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Geithner and Bernanke Are Wrong about Fed Power

Wednesday, March 31, 2010

Letting the Federal Reserve keep a hand in bank supervision and regulation is a mistake.

Treasury Secretary Timothy Geithner recently appeared at the American Enterprise Institute to push for financial reform legislation. In response to a question about where bank supervisory powers should reside, the secretary, who previously was president of the Federal Reserve Bank of New York, demonstrated once a Fed official, always a Fed official. The Fed, he reasoned, needed to examine banks to understand financial institutions and markets critical to making monetary policy. The secretary's remarks were consistent with Federal Reserve Chairman Ben Bernanke's aggressive defense of the retention of bank supervisory responsibilities.

Both officials are wrong. Letting the Fed keep a hand in bank supervision and regulation is a mistake. Their arguments are mostly specious. Moreover, the slim benefits that accrue to the Fed from supervision could easily be protected, indeed strengthened, in legislation. This defensiveness reflects a misreading of the political economy that puts the institution on a perilous course.

The reality is that, even if the Fed were stripped of its supervisory role, the Fed would still have a wide window on the financial world.

First, the misdirection. Any reasonable student of central banking would agree with Bernanke that the Fed needs to understand financial institutions and markets in order to perform monetary policy effectively. From that bedrock truth, the choice presented is that the Fed either retains its supervisory role or becomes blinded and ineffectual without it. But the reality is that, even if it were stripped of those regulatory powers, the Fed would still have a wide window on the financial world.

Most importantly, the Fed runs the factory floor of the dollar payment system. Its system arranged about 490,000 fund transfers among banks totaling $2.5 trillion in value, on average, each business day of 2009. It conducts, clears, and settles auctions of securities for the U.S. Treasury. Indeed, government securities only exist as electronic records of the Federal Reserve. The Fed handled about 84,000 transfers of government securities, or about $1.2 trillion in value, on average, each day last year.

The Fed can increase the frequency and coverage of its data collection efforts to provide systematic information to compensate for that loss (if any) from no longer being intimately involved in the examination process.

This activity provides the Fed with a deep understanding of financial institutions, market utilities, and financial markets. Indeed, the Fed's services are absolutely critical to big banks, giving Bernanke and his colleagues powerful leverage to learn about the balance sheets and risk-taking strategies of systemically important institutions. That window will remain open regardless of the Fed's role in banking supervision.

What about the other information the Fed gets about bank behavior that is useful in understanding the economy? By and large, it comes from sources outside the supervisory community. This includes weekly compilation of data on balance sheets (required for the monetary function of assessing compliance with reserve requirements) and less frequent readings on lending intentions and the terms and standards on loans.

Second, potential protections. A less-defensive Fed could work with Congress to ensure that shedding supervision does not potentially impair its monetary policy making. For one, the Fed can increase the frequency and coverage of its data collection efforts to provide systematic information to compensate for that lost (if any) from no longer being intimately involved in the examination process. For another, the mission of the new supervisory agency could include an explicit—and tough—information-sharing requirement. Indeed, the Fed could be required to provide regular grades on the quality of the new institution's performance in that regard.

Some positive reasons for stripping the Fed of supervision: sharpening the Fed's focus on the core mission of monetary policy, eliminating possible conflicts of interest among multiple missions, and facilitating congressional oversight of functionally dedicated institutions.

As a last example, some Fed officials stress that they might be reluctant to lend to a financial institution if they were not its supervisor. That is an odd assertion because the Fed can lend to any depository institution, the majority of which it does supervise, and takes collateral to protect itself from risk. If the Fed really needs extra protection for its discount window, legislation could entail loss sharing between the Fed and the new regulator, for which there is precedent.

Debunking the Fed's defense is easy. So, too, is listing the positive reasons for stripping it of supervision. These advantages include, but are not limited to, sharpening the Fed's focus on the core mission of monetary policy, eliminating possible conflicts of interest among multiple missions, and facilitating congressional oversight of functionally dedicated institutions.

Finally, the misreading of politics. The Fed may win this battle, but it will then lose the war. Elected officials will face hostile voters in the fall. A platform that prominently includes adding powers at the Fed, which has received a great deal of blame for the worst financial crisis in three generations, does not seem like a winner. If the Fed keeps its regulatory powers, Congress will clip its wings elsewhere. It would be better for the Fed and the nation to cooperate now and get change that strengthens monetary policy making rather than have more risky changes imposed.

Vincent Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Among Reinhart’s other financial tracking for THE AMERICAN, he has described “Bernanke’s Confidence Game,” “The Crack-up” of financial reform proposals, and “When the Fed Was Boring.” He has suggested what to do concerning how “Europe Fiddles While Greece Burns,” made “The Case for Simpler Financial Regulation,” and explained “The Right Role for the Fed.”

Image by Rob Green/Bergman Group.

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