Cleansing the Temple

In 2008, many Americans were surprised to discover that they live in what an earlier article in these pages called the "Republic of the Central Banker." The Federal Reserve, an institution whose opacity rivals only its reach, was forced by crisis to exercise its powers more publicly and more broadly than it had in a generation.

Under the current chair, Ben Bernanke, and before him, Chair Alan Greenspan, the Fed failed in nearly all its responsibilities. It did nothing to pop a burgeoning asset bubble in the housing markets and related derivatives. It refused to prevent that bubble by restricting pernicious lending practices despite ample regulatory authority on the books. The banks under the Fed's supervision took extraordinary risks and blew themselves up.

When the crisis came, though, the Fed acted quickly to stabilize the financial system with a massive leveraging of its balance sheet, deploying loan guarantees and discounts to keep lending alive even as it dropped interest rates to zero. In the face of pressure from Congress, it even belatedly enacted consumer protections on the mortgage and credit-card markets.

Do these actions demonstrate that the Fed has learned from its mistakes? Should the Fed's more recent behavior mitigate the need for reform?

Not at all. It is clear that without the pressure of a crisis, the Fed would not act to preempt disaster. It is time to rethink what we expect from our central bank and how its different functions work in concert and in tension. Unfortunately, present congressional efforts to overhaul the bank could leave the institution even more convoluted as reformers clash with moderate Democrats who are skeptical of more regulation, Republicans who oppose it outright, and the Fed's own attempts to defend its turf.

The problems start with the basics of the Fed's outmoded and undemocratic structure. Just consider the geographic spectrum of the Fed's regional branches: five banks east of the Appalachian Mountains -- including one in Richmond, Virginia, barely 100 miles from Washington -- and only one bank west of the Rockies. Each of those banks is run by a president and board of directors selected largely by the private banks they are meant to regulate. At its most absurd, this involved a Goldman Sachs banker being tapped to represent the public interest at the New York Federal Reserve.

Reformers want to change the structure of those boards, but legislation proposed by Senate Banking Committee Chair Chris Dodd allows the president of the United States to select only the head of the New York Fed (other regional Fed presidents would still be appointed by boards selected by bankers). The bill bars bankers from serving on the boards but not from picking who does. Mandating real public representation on these boards and limiting conflicts of interest is the only way to ensure that the Fed has the independence it needs from the political process and financial interests.

The Fed also lacks transparency, keeping its ledgers secret from the public eye. With the central bank's balance sheet rapidly expanding due to its rescue efforts, critics in Congress have demanded more accountability in the form of an independent audit. An audit bill passed in the House's financial committee by a bipartisan vote of 43 to 26, but it is vehemently opposed by the Fed and isn't included in the Senate's discussions of financial reform. It's hard to explain, though, how knowledge of what the Fed is doing is a detriment to its independence.

Similarly, there's no clear reason why the Fed should be responsible for both regulatory supervision and monetary policy. In fact, the central banks of the United Kingdom and the European Union have no regulatory role at all. While monetary policy requires independence from politics, regulation requires independence from industry -- but at the Fed, banks have essentially been picking their own supervisors. An equally salient point is that consolidation in prudential regulation is critical to avoid the kind of race-to-the-bottom regulatory arbitrage we saw in the run-up to the financial crisis.

Richard Carnell, a Fordham Law professor who has worked at both the Fed and the Treasury Department, notes that even now the majority of banks aren't regulated by the Fed at all. Greenspan, a staunch defender of the Fed's prerogatives, has recognized that giving even more regulatory authority in the Fed would be unwise.

But legislators are taking half measures. There is general agreement that the supervision of bank-holding companies should end up in a consolidated regulator. Policy-makers also recognize that the overhaul requires increasing supervision of both systemic risk and of non-bank financial institutions. But, strangely, they've decided that the Federal Reserve is the right place to house those responsibilities. (Broader systemic risk oversight will likely rest in a council of regulators that includes the Treasury secretary.)

There is some logic to the plan; the Fed is powerful, and as the economist Tyler Cowen writes, its independence makes it uniquely suited to responding to crises: It "is the fireman with the awesome power to print money, move markets, lend to the banking system on a large scale, and now even conduct fiscal policy, all without Congressional approval."

But Dodd's bill significantly limits the Fed's emergency-response powers, barring the bank from lending to individual companies during emergencies, putting new checks on its role as an emergency liquidity provider, and transferring the task of dealing with failure to the Federal Deposit Insurance Corporation and the proposed regulatory council. New authority for systemic risk and non-bank institutions shouldn't be in the Fed, either, but in a consolidated regulator.

The Fed has protested every effort to strip it of its powers, saying that it needs to retain oversight of the banking system to augment its monetary policy-setting powers. Many experts disagree, saying that access to the information provided by other supervisors would solve the problem.

"I don't think that supervising individual banks is important to making monetary policy," Alice Rivlin, a former vice chair of the Fed, told the Senate Banking Committee last summer. "That was said around the table when I was at the Fed, but I didn't really experience that we learned a lot from the supervising [of] particular banking institutions."

The Fed's critics have long complained that the central bank is captured by the financial industry. A good example is the Fed's famous dual mandate -- to pursue both low inflation and maximum employment. While the financial industry prefers low inflation, the labor market cries out for a more dovish attitude toward interest rates; it's no surprise who usually wins. Today's crisis is the rare case when the Fed has turned to very low interest rates. But what will it do when the immediate financial crisis is over, and its characteristic inflation-phobia returns?


This confusion over its constituency- -- citizens or bankers? -- was reflected in the central bank's unwillingness to use its consumer-regulation powers. Reformers concluded that an independent agency was needed to regulate everyday lending, from mortgages and automobile loans to check cashing and savings accounts; only a single point of accountability would provide the correct incentives.

What happened next illustrates the challenges of making these proposals a reality. Legislators crafted a strong proposal for a Consumer Financial Protection Agency (CFPA), and Rep. Barney Frank, who led his chamber's financial-reform effort, secured a final bill that included an independent agency, albeit one with significant loopholes that exempted entire industries from coverage.

In the Senate, Dodd engaged in political horse-trading to find Republican votes, first endorsing an independent agency, then suggesting its placement in Treasury, and finally deciding to house the bureau back where it started -- inside the Fed! -- but with several layers of political and financial insulation from its landlord. However, the Senate version also closes many of the House's loopholes. Nonetheless, while the plan may work, it adds another layer to an already messy institution inclined to inaction.

The difference between the Dodd and Frank bills, at least when it comes to the Fed, is a question of degree. Both bills restrict the Fed's emergency-rescue powers with new checks by a council of other regulators. The House bill includes the audit provision lacking in the Senate, while the Senate bill includes more governance reforms than the House. Both give the Fed the ability to regulate the largest financial firms whether they are banks or not, while passing more prosaic bank supervision to a consolidated regulator.

Ultimately, reformers hope that when the Senate passes Dodd's bill -- expected sometime in May -- the conference procedure to bring the two pieces of legislation together will amplify the good ideas in both bills while further streamlining the institution's functions.


Carnell told me a story of his interactions with the Fed after leaving to be an assistant Treasury secretary in the Clinton administration. He formally requested that the Fed deploy some of its regulatory powers to pursue predatory lenders, and the Fed, in so many words, formally declined. Disappointed, Carnell called a Fed official he knew to get a straight answer. "Only if the industry wants it," he was told.

The anecdote underscores the need for a clearer approach to the Fed's role. It is not balancing its institutional responsibilities. Reform demands real structural change, including making regional branches less conflicted and more accountable, giving direct supervision to a consolidated regulator, and making a consumer protection agency as independent as possible. Letting the Fed focus on its central monetary policy responsibilities -- while playing a key role alongside other regulators on a systemic risk council -- would maximize its institutional effectiveness.

But the Fed fix, as currently envisioned, is confusion. The overhaul takes away some regulatory powers and adds others. It doesn't do much to fix the regional branches and uses extensive oversight and new checks as a replacement for a clear mandate and transparency. The legislation removes consumer protection and puts it back in, albeit with more safeguards for independence.

All this comes at a time when the Fed's very existence is being questioned by populist critics on the left and right. Restoring its legitimacy requires transparency, so that people understand what the institution does and respect the decisions it makes. Further confusing its structure and mandate will only increase criticism of the Fed. That's a systemically risky move indeed.

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