The Price of Financial Stability in a Digital Economy

By Thomas P. Vartanian

Financial Stability in a Digital Economy

I was invited to the White House in March 2017 to discuss being nominated as Vice Chair of the Federal Reserve Board. Based on my five decades of experience as a bank regulator and financial services lawyer, I suggested that the regulatory system badly needed to be modernized to prevent an increasing number of financial disasters, particularly in light of the continued digitization of the economy. I expected that any Congressional revamping of the financial regulatory system would be an uphill battle. But the absence of enthusiasm in that meeting for such an effort told me that whatever energy I could muster as a governor of the Federal Reserve would be unlikely to produce the changes that were necessary.

The collapse of FTX and other crypto companies are examples of how our financial regulatory system has become ineffective. It takes Congress forever to react to real time challenges, and while the White House and financial regulators are taking bows for recently issuing warnings about the risks created by cryptocurrencies and increased cybersecurity threats, little to no action has been taken to adjust the regulatory system to the new risks in the fourteen years since Bitcoin appeared. Ironically, however, banks continue to be smothered by multiple layers of regulation by multiple agencies while nonbank, crypto, and fintech companies circumvent most of that regulatory muss and fuss.

A Practical Solution

The current segmented form of financial oversight only does half the job, because it regulates only half of the financial companies that operate in the market. It identifies and redresses past violations of the rules by traditional financial institutions but does not necessarily create safe and secure financial markets as unregulated companies impact them. Such an asymmetrical approach to regulating financial risk has led to national and global panics such as occurred in 2008. In a digital economy where the internet and clouds gather, store, and transmit data supported by real time payments and cryptocurrencies, financial disasters will increase in size and number unless regulation is correspondingly enhanced. Regulators need more technological resources and talent to do the job. They will never get them.

A more practical solution would be to shift the emphasis of regulation from individual institutions to the stability and resilience of the system. The responsibility for that should be delegated to government regulators and financial companies working together. Congress tried to initiate a systemic-focused form of regulation in 2010, but the Financial Stability Oversight Council was poorly conceived and failed in it execution.

Involving financial executives in the regulatory process would enrich it far beyond the effects of any business contagion it could ever have. Sure, such a model would raise legitimate concerns about conflicts of interest, but those are merely speed bumps that require thoughtful remedies and creative work arounds. Federal agencies already have advisory boards composed of business executives, and the twelve Federal Reserve Banks choose their boards of directors from the CEOs of their member financial institutions which they also regulate and lend to.

The Next Level of Collaboration

The internet is causing government policymakers and financial executives to necessarily forge a greater reliance on public/private partnerships to aggregate data and create backup facilities to deal with financial doomsday scenarios. The National Information Protection Plan, the Financial Action Task Force, the Critical Infrastructure Partnership Advisory Council, and other industry information sharing groups such as the Financial Services Information Sharing and Analysis Center are just some of the collaborations that the public and private sectors are deploying to gather cybersecurity data and plan for cyber-attacks. Moving to the next level of collaboration to create a more robust and effective system to regulate the financial services sector could close the asymmetrical gap that allows so much financial risk to escape oversight. It needn’t affect government agencies going toe to toe with financial institutions to enforce the law and impose penalties.

Markets usually react to potential financial crises before they arrive or governments can act. If a collaborative form of systemic regulation had been in place overseeing all financial activities, the 2008 subprime crisis might have been averted, and crypto companies would have been more closely scrutinized, perhaps averting the economic carnage the failure of so many of them has created. Systemic regulation in the hands of boards and commissions comprised of government experts and business executives would create a potent combination of expertise and generate advance warnings that would permit regulators to take evasive action. The benefits of such an enhanced system would be significant, and any additional risks manageable.

Luckily, the crypto canary screeched before it got large enough to threaten the entire economy. But its warning has created a unique opportunity to modernize the regulation of new money and financial activities. If we don’t take that opportunity, the inadequacies in the system will continue to cost us dearly.

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