Will the Private Federal Reserve Lose Regulatory Power?

Federal Reserve in crosshairs, but many experts say hold fire
Kevin G. Hall
McClatchy Newspapers

WASHINGTON — Senate Banking Committee Chairman Christopher Dodd's sweeping new financial overhaul legislation, which proposes to strip the Federal Reserve of its authority to regulate banks, threatens the central bank's time-honored independence and its premier international standing, experts warn.

Critics counter, however, that the Fed pumped trillions of dollars into the economy to combat the recent financial crisis with virtually no direct authority to do so, and no effective oversight from publicly accountable branches of government. They argue that the Fed should be subjected to democratic checks and balances, just as other powerful arms of government are.

Under Dodd's proposed bill, the Fed would lose its power to regulate banks and to issue rules affecting mortgages and other forms of consumer credit. Dodd, D-Conn., would combine several existing bank regulators into a single new Financial Institutions Regulatory Administration.

That approach would be similar to Britain's Financial Services Authority, which guards against risks to the financial system and leaves monetary policy to the Bank of England, the British central bank. Dodd reasons that the Fed and other bank regulators didn't foresee the coming financial storm because they were too close to the banks they oversee.

Dodd called the Fed's regulatory record an "abysmal failure" and said it should concentrate on its primary mission of conducting monetary policy to promote its twin goals of restraining inflation and promoting full employment.

His approach differs greatly from the Obama administration's and the legislation going soon before the House of Representatives. Both would empower two bank regulatory agencies and give the Fed more power, not less.

Which approach is right? There isn't consensus, even among former Fed governors.

"I am with Dodd on this one," said Alice Rivlin, a former vice chairman of the Fed from 1996 to 1999. "The Fed has not distinguished itself as a regulator."

Rivlin said that bank regulation is too fragmented, which creates opportunities for banks to shop for the weakest regulator.

"I think Dodd is right to consolidate bank regulation and not put it at the Fed," she said. "The Fed needs to concentrate on its role as central bank."

On the other side, Rivlin's former colleague Laurence Meyer, a Fed governor from 1996 to 2002, called the Dodd legislation "political posturing" by a "hate the Fed crowd." He warned that taking the most experienced regulators off the supervisory beat "increases the risk of crisis going forward."

What's indisputable is this: the Fed is at a crossroads, and in the crosshairs of Congress like a deer in hunting season.

Another sign of this is a bill by Fed critic Rep. Ron Paul, R-Texas, to have the Government Accountability Office — the auditing arm of Congress — audit the Fed's operations. That measure now has at least 307 supporters in the House and 30 or more in the Senate. Paul's book "End the Fed" is a national best seller.

The Fed's a convenient political target because many ordinary Americans are thirsty for revenge for the damage that Wall Street wrought on Main Street. Lawmakers are angry that the Fed acted largely without their approval last year when it brokered the sale of failed investment bank Bear Stearns and later engineered the rescue of faltering insurer American International Group.

Many mainstream economists say those moves helped prevent a collapse of the financial system. Nonetheless, they were wildly unpopular because taxpayers were at risk for losses while bad actors were rewarded.

At 82, Lyle Gramley brings the long view to the debate. He was a Fed governor from 1980 to 1985, a turbulent period of deep recession, and understands why the Fed is so unpopular today.

"In all candor, we all have to recognize that the Fed didn't do the job they were supposed to do. They didn't see this coming. This is a crisis that snuck up on us," Gramley said.

Taking bank supervision away from the Fed, however, could come back to haunt lawmakers, he cautioned.

"The major original purpose of central banks was to be lenders of last resort. You have to know to whom you are lending, how good is their collateral, how solid the institution is as a whole," Gramley said, arguing that the Fed must retain its regulatory authority over banks. "It just seems to me that having the expertise that the Fed has . . . is absolutely indispensable."

Dodd's bill also carries international implications. Since 1974, the Fed has played a lead role on the Basel Committee on Banking Supervision, formed by major central banks to develop rules of the road for global bank regulation.

A Dodd aide said that even if the Fed lost bank supervisory powers it would remain in the continuous Basel negotiations, along with Dodd's new unitary bank regulator.

Economic historian John Murray, a professor at Ohio's University of Toledo, sees an old-fashioned political power grab at play with the Dodd legislation.

"I think Congress doesn't want to let a crisis go to waste," Murray said, warning that any legislation that weakens central bank independence invites politicization of monetary policy. "I think in the long run, that's probably not a very good idea."

Congress answers to the same public that's enraged by the bailouts, and it wants more control over the Fed — which has long operated without the usual sort of checks and balances erected elsewhere in government, Murray suggested.

That sentiment also explains why Paul's proposed Fed audit has such broad support. It echoes the 1990s, when former House Banking Committee Chairman Henry B. Gonzalez, D-Texas, routinely clashed with the Fed. Robert Auerbach, now a University of Texas professor, worked with Gonzalez in probes of the Fed, which he said discovered waste, mismanagement, abuse of power, lack of public transparency and alleged corruption.

"We found so many things wrong at the Fed and there doesn't seem any way to correct it," said Auerbach, the author of the book "Deception and Abuse at the Fed."

Despite its nominal independence, the Fed is never far from politics. Congress and the president often pressure the Fed chairman to boost the economy. Fed governors are appointed by the president and confirmed by the Senate, but the Fed's 12 district banks are largely removed from Washington politics.

Dodd would change that. Under his bill, the U.S. president would nominate the presidents of the 12 district banks, and most of their board members would be selected in Washington, not locally. Today, district-bank presidents are elected by each bank's board of directors. Two-thirds of those board members are chosen by banks in their region. The remaining third are selected by Washington-based Fed governors.

"It's highly politicized, trying to please the banks in your district, because they're going to elect the board of directors," Auerbach said. "It means that you've got a system in this country where the banks are essentially regulating themselves — they're on the board of directors. You have tremendous conflicts of interest."

One example Auerbach cited was last year's Fed-brokered sale of Bear Stearns to J.P. Morgan Chase, whose chief executive, Jamie Dimon, was on the New York Fed's board. The Fed assumed control of many of Bear Stearns' bad assets under the deal.

Such cozy ties convince critics that the Fed is too close to the banks it regulates.

"Anything that takes it out of the hands of local commercial banks in terms of creating their own (district bank) boards would be a good reform," said Chuck Collins, a senior scholar at the Institute for Policy Studies, a liberal policy organization.