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Fed Gov. Stein Explores Regulation, Conflicts between Public and Firm Interests

Fed Gov SteinSince the financial crisis, the conventional debate about how policymakers should approach financial imbalances—focusing on trying to prevent them versus focusing on the postcrisis cleanup—has decidedly shifted in favor of prevention, Federal Reserve Governor Jeremy C. Stein said in an October 18 speech.

"Discussion these days tends to focus instead on which ex ante measures are best suited to safeguard financial stability," Stein remarked at a National Bureau of Economic Research conference in Boston. Ex ante refers to preventive measures taken against financial imbalances as they accumulate.

Debating two schools of thought
While the debate over financial regulatory policy often breaks down into those distinct camps, Stein noted that more attention should be paid to the often-protracted time during which financial crises develop. And regulators must develop the intellectual case and "institutional resolve" to take actions that are in the best interests of the broad public and economy, even when affected financial institutions oppose those regulatory actions, he said.

"Many financial crises unfold over months or even years, and the choices made during this in-between period can be among the most crucial to the eventual outcome," Stein observed.

For example, he pointed out that problems with subprime mortgages began to surface in late 2006. But it would not be until September 2008 that the collapse of Lehman Brothers ignited the worst of the financial crisis.

Regulators confront quandaries
During his talk titled "Lean, Clean, and In-Between," Stein discussed one of the fundamental quandaries financial regulators face. That dilemma involves scenarios like ones that unfolded leading up to the 2008 crisis, when the short-term interests of financial firms conflict with those of the larger economy and society.

Stein noted that from the start of 2007 through the third quarter of 2008, the largest U.S. financial institutions paid out nearly $125 billion in cash to shareholders via dividends and share repurchases. "This all happened while there was a clear and growing market awareness of the solvency challenges they were facing," Stein said of the institutions. "Indeed, the collective market cap of these firms fell by approximately 50 percent from the start of 2007 through the end of June 2008."

Thus the dilemma for regulators: how to act when the actions of institutions are in the interest of shareholders but are clearly in conflict with the best interests of the broader public and the economy. Stein then explored the role of macroprudential regulation—and stress tests in particular—in the context of this conflict.

October 24, 2013


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