Federal Reserve Bank: Money and Banking - Case Study Example

Introduction Any central bank has two important goals of achieving the required stability as well as the economic growth. The overall operations andpolicy issues therefore are mostly directed in this direction as monetary policy authorities i.e. central bank of any country pursue these goals. The current financial crisis that hit the developed world especially US also served as a litmus test for the central bank of the country to pull it out of the crisis that seem to engulf the whole economy of the world. As a result of the crisis, FED undertook major steps to correct the imbalances in the economy and achieve the much needed stability in the system. However, it is generally believed that the current financial crisis have forced FED to diverge from its traditional monetary policy tools and exercise options that were not generally associated with a central bank. However, considering the overall bailout plan, it is also argued that the FED has basically attempted to keep afloat richest of the society at the cost of the taxpayers money. The overall impact of the bailout plan given by the Obama administration seems to have cost more than $17000/- per household. The notion of so called ‘Oligarchy of Power” that finance industry has effectively taken the US Government has been labeled as a “quite coup”. (Johnson, 2009). This paper will effectively discuss three most important arguments including the assessment of whether the FED has done the best job possible to save the system from complete collapse, whether there were very select few who got the benefits of the bailout plan rather than the whole country and finally there will be a set of recommendations that will potentially identify the steps to be undertaken to overcome the present deficiencies in the system and achieve the stability and growth of the economy. Stability and Growth Two of the most important objectives of monetary policy are to achieve the stability of the financial system as well as to ensure that the growth objectives are achieved. Central bank aim to achieve these two broader objectives with the help of certain tools including open market operations, changes in the discount rates, changes in the statutory liquidity requirements etc. above all, a central bank also serves as the lender of the lost resort i.e. in case when banks and financial institutions face a situation wherein they could not generate the required liquidity from the market than central bank can lend them as a lender of the lost resort. Further, a central bank is also supposed to be the supervisor of the banking and financial system and devices regulations which basically restrict the excessiveness in the financial system. With the passage of time, however, achieving stability as well as growth remained two most important objectives of the central bank. The main objectives of the FED include serving as the lender of the last resort and to ensure that the efficient and stable financial system is in place which is equitable for all the stakeholders. Achieving low inflation rates, efficient management of interest rates for ensuring orderly capital markets as well as achieving growth in GDP, reduction in unemployment as well as regulating the money supply and interest rates. Sub-Prime Mortgage Crisis The most apparent reason for the current financial crisis is the sub-prime mortgage crisis which engulfed the whole financial system. Before discussing the role of FED in this whole episode, it is critical to discuss the background of the current crisis in order to understand the subsequent actions taken by the FED. Loosening of regulations during last part of the 20th century, allowed banks to take excessive risk and they started to bring in more risky customers into their folds by offering them mortgage loans at higher prices. Sub-prime borrower is such a borrower whose credit worthiness does not permit her to obtain loan from the financial institutions at relatively easier terms. However, such borrowers offer high return because of their high risk and banks started to take exposure on them in a bid to achieve higher profitability. As will be discussed in subsequent sections that this was basically done in a bid to improve the compensation of the executives therefore banks were inherently compelled to take higher risks because this provided the opportunity to get higher compensation. The real problem however, started when banks and other financial institutions started to securitize their subprime mortgage portfolio in order to recoup the liquidity drained in granting such loans. By matching the cash inflows from the sub-prime mortgage portfolio with that of the outflow on the securitized obligations banks basically aimed to achieve the desired profitability targets. However, this did not worked out as mass scale default by the subprime borrowers forced banks to pay on their collateralized obligations without receiving the related cash flows from their borrowers. This resultantly created credit crunch which reduced the extension of credit to the consumers and started to engulf other sectors of the economy and finally culminated into the serious challenge to the viability of the financial system itself. Has the Federal Reserve Bank done the best job possible for righting the near collapse of the US Financial system? Considering the above objectives, a natural question than arises as to whether the Federal Reserve Bank has done enough to ensure that the US financial system does not collapse in the midst of current financial crisis. The initial response from the FED of the financial crisis was swift and a collaborative effort by the FED along with other countries of the world. Interest rates were drastically reduced and so was the fresh injection of funds into the system to ensure that the liquidity is increased within the system. One of the major impacts of financial crisis was the lack of liquidity with the financial institutions and FED’s initial steps included pumping enough liquidity in the market to ensure that financial institutions have the required funds to lend. Another important step undertaken by the FED was drastic reduction in the interest rates to stimulate the demand within the economy. During 2008, it was speculated that the FED will cut down the rate to zero percent and all subsequent rate cuts were basically targeted at managing the interest rates to a level where it can basically stimulate the economy and encourage spending by the consumers to push up the economic activity. It is however, critical to note that the exhaustion of the option of policy rate management forced FED to push for adapting other non-conventional methods of managing the interest rates such as directly buying the bonds of Fannie Mai so as to ensure that institutions such as Fannie Mai get the required funding support to keep the running. (Irwin, 2008). Further, it pumped money into various financial institutions including nationalization of Fannie Mai, AIG as well as financial stimulus provided to JP Morgan indicate that FED has been able to play its role of the lender of last resort in most appropriate manner. Similar type of crisis were faced by the East Asian economies too however with the passage of time this gap was filled with more prudent banking policies from the central bankers of these countries and there was a complete These steps indicate that the FED has taken very prudent steps to ensure that the viability of the whole financial system remains intact and as such financial system is secured against extreme movements into the various economic variables. However, there remains a question of whether the steps undertaken by the FED were in the best interest of the country as a whole or it benefited the very select few? This discussion therefore needs to be viewed in larger context of how the FED responded to the crisis and who were actually the beneficiaries of the stimulus plan that offered monetary help to many organizations. Oligarchy of Power As discussed above that eyebrows were raised over the actual impact of the actions of the FED on the country as a whole or whether they only supported the very few and FED was serving the interests of those in power at the cost of taxpayers’ money. One topic of hue and cry is that of the executive compensation as well as the role of various individuals in the banks. It was revealed that the executive compensation was one of the most important aspects of the crisis. This is critical due to the fact that financial instruments like collateralized debt obligations as well as other securitized instruments were too tempting for the executives to launch because of their potential to offer the return. The executive compensation was tied with the return and not with the risk therefore it became a norm within the industry to take large bets at the cost of the deposit holders’ money. The issue therefore also arouse as to why the bailout plan was offered to such institutions which willfully indulged into the behavior that was more willful and out of greed. It is also important to note that the financial institutions like JP Morgan as well as AIG were betting against the assumption that the property market will never cool down despite the fact that if risky assets tend to outstrip the resources of the financial institutions. The assumption was that the losses incurred due to securitized instruments will be covered through the appreciation in the value of real estate taken as collateral. (Keller & Stocker, 2008). Such excessive risk taking is also associated with the fact that FED let the banks to take on excessive risks into assets that could have been too risky for the overall survival of the financial system. For example, banks continued to take positions in the sub-prime mortgage market in order to earn higher profitability. Further, the rapid development of innovative financial instruments such as financial derivatives further pushed the banks to take on risks which virtually went unnoticed. During this whole period, FED however, remained silent on the behavior of the banks to take on the excessive risks. Another important element of this whole discussion is also the fact that Congress is considering remove the powers held by FED for the oversight of the banking system. Senator Croker is considered as the chief architect of the new sets of rules that may eliminate the powers of the FED for the oversight of the banking system as a whole as well as the removal of the consumer protection by FED. Rather a new consumer protection agency is proposed with the designated role of policing the behavior of the banking companies thus both FED as well as the National Deposit Insurance Corp may lose their powers of over-sighting the banking system. (Vekshin & Jensen, 2010) Though FED Chairman maintains that the stability of the financial system is mostly achieved through the oversight of the banks therefore he is strongly advocating for not stripping off the FED for its powers to oversee the financial system of the country because it will further create a gap between the country’s central bank and other banks. Both of these contrasting points however need to be discussed in larger context of whether the FED has been able to really protect the interest of the consumers? Whether it has justified the powers of overseeing the financial system despite its failure to avert the financial crisis and restrict the banks from taking the excessive risks into those areas which potentially had more severe consequences for the financial system as a whole. Simon Johnson compares the attitude of the FED with that of the attitude of a central bank of a developing country which often attempts to protect the interests of the elite of the society. The subsequent emergence of powerful political nexus between the politicians and the investment bankers therefore served as one of the important reasons as to why the lightweight regulations basically benefited the financial organizations and their executive to achieve what banking sector was probably unable to achieve in its entire modern history. (Johnson, 2009). What is also however, significant to understand that Johnson believes that this powerful nexus that resulted into the culmination of this crisis is now preventing most important reforms to take place. The lack of reforms and potential silence of FED therefore is largely viewed as agreement of FED to succumb to the pressures of the powerful elite to coverup their wrongdoings and provide the necessary help to bailout the financial mess created by the imprudent decisions taken by this elite. Thus, it is easy to infer that there existed an oligarchy of power that actually benefited more from the actions of the FED rather than the whole country. The individual American may be wors off under the proposed actions taken by the FED rather than being helped to face the severe impact of the financial crisis on the life of an ordinary American. Recommendations The above discussion indicates that there is a need to have a focus on the overall affairs of the financial system of the country in more radical manner. The radical changes need to be undertaken in order to make the system more stable and self sufficient to sustain the external shocks like the one it is currently experiencing. Some of the recommendations include: Improving Regulatory Over-sight Improving the regulatory oversight of the financial institutions is probably one of the most important steps that need to be taken. This is important due to the fact that increase in the supervisory role of any institution (whether a new institution is created or FED’s powers are increased) will allow them to have more powers to regulate the behavior of the banks. Apart from that, the risk based development of prudential regulations will also serve as an in-built corporate governance code for the banks not to indulge into the excessive risk taking behavior. FED’s role Financial markets when left alone on the mercy of market forces often result into the kind of failure that is being witnessed now. However, there is a greater need to have more involvement of the government and its regulatory authorities to discipline the financial institutions and develop the flexibility to regulate the markets as and when required. This also means that the role of FED must be enhanced and rather than splitting the powers of the FED, there is a need to have more consolidation of powers of FED in order to allow it to develop its expertise to put an effective check on the stability of the financial system. Consumer Protection The new proposed Consumer Financial Protection Agency is supposed to offer the much needed protection to the customers rather than offering help to the large US banks to have attractive quarterly results. (Carter, 2010). This suggestion seems to be plausible as it will allow the banks to re-focus themselves on achieving the necccessary protection for their depositholders rather than strengthening their short term results. This will also allow to put a check on the rising and excessive executive compensation in the banks also. Bibliography 1. Carter, Z. (2010, March 10). Dodd to Defang Financial Reform? . Retrieved March 14, 2010, from The Nation: http://www.thenation.com/doc/20100315/carter 2. Irwin, N. (2008, December 17). Fed Cuts Key Rate to Record Low. Retrieved March 16, 2010, from The Washington Post: http://www.washingtonpost.com/wp-dyn/content/article/2008/12/16/AR2008121601754.html 3. Johnson, S. (2009, May). The Quiet Coup. Retrieved March 14, 2010, from The Atlantic: http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/ 4. Johnson, S. (2009, May). The Quiet Coup. Retrieved March 14, 2010, from The Atlantic: http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/ 5. Keller, C., & Stocker, M. (2008, November 18). Executive Compensations Role in the Financial Crisis. Retrieved March 15, 2010, from The National Law Journal: http://www.law.com/jsp/cc/PubArticleCC.jsp?id=1202426091714 6. Vekshin, A., & Jensen, K. (2010, Feb). Senate’s Corker Considers Reducing Fed’s Bank-Oversight Role . Retrieved March 13, 2010, from Bloomberg.com: http://www.bloomberg.com/apps/news?pid=20601070&sid=aIV362XpVNZk Read More