The Unwritten Mandate: Is Financial Stability Worth The Fed's Time?

by: The Intercollegiate Finance Journal

By Christian Ackmann

When the Federal Reserve System was created in 1913, Congress declared only two main objectives: maximum sustainable employment and stable prices. These two objectives are often called the Fed’s “dual mandate.” Given these simple goals, it may have been surprising when the Federal Reserve lent trillions of dollars to individual institutions during the recent recession.

Over time, the responsibilities of the Federal Reserve have expanded beyond this dual mandate. Financial regulation is always changing, and the recently passed Dodd-Frank Act was of the most massive regulation overhauls since the Fed’s inception. The ultimate goal of this constantly-expanding regulatory environment is to improve financial stability — that is,to mitigate economic shocks and avoid system-wide financial crises.

While lending to targeted firms like AIG in 2008 was justified in the name of financial stability, not economists and members of the Fed disagree on whether financial stability should be the institution’s explicit third mandate.

Time for a change?

In her testimony to Congress in July, Federal Reserve Chairwoman Janet Yellen referred to financial stability as an “unwritten third mandate” of the Federal Reserve. Not long after, a new Financial Stability Committee was created, led by Vice Chairman Stanley Fischer. The committee was charged with monitoring potential threats to the financial system and provide recommendations to the Fed on how it should respond.

Fischer has previously used regulatory tools as the head of the Bank of Israel to fight a housing market bubble with limited success. Fischer attempted to protect the entire financial system’s stability through macroprudential tools, such as raising the minimum down payments for mortgages. In theory, macroprudential tools like this can replace interest-rate increases to pop asset-price bubbles.

In a speech given at the National Bureau of Economic Research, Fischer said that every regulatory institution “should have the goal of financial stability added to its mandate.” Advocates for an explicit financial stability mandate argue that it would give regulators more authority to combat risks. Preventing asset bubbles is especially important in the low-interest rate environment that the United States has experienced since 2008, which has created incentives for investors to reach for yield.

The risk of preventing risks

Despite the compelling arguments for financial stability, some Fed leaders believe that a financial stability mandate would not reduce systemic financial risk. In an essay written for the Fed’s centennial, Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, claimed that creating this third mandate “would seem to imply a central bank obligation to intervene to alleviate potential damage in cases of financial distress.” Lacker fears that bailouts like those in 2007 and 2008 create an expectation that the Fed will help financial institutions in future periods of economic stress.

Critics of a financial stability mandate believe that this expectation will create moral hazard. That is, financial institutions could be encouraged to make unusually riskier investment decisions to earn a profit because they expect a government safety net in the event of a collapse.

Opposition is furthered by the potential self-perpetuating cycle of financial distress followed by Fed intervention. A financial stability mandate would imply that the Fed would continue to lend to large financial institutions to prevent financial instability.

The expectation of crisis lending would encourage further risk-taking and perpetuate the cycle of moral hazard and government intervention.

Is the Fed falling behind?

Other countries have already tried to answer the financial stability question. The Bank of England created the Financial Policy Committee (FPC) in 2012, which is in charge of “taking action to remove or reduce systemic risks” in the U.K. financial system, according to the bank’s website. Explicitly stated goals like this allow the FPC to directly influence monetary policy decisions, whereas the Financial Stability Committee in the United States is more likely to advise than act.

Does the Fed need an explicit financial stability mandate to empower regulators and the new committee? Or would a third mandate just perpetuate risk-taking? Only time will tell if the benefits of such a mandate will outweigh the risks.

Disclosure: None