Dear Senator Warren:
Thank you for your leadership in getting the Federal Reserve Board filled with qualified public servants of integrity. I support your standing up for the current slate of Board nominees under consideration by the Committee on Banking, Housing and Urban Affairs and soon I hope by the full Senate. In particular, I wish to add my voice to yours and others arguing that leaving the post of Vice Chair for Supervision unoccupied presents real and present risks to financial stability and therefore the economic well-being of all Americans.
To that effort, please allow me to respond to the questions posed in your letter of February 22nd:
1. The U.S. economy is at rising financial stability risk right now due to the combination of Russian aggression in Ukraine and the coming increases in interest rates to counter high inflation.
a. These feedback on each other. The Russian invasion and related geopolitical tensions are causing large jumps in energy and commodity prices, feeding inflation and thus the need for interest rate increases; sanctions on Russian financial institutions and individuals, and a potential exclusion of Russia from SWIFT and the Western financial system, increase risks of criminality and cyberattack, as well as the burdens on bank supervision.
b. Sharply rising interest rates after years of low for long rates expected force adjustment on lenders and borrowers, and potential financial crises in foreign economies where U.S. savings and companies are exposed.
c. The extreme volatility of crypto assets which are directly or indirectly tied to activities in Russia and Eastern Europe also are likely to undermine confidence among a subset of small investors, and may provoke cyberattacks on the U.S. financial system.
d. Flight to safety and quality may put at risk leveraged businesses and investments in the non-bank financial intermediary space (aka shadow-banking) which is rightly not in the same safety net.
e. While the capitalization of the core U.S. banking system is sound and the balance sheets of the vast majority of U.S. households are in good condition, the risks around these bulwarks are rising, and spillovers onto them are more likely.
2. In the face of these risks, it would be helpful to have a Vice Chair for Supervision in place for three significant reasons.
a. First, there are no simple automatic rules which can be applied to assess let alone manage these risks to the American economy. An experienced publicly accountable Senate-confirmed appointee who has the responsibility and remit of the Vice Chair for Supervision is the only legitimate official to make hard judgments having to do with the fate of financial businesses and the implementation of dynamic provisioning under stress in specific situations. The Vice Chair for Supervision is also the only official who can credibly prioritize decisions and discussion of risk scenarios for the full Board or Governors or entire FOMC – leaving it to career civil servants will weaken the ability of the Committee to confront risks and discuss them credibly.
b. Second, management of financial stability in the U.S. is not solely up to the Federal Reserve Board or FOMC. This reflects the real-world diversity and complexity of our financial system, and Congressionally mandated diversity of regulators and supervisors in our government, This is why the FSOC was created. For that reason, our system works best when there is a strong Federal Reserve presence in inter-agency discussions, both to bring the analytical and data firepower to bear which is unique to the Fed, and to bring the perspective of the institution raising interest rates and assessing macroeconomic impact. Having the Vice Chair for Supervision chair empty distorts the decision making across the government, and it strengthens the hand of regulators with more partial views (important for them to have a voice, but they should not be left to be dominant).
c. Third, the global financial system is of direct importance to the well-being of U.S. households and non-financial businesses. This comes through risks of debt crises abroad, volatility in capital flows (including funding of U.S. Treasuries, and short-term financing for systemically important financial institutions), financing of criminal activities and hostile state actors, regulatory arbitrage reducing security for small savers, and technological shifts in finance having unintended or unforeseen consequences. International information sharing, coordination on rules and enforcement, setting of common standards, and making sure that financial actors do not elude the system all directly benefit U.S. security. That requires strong U.S. engagement at the G20, the FSB, and other international bodies. That role is played in large part by the Vice Chair for Supervision – in her or his absence, international standards and enforcement can be biased by parochial interests or even hostile powers. Given geopolitical tensions with states that are known to engage in financial crime and subversion, this is all the more important right now.
3. A confirmed Vice Chair of Supervision could undertake several steps to reduce the financial stability risks to the U.S. economy and to improve our resilience in response.
a. S/he should develop a comprehensive oversight framework for nonbank financial intermediation, including enhanced supervision of both entities and activities. While the Dodd-Frank regulations and following implementation have made the core safety-net banking system demonstrably more resilient, such measures have not been extended far enough into the nonbanks of various kinds. This is not only an uneven playing field, which encourages the migration of riskier activities outward, it hides those activities from the public and from supervisors, and it leads to leverage which is under-provisioned.
- As my PIIE colleague Anna Gelpern has argued, "Financial stability requires both entity and activity regulation. These are no more mutually exclusive than traffic lights and licensing drivers. With access to its emergency lending on the line, the Fed should press for a more holistic approach to managing systemic risk in the financial markets—even where it does not have direct supervisory authority. FSOC should coordinate the development of a comprehensive analytical framework, instead of leaving it to functional regulators and their limited tools."
b. The risk of cyberattacks, financial crime, and attacks on vulnerable parts of the investment system (such as crypto currencies) is manifest given Russian involvement and capacities in those areas. The Fed Vice Chair in consultation with the FSOC should be engaged in off the record check ins with systemically important and event just critically located financial institutions, and publicly be advocating for greater oversight of crypto and greater funding (reallocation or reappropriation) for U.S. government and related payment systems hardening of targets.
c. Past stress tests and their results should be reviewed at the Vice Chair level, and re-examined for whether plausible interest rate hikes by the Fed – which now must realistically include 450+ basis points from here given inflation trend and risks – and cutoff of Russian and therefore some European and Chinese financial flows were adequately covered. If not, then new stress testing with these interest rate conditions needs to be set out. If yes, then supervised institutions need to be checked with and reminded to prepare accordingly.
d. The Vice Chair for Supervision should be reaching out to FSB and Euro member counterparts (as well as UK due to Russian money flows there) to create greater information exchange and coordination.
e. The Vice Chair for Supervision should be gathering assessments from the IMF, OECD, World Bank and private-sector sources of which emerging market and developing economies are most vulnerable to the level of interest rate increase likely, and the nature of these vulnerabilities (private sector versus sovereign; dollar or RMB or local currency debt; duration of debt) in a rising interest rate and rising commodity inflation environment. Informal pre-positioning of official sector liquidity provision and of creditor committees should be underway immediately.
f. Again, citing Anna Gelpern, "technology firms that deliver financial services outside the regulated financial sector will continue to challenge regulators, especially in areas such as payments and small-scale consumer lending…Increasingly diverse actors will demand access to payment systems, raising thorny questions of operational and counterparty risk, and prudential supervision, even when no deposit-taking is involved." A full risk assessment to consumers as well as to the financial system led by the Vice Chair and the Fed is necessary, as well as an action plan for skilling up the supervision capabilities and making clear decisions on central bank digital currency and the like.
4. I believe it is reckless and irresponsible for Congress to delay the confirmation of a Vice Chair for Supervision of the Federal Reserve Board. At any time, depriving critical U.S. government agencies of qualified officials at the level of seniority to be Senate accountable and to pursue effectively a public interest agenda exposes the American public to avoidable serious risks. This is particularly true of policy areas where missed challenges or failures can do rapid widespread significant harm and feed on themselves – financial stability is in this category along with pandemic prevention and military readiness. Given today's combination of high inflation, rising interest rates, geopolitical stress, and technological change in the financial sector, delaying the appointment of a Vice Chair puts the American economy in danger.