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How Did the Financial Crisis Change the Fed’s Role?

microphoneAmong the lessons learned from the 2008 financial crisis was that the regulatory community “did not fully grasp the vulnerability of the financial system” and that some of the largest financial institutions were not able to cope with the crisis without assistance—and that the problem spread quickly among institutions, according to Federal Reserve Bank of New York President and CEO William C. Dudley.

Speaking at the Annual Meeting of the Virginia Association of Economists at the Virginia Military Institute in Lexington, Virginia, earlier this week, Dudley discussed some of the significant changes the Fed has made since the crisis on the way the central bank supervises financial institutions.

“We have raised capital and liquidity requirements, put banks through annual stress tests, established the Large Institution Supervision Coordination Committee (LISCC) to enable us to evaluate the largest firms collectively and relative to one another, and set up the Office of Financial Stability to enable us to look at the financial system more holistically,” Dudley said. “Financial stability now receives the attention it deserves. For example, there are now regular briefings and discussions on financial stability at FOMC meetings.”

Dudley noted that while the “extraordinary interventions” by the Fed on behalf of certain institutions were “warranted and within our authority” under the power granted to the central bank by the Section 13(3) of the Federal Reserve Act, he also said he suspects that the “scale and scope of these interventions went considerably further than envisioned by the public and Congress prior to the crisis.”

As a result, the Dodd-Frank Act passed in 2010 narrowed the scope of Section 13(3) of the Federal Reserve Act to limit the Fed’s authority to extend credit through facilities with broad-based eligibility, and it also limit’s the Fed’s authority to extend credit to a single company, Dudley said.

Bill Dudley

Bill Dudley, New York Fed President and CEO

On a larger scale, Dodd-Frank addressed the problem of “Too Big to Fail” by establishing a process to ensure that any financial firm could be resolved without threatening the financial system’s viability and putting the money of taxpayers at risk, Dudley said. Dodd-Frank also created the Financial Stability Oversight Council, which has the authority to designate institutions as “systemically important”; institutions designated as such are subject to tougher prudential standards and increased supervision by the Fed, according to Dudley.

“The intent behind these measures is to reduce the likelihood of a failure of a large financial firm, and the consequence of such a failure for the financial system, should one occur,” Dudley said.

Dudley also noted that the Fed has “not always been sufficiently transparent,” which Dodd-Frank addressed by establishing disclosure requirements for participation in Federal Reserve Facilities. Dudley said he also believes the Fed could have done more to explain the central bank’s motivation for its “extraordinary interventions.”

“At times, while the motivations and objectives might have been obvious to us, they weren’t always as readily apparent to Congress or to the public,” Dudley said. “I think this created uncertainty about what we were trying to accomplish, and made it more difficult for outside observers to assess the appropriateness of our actions and our motives.”

To address the transparency issue, after each FOMC meeting, the Committee issues a statement setting the current federal funds target range and explains the monetary policy decision. The Fed Chair holds four press conferences per year explaining the monetary policy decision while the Committee releases its Summary of Economic Projections (SEP), which provides forecasts by Committee members on key economic variables and the federal funds target rate for the next few years.

“In addition, the FOMC participants give numerous speeches explaining their views on monetary policy and other issues, and the chair regularly testifies about monetary policy and the Federal Reserve’s other activities before Congress,” Dudley said. “Overall, I have found that this move towards greater transparency has held us in good stead.”

Click here [1] to view Dudley’s complete address.