RTTNews - Boston Fed President Eric Rosengren defended the move to make the Federal Reserve a central part of the new system-wide approach to regulation Monday. Speaking at the Risk Capital 2009 Conference in Brussels, Belgium, Rosengren said that because the Fed is the discount window operator, it is logical for them to have a role in macroprudential supervision.

In his remarks, Rosengren did not address the current economic outlook, choosing instead to focus on the restructuring of the regulatory system. He offered his view of what a systemic regulator should look like and what the goal of such a supervisor should be.

A systemic regulator should have the ability to supervise capital structure, supervise liquidity risk and asset-liability management, and supervise risk management - all to minimize the likelihood of systemically important institutions negatively impacting market functioning and economic stability, proving contagious to counterparties, and possibly needing government support to avoid further spreading damage or instability, Rosengren said in prepared remarks.

In addition, he suggested that such a regulator should have the power to curb the enthusiasm of financial and systemically important institutions if they are becoming overly leveraged.

A systemic regulator or macroprudential supervisor would need not only the ability to monitor systemically important institutions, but also the ability to change behavior if firms are financing a boom by increasing leverage and liquidity risk, Rosengren said.

Therefore, regulators must be granted the authority to make such changes in the system to force institutions to reign in their leveraging, effectively preventing the build-up of excessive leverage or liquidity risk, the Boston Fed president explained.

The monitoring of the system is something discount window operators are responsible for, Rosengren said, making the Fed a prime candidate for playing a central role in a macroprudential approach to regulation.

It is noteworthy that the role of closely monitoring solvency and liquidity risk on an ongoing basis would be very similar to what might be expected of discount-window operations, were the discount window to be made available to systemically important institutions regardless of whether they owned a depository institution, he said. This of course suggests the logic of a role for the discount window operator - in the U.S., the Federal Reserve - in macroprudential supervision.

Doing so will help close the significant gaps in financial regulation, Rosengren said. Specifically, the regulator should supervise capital structure by requiring banks to meet capital levels during expansionary periods and mandating higher capital ratios for systemically important firms.

Second, Rosengren called on the regulator to supervise liquidity risk and asset-liability management to minimize the likelihood, and impact, of runs on institutions.

Third and finally, the regulatory overhaul should include supervision of risk management, ensuring that institutions have effective means and evaluating risk. In the long run, that should minimize the need for government intervention, Rosengren said.

Such responsibilities overlap with what is needed for effective oversight of potential discount window borrowing, if such borrowing is available to non-depository systemically important financial intermediaries, Rosengren said. Monitoring solvency risk and liquidity risk are key elements of discount window analysis, and are also key components of macroprudential supervision.

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