news_events/pres/nrk02-16-10.pdf

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