The Fed botched banking regulation once already. So why does Obama want to give it more power?

Making government work better.
June 30 2009 4:22 PM

Don't Get Fooled Again

The Fed botched banking regulation once already. So why does Obama want to give it more power?

Federal Reserve Building. Click image to expand.
Federal Reserve building in Washington, D.C.

The Federal Reserve Bank has managed through most of its history to reside in obscurity—little understood, rarely questioned, viewed as hovering above the political fray, the domain of technocrats and erudite economists. That should all change.

The Fed's power over all things economic is hard to overstate, and it now desires even more, seeking the title of "systemic risk regulator." Some of us have argued that regulators—and the Fed in particular—have had virtually all the power they needed to avert the economic traumas we have been living through: They just failed to use it. Yet the proposed formalization of the Fed's mega-regulator role requires that we lift the veil that has shielded it from scrutiny for too long.

The United States should not lightly put our fate back in the hands of the very entity whose oversight of the economy and financial sector brought us into the abyss. The Fed's lack of accountability and transparency is no longer justified by its record or sound principles or public policy. Granting the power without asking the tough questions would be following the path of least resistance—regulators don't want to answer the tough questions, and legislators would still rather defer to the Fed than grapple seriously with a tough problem.

When I recently asked for minutes and attendance records of the New York Fed board meetings, the N.Y. Fed declined, saying simply that it doesn't give out such information. That answer might have been acceptable in times of economic stability or robust growth. But these are not normal times. In the past year, the N.Y. Fed has clearly missed some of the most important economic trends and inflection points over which it had regulatory jurisdiction; has orchestrated some of our nation's most significant financial transactions behind closed doors; and has made fundamental public-policy choices involving trillions of tax dollars without being required to explain the rationale for those choices in public.

So it's reasonable to ask whether the Fed is up to the task it seeks to formally embrace and, if it is, whether its governance structure is appropriate. These questions must be both retrospective, examining with exacting care the decisions the Fed has made, and also prospective, asking how would it define its role and tasks.

Here are a few questions relating to past decisions:

Where is the legal analysis showing the Fed had no power or insufficient power to intervene to save Lehman Bros.—widely viewed as the failure that precipitated the credit crisis—as it has claimed repeatedly, yet had sufficient power to orchestrate the gift of Bear Stearns assets to JPMorgan Chase? How did it differentiate between the two?

What analysis had the Fed done of the potential impact of derivatives trading over the five years preceding the meltdown as derivatives trading grew exponentially? Was there any effort made to assess the overall risk facing the banks the Fed was supposed to oversee?

Did the Fed do any analysis of the risk that would result from AIG's potential default, and how did the Fed analyze the risk to each of AIG's counterparties?

When the Fed authorized the first $80 billion payment to AIG, almost all of which flowed directly through to counterparties, why did the Fed not arrange for taxpayers to get equity in the counterparties, rather than the essentially worthless AIG equity? What communications did the Fed have with the counterparties over this period?    

When did the Fed ask the banks it is responsible for overseeing how they evaluated the potential risk of expanded derivatives trading and how these banks assessed the stability of their counterparties?

What analysis had the Fed done of the general leverage ratios in the financial-services sector and the need for additional capitalization? Had it done any "stress tests" during this period, or did it believe that there would never be an economic downturn?

And a few questions related to the Fed's governance:

Is the N.Y. Fed willing to release minutes and attendance records of the past five years, even if redacted to avoid company-specific information? How can the public be assured that this powerful institution is focusing on the right issues?

Since the N.Y. Fed is controlled by the very institutions that were at the heart of the meltdown, and these institutions used the Fed to give themselves hundreds of billions of taxpayer dollars to resuscitate their balance sheets without any public scrutiny, will the Fed release any conflict-of-interest rules it has in place to assure the public that board members do not act on policies that will affect their own corporate interests?

Six of the nine members of the N.Y. Fed board are supposed to be "public" representatives, yet these individuals have all too often been CEOs of major corporations or financial entities. How does the Fed define "public" board members, and what is the process by which those board members are selected?

And some questions about its prospective functions:

The Fed itself states that "the safety, soundness and vitality of our economic system" is its responsibility. How exactly are these terms measured? By GDP growth? Bank profits? Job growth? Growth of median household income? Without knowing how it will measure success, how can we measure whether the Fed is succeeding or failing?

How does the Fed believe it can regulate "systemic risk" meaningfully if institutions remain "too big to fail," necessitating that the federal government be an insurer of their risk in any serious downturn?

How does the Fed plan to limit the interconnectedness of the major institutions to prevent the risk of dominos falling sequentially?

Has any thought been given to refocusing on a financial services model that has more smaller institutions and fewer mega banks, thus diversifying risk?

Others, no doubt, will have more probing questions for the Fed; and President Obama, Treasury Secretary Timothy Geithner, and Congress should listen to them before they grant the Fed vast new powers.

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