Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

In every step we take to deter or manage financial crises, it is important that we recognize that we impose costs, and that our efforts can be most effective if we both enhance and are supported by market discipline. Institutions and investors must be allowed to take risks and must be prepared to accept the consequences of their actions. For its part, the government should limit its intervention to those circumstances that could lead to placing the system in serious danger and could spill over to the economy. Otherwise, even the most well-intentioned government intervention can actually weaken the system by undermining the incentives for market participants to limit the risks they undertake.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

I’ll confine most of my comments to Fannie Mae and Freddie Mac, where the largest issues arise. My purpose is to make the case once again that failure to reform these firms leaves in place a potential source of financial crisis. Although there is pending legislation in Congress, a major restructuring of these firms and genuine reform appear to be as distant as ever.

...

These two firms ...  cannot meet their growth targets in the long run if they confine their operations to conforming home mortgages. Their interest in increasing the conforming mortgage limit is clear. Moreover, in my opinion it is inevitable that they will look for ways to extend their operations into new areas. They have that clear incentive because of the implicit federal guarantee they enjoy. For them to extend their operations into market segments already well served by existing private firms will not enhance the efficiency of mortgage markets or reduce costs to mortgage borrowers.

The safety net reduces the incentives of private financial counterparties to manage the exposures they take on. And these incentive effects arise not just from such explicit safety net guarantees as deposit insurance. They may also result from the expectations of private market participants about actions that the central bank or other public sector entity might take during a financial crisis. The mere possibility of public sector action to stem so-called "systemic" losses, such as central bank lending, can provide an implicit safety net that makes some participants more willing to hold concentrated exposures. Hence, under this moral hazard view of the need for regulation, the safety net itself can be a source of "systemic" risk.

Market discipline, however, may not always be fully effective in this context. The development of the federal safety net--deposit insurance, the discount window, and access to Fedwire and daylight overdrafts--has inevitably impeded the workings of market discipline in the regulatory arena. That is, the various elements of the safety net provide depository institutions and financial market participants with a level of safety, liquidity, and solvency that was far less prevalent before the advent of the Federal Reserve and the subsequent establishment of federal deposit insurance. By deterring liquidity panics, the safety net shields the overall economy from some of the worst effects of instability in the financial system. These benefits, however, are not without costs. The prospect of government intervention distorts market prices and may also engender excessive risk-taking.

The key issue ... is time inconsistency. It seems to make sense in the middle of a financial crisis for someone to bail out a failing firm or firms. However, the inconsistency is that, however sensible a bailout seems in the heat of crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too little capital and take too many risks. As every economist understands, a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts. Along the way, the policy also encourages inefficient risk-management decisions by firms.

I believe that supervisory oversight is in pretty good shape, with one glaring exception. Government-sponsored enterprises are not adequately capitalized and the supervisory powers of the Office of Federal Housing Enterprise Oversight (OHFEO) are inadequate. I’ll concentrate on the housing GSEs—Fannie Mae and Freddie Mac. This is a topic I’ve addressed several times in the past (Poole, 2003 and 2004) and I’ll not repeat those arguments in any detail here. Although the GSEs are not formally insured by the federal government, the market clearly believes that they are effectively backstopped.

It is hard to look at this record and find support for the argument that the financial resources deployed by the IMF and the major economies in the crises [in the 1990s] produced a damaging degree of moral hazard—moral hazard in the form either of governments more prone to profligacy or investors prone to excess risk-taking in lending to banks and sovereign in emerging markets because of the expectation of financial resources from the IMF. Of course, those interventions must have produced some increase in moral hazard, but the effect on incentives does not seem to have been powerful relative to the countervailing effect of the economic and financial losses incurred in the crises.

Alan Greenspan commented on the eve of his departure from the Fed that confidence in central banking had risen to exceptionally high levels, and he asked whether this was entirely healthy.

And finally, policies designed to reduce the risk of failure in financial markets create moral hazard, dulling the incentive individual firms face to self-insure against potential loss. We apply a set of capital requirements and supervisory constraints to offset the distortion created by the safety net, but these may not fully compensate for the impact on behavior of the broader range of financial intermediaries of the perception that the authorities will act to protect the financial system from systemic risk.

Some may see government regulation of OTC derivatives dealers as essential to ensuring efficacious risk management. This view presumes that government regulation can address the challenges these types of markets engender and that it can do so without lessening the effectiveness of market discipline supplied by counterparties. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some counterparties assume that government regulations obviate private prudence.

We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.

If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt.

It may be useful, as a first step, to consider both the economic circumstances most likely to impede the development of bubbles and the circumstances most conducive to their formation. Destabilizing macroeconomic policies and poor economic performance are not likely to provide fertile ground for the optimism that usually accompanies surging asset prices.

Ironically, low inflation, economic stability, and low risk premiums may provide tinder for asset price speculation that could be sparked should technological innovations open up new opportunities for profitable investment. ...

The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient time to erode the traumatic memories of earlier post-bubble experiences.