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Thursday, January 14, 2010

Should the Fed Have a Large Role in Bank Regulation?

I know you are tired of hearing me make this point, and that many of you disagree, but maybe you'll be convinced by Paul Volcker? Should the fire code designers, inspectors, and enforcers be part of the fire department, or housed in a separate, independent agency? Does, for example, the knowledge inspectors gain about the risks of fire in various buildings along with knowledge about the nature of those risks (e.g. of spreading to particular adjacent buildings) help firefighters plan a more effective response if a fire does break out? Conversely, does the knowledge that firefighters have help the inspectors to know what to regulate and what to look for during inspections? Are there economies of scale from consolidation, e.g. if we want experts on how fires spread from building to building present among both inspectors and firefighters, is it most efficient and effective to concentrate this expertise in a single agency?:

Volcker Stands Up for Fed Role in Financial Oversight, Reuters: The Federal Reserve must have a “strong voice and authority” on regulatory matters, Paul Volcker ... said on Thursday. Mr. Volcker, a former Federal Reserve chairman, told a lunch meeting at the Economic Club of New York that he had been “particularly disturbed” by proposals to strip the Fed of its supervisory and regulatory responsibilities. “What seems to me beyond dispute, given recent events, is that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined,” said Mr. Volcker...

What are the actual arguments for this?:

The Public Policy Case for a Role for the Federal Reserve in Bank Supervision and Regulation, by Ben Bernanke: Like many other central banks around the world, the Federal Reserve participates with other agencies in supervising and regulating the banking system. The Federal Reserve’s involvement in supervision and regulation confers two broad sets of benefits to the country.
First, the financial crisis has made clear that an effective framework for financial supervision and regulation must address both safety-and-soundness risks at individual institutions and macroprudential risks--that is, risks to the financial system as a whole. All individual financial institutions that are so large and interconnected that their failure could threaten the functioning of the financial system must be subject to strong consolidated supervision. Both effective consolidated supervision and addressing macroprudential risks require a deep expertise in the areas of macroeconomic forecasting, financial markets, and payments systems. As a result of its central banking responsibilities, the Federal Reserve possesses expertise in those areas that is unmatched in government and that would be difficult and costly for another agency to replicate.
Second, the Federal Reserve’s participation in the oversight of the banking system significantly improves its ability to carry out its central banking functions. Most importantly, the Federal Reserve’s ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank. In addition, supervisory information and expertise significantly enhance the safety and soundness of the credit the Federal Reserve provides to depository institutions by allowing the Federal Reserve to independently evaluate the financial condition of institutions that want to borrow from the discount window as well as the quality and value of the collateral pledged by such institutions. Finally, its supervisory activities provide the Federal Reserve information about the current state of the economy and the financial system that, particularly during periods of financial crisis, is valuable in aiding the Federal Reserve to determine the appropriate stance of monetary policy. These benefits of the Federal Reserve’s supervisory role proved particularly important during the financial crisis that emerged in 2007.

See the link above (beginning on page 2) for more on "(1) how the expertise and information that the Federal Reserve develops in the making of monetary policy enable it to make a unique contribution to an effective regulatory regime, especially in the context of a more systemic approach to consolidated oversight; and (2) how active involvement in supervising the nation's banking system allows the Federal Reserve to better perform its critical functions as a central bank."

Yes, the Fed made mistakes in its duties as a regulator, there's no denying that. But we need to understand the institutional and other failures that caused the breakdown in oversight and fix them. If we ask tough questions and insist that the Fed take action in response to the problems that are uncovered, oversight can be improved without moving the authority outside of the Fed. Simply moving the existing problems to an outside agency -- and losing the important complements between policy and regulation -- is not the answer.

    Posted by on Thursday, January 14, 2010 at 04:32 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (21)


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