Banks' Influence on Congressional ''Reform'' of the Fed

Narayana Kocherlakota:

Banks' Influence on Congressional “Reforms” of the Fed: Senator Sanders’ December 23 NYT op-ed expressed concern about what he perceived to be an undue influence of the financial sector on the Federal Reserve. In my last post, I explained how the Fed could allay these concerns through greater transparency about the role of the Board of Governors. In this post, I elaborate on what I see as a much bigger problem: the financial sector’s influence on Congress as it seeks to “reform” the Fed.

Here’s an example of what I mean. Last year, Congress amended Section 10.1 of the Federal Reserve Act. That section now requires a person who is experienced with community banks to be on the Board of Governors. There is no other explicit sectoral requirement of this kind in the Act.

How should one interpret this new statutory requirement? The issue is not whether it is often beneficial to have a Board member who has prior experience with community banks. I fully agree that it is. But that’s true of many other sectors in the US economy. So why is Congress picking this particular sector as being one that needs to be represented on the Board?

Unfortunately, the answer is clear to me (as I suspect that it will be to anyone who fills this new slot): Congress wants the Fed to tilt supervision, regulation, and monetary policy to be more favorable to community banks. This interpretation is consistent with the fact that the passage of this statutory change came after six years of lobbying from the Independent Community Bankers of America.

This statutory preference for community banks is disturbing. It’s true that community banks are often located on Main Street. But the interests of community banks are absolutely not the same as the interests of Main Street.

In terms of supervision and regulation: lax supervision and regulation increases the probability of bank failure. Bank failures impose a cost on the FDIC which is, ultimately, backstopped by the taxpayer. Community banks operating in the interests of their shareholders should not - and don’t - fully internalize these taxpayer costs. Accordingly, community banks systematically favor less supervision and regulation than would be in the public interest.

In terms of monetary policy, the profits that banks derive from many of their products are positively correlated with the overall level of interest rates in the economy. For this reason, community bankers typically favor higher interest rates than is in the general public interest. (Of course, this preference is shared by larger financial institutions for similar reasons.)

In writing the above, I’m not intending to be critical of community banks. They’re private businesses. No one should expect the interests of a given private business to coincide with the general public interest.

The problem is with Congress. Congress is supposed to act in the interest of the public. But this law is not in the public interest. Instead, it is a rather clear attempt to influence the Fed so that it acts more in the interest of (part of) the financial sector.

In his op-ed, Senator Sanders says that he wants to reform the Fed so that “the foxes would no longer guard the henhouse”. The first step in this agenda should be to repeal the recent amendment to section 10.1 of the Federal Reserve Act. This step will not be easy to accomplish. The amendment passed with overwhelming support from both parties in both Houses of Congress.