AIG and the Fed: Prologue to future financial regulation?

Financial sector regulatory reform has been a leading national issue since the U.S. Treasury issued its Blueprint for reform in spring (2008). The mortgage foreclosure and financial crises reinforced popular interest in whether the U.S. regulatory framework was deficient and how to fix the regulatory framework. Meanwhile, some key decisions in the United States, particularly concerning the failure and bailout of AIG and some investment banks in fall 2008, have established precedents for a new regulatory framework and policies. Where policymakers go from here is not certain, but the ideas on the table and the direction of policy suggest that the role of the Federal Reserve (Fed) in financial regulation will become central, at least in critical periods. This paper reviews the calls for a new “financial stability” regulator and the potential role of the Fed as such a regulator. It argues that the takeover of AIG provides a useful example and precursor of the Fed’s suitability in that role. Section 1 explains the Fed’s role as regulator and the relationship of the Fed’s lender of last resort function to systemic risk. It also addresses recent changes in the notion of systemic risk and systemically significant firms in concluding that there is a remaining case for a new regulator of such risk. Section II reviews the financial problems of AIG and the changing intervention of the Fed and the U.S. Treasury in AIG. The last section takes up some related issues, the role of a central bank versus a Financial Stability Authority in regulating banks or systemic risk, the potential role of the Fed or a another federal regulator in regulating the insurance industry and the risk to Fed independence from extending its regulatory role to cover systemic risk. The Fed’s actions with regard to AIG provide strong evidence that broadening the too big to fail policy or broadening the Fed’s lender of last resort policy to include non-bank firms pose strong conflicts for the achievement of the objectives of monetary policy or of financial stability. Moreover, the loss experience of AIG indicates the problems of fragmented or absent federal regulation of insurers for regulatory reform