The Federal Reserve has long been the odd man out in the American system of government — powerful, yet designed to be nonpolitical and neither checked nor balanced. Now two contradictory crosscurrents are swirling in Washington — one that would enhance the Fed’s powers and one that would curtail them.
The Treasury’s recent white paper on financial regulatory reform would have the Fed “supervise all firms that could pose a threat to financial stability,” even if they are not banks, turning the Fed into what some people are calling the nation’s “systemic-risk regulator.” Doing so would expand the Fed’s reach — though, of course, it has reached into those places already. (Think Bear Stearns, AIG , etc.)
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On the other hand, some members of Congress are grumbling that the Fed has already overreached, usurping Congressional authority. Others contend that it has performed so poorly as a regulator that it hardly deserves more power. Representative Ron Paul, the Texas Republican, has even introduced a bill that would have the Government Accountability Office audit the Fed’s monetary policy — a truly terrible idea that could quickly undermine the Fed’s independence.
Let’s break down the issue into three questions: Should the United States have a systemic-risk regulator? If so, should it be the Fed? And, if so, are there other powers the Fed might give up in return? My answers are yes, yes and yes.
The main task of a systemic-risk regulator is to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Can this job be done perfectly? No. Is it worth trying? I think so.
Suppose such a regulator had been in place in 2005. Because the market for residential mortgages and the mountain of securities built on them constituted the largest financial market in the world, that regulator probably would have kept a watchful eye on it. If so, it would have seen what the banking agencies apparently missed: lots of dodgy mortgages being granted by nonbank lenders with no federal supervision.
If the regulator saw those mortgages, it might then have looked into the securities being built on them. That investigation might have turned up the questionable triple-A ratings being showered on these securities, and it certainly should have uncovered the huge risk concentrations both on and off of banks’ balance sheets. And, unless it was totally incompetent, the regulator would have been alarmed to learn that a single company, American International Group, stood behind an inordinate share of all the credit-default swaps — essentially insurance policies against default — that had been issued.
This counterfactual suggests that history might have been quite different — and much better.
Some people would end the systemic-risk regulator’s role there, making it an investigative body and whistle-blower whose job is to alert other agencies to mounting hazards. But if systemic problems are uncovered, someone must take steps to remedy or ameliorate them.
Under one model, the regulator would be like the family doctor, taking a holistic view of the patient, making a general diagnosis and then referring the patient to appropriate specialists for treatment: to the Securities and Exchange Commission for securities problems, to the banking agencies for safety and soundness issues, and to someone for problems with derivatives — once we figure out whom that someone is.
But if multiple agencies are involved, their actions would need coordination. Would a systemic-risk regulator become the field marshal of a well-coordinated army, or find itself herding cats?
An alternative model would work more like a full-service H.M.O., where an internist refers patients to in-house specialists as necessary. To make that work, the systemic-risk regulator would need more power — not just to diagnose problems, but also to fix them. And it would need a huge range of in-house expertise.
Crucially, when truly systemic problems arise, a lender of last resort is almost certain to be part of the solution — and that means the central bank. So if there is to be a systemic-risk regulator in the United States, it should be the Fed.
Furthermore, unlike any other agency, the Fed would not be starting from scratch in performing these expanded regulatory duties. At least in theory, every central bank is its nation’s principal guardian of financial stability. The Fed already has the eyes and ears (though not enough of them) to do this job, and has the broad view (though, again, not broad enough) over the entire financial landscape. It must have such a view to handle monetary policy properly.
I am also deeply skeptical that a consortium or a committee would succeed at systemic-risk regulation. Creating a hydra-headed regulator, as some have proposed, invites delays, disagreements and turf wars — and dilutes accountability. So the Treasury plan sensibly puts the Fed in the driver’s seat, with the others playing advisory roles.
Now to the final question. Critics who worry about the Fed accumulating too much power have a point. But the Treasury proposal already clips the Fed’s wings by stripping away its authority over consumer protection, and further wing-clippings are possible. But when it comes to dealing with systemic risk, Treasury Secretary Timothy F. Geithner said last month, “I do not believe there is a plausible alternative.” Neither do I.
