Long Live The Fed

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Senator Chris Dodd, the head of the Senate Banking Committee, is out this afternoon with his proposal for an overhaul of financial regulation. The big headline is that the bill gives more power to the Federal Reserve–a lot more. There was a time in the months following the financial crisis where there seemed to be a strong movement from both the left and the right to restrict the power of the Fed. Even Dodd was for a smaller Fed. But now it looks like the Fed’s role is expanding, not shrinking (emphasis mine).

Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

Giving more power to the Federal Reserve is not my ideal solution, but it is better than what we have. And you can argue that Dodd didn’t go far enough in centralizing power at the Federal Reserve. Here’s why:

Like others, following the financial crisis my general feeling was that the Fed should be stripped of its regulatory power. Let it set interest rates and nothing else. No. 1 the Fed hasn’t done a good job of regulation. The financial crisis proved that. No. 2 the Fed’s primary objective is smoothing the economy, and ending recessions when they happen. That gives the Fed the incentive to push money into the market and financial system in times of recession or recovery. One of the ways you can do that is to stop regulating banks and lenders, and allow anyone to get a loan, so they can buy a house, or just spend more money than they have. Short-term this is good for economic activity. It also, of course, leads to massive long-term problems for the economy, and financial crisises.

But here’s why making the Fed more powerful not weaker might actually end up being the smarter approach. One of the main problems of the old system was regulatory arbitrage. Banks effectively had their choice of regulators. Didn’t like the Office of Thrift Supervision, go for the Office of Comptroller of the Currency or the Fed. The regulator that got the most banks to sign on, ended up with the largest budget. So then everyone starts to switch to someone else. Some banks could claim more than one regulator, so they could always say someone else was responsible for them. Eventually you find a regulator or more than one that will look the other way when you start making home loans to people who have no income for more than a house is worth.

Under the Dodd proposal, the Federal Reserve will be the primary regulator for large banks. The Federal Deposit Insurance Corp and the OCC get small banks. The Office of Thrift Supervision is to be eliminated completely. So small bank regulation doesn’t get as clear a regulator as one might like. But when it comes to big banks, which was the real problem, this time around, at least so far, there is no where else to turn. The Fed can’t pass the buck and say it was someone else’s responsibility. Banks can shop around. Also, the new Consumer Financial Protection Agency will be at the Fed. This again underscores that it is the Fed’s responsibility to regulate banks. Put it somewhere else, and a bank could claim that a particular line of business was outside the authority of the Fed. Or visa versa. No longer will the Fed be able to say don’t blame us for say option ARM mortgages.

The Fed is getting other powers as well. It will have the responsibility to identify and monitor systematically important aspects of the financial system, like clearinghouses and the repo market. The Fed will also be charged with deciding when a bank has become too big to fail and needs to be broken up.

But here’s where the Dodd bill falls short. The bill creates a Financial Stability Oversight Council made up of a number of regulators.

The newly created Financial Stability Oversight Council will focus on identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.  It will make recommendations to regulators for increasingly stringent rules on companies that grow large and complex enough to pose a threat to the financial stability of the United States.

The chairman of that group will be the head of the Treasury and not the Fed. As others have argued, making the Treasury the head of that group is probably a mistake. The one thing the Fed has going for it is that among large Washington institutions it is the least political. The Treasury on the other hand is the most political of financial watchdogs. If a President wants to push the ownership society, you could see how aggressive mortgage lending, and the CDOs and other complicated financial instruments that make the possible would not be considered a systemic risk. Nonetheless, the Dodd bill probably gets a lot right.

One more positive: The Volcker rule is in. At least in part. That’s a good thing. Proprietary trading and principal investments played a much bigger role in the financial crisis than many admit.

Bonus: Here’s a statement from Elizabeth Warren:

“Since bringing our economy to the brink of collapse, Wall Street has spent more than a year and hundreds of millions of dollars in an all-out effort to block financial reform.  Despite the banks’ ferocious lobbying for business as usual, Chairman Dodd took an important step today by advancing new laws to prevent the next crisis.  We’re now heading toward a series of votes in which the choice will be clear: families or banks.”

Remember Warren wants a stand alone Consumer Financial Protection Agency, which she would not get under Dodd’s plan. Nonetheless, she seems reasonably pleased so there must be something else she thinks Dodd is getting right, or at least not totally wrong.