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Wednesday, February 22, 2012

The Fed as a Regulatory Agency

According to the Wall Street Journal, the Federal Reserve “has operated almost entirely behind closed doors as it rewrites the rule book governing the U.S. financial system.” The paper notes that this has been in sharp contrast to the trend at the Fed toward greater transparency in its interest-rate policies and emergency-lending programs. The complaint of a dearth of public meetings misses, however, not only the scripted nature of such displays, but also the more fundamental question of whether a central bank buffered from political pressure should play such a salient role as regulator. At the very least, the democratic deficit and a lack of accountability may be exacerbated by the Fed’s greater role as a regulator of banks—particularly after the major investment banks become commercial banks, and thus subject to the Fed’s regulations.

“While many Americans may not realize it,” the Journal continues, “the Fed has taken on a much larger regulatory role than at any time in history. Since the Dodd-Frank financial overhaul became law in July 2010, the Fed has held 47 separate votes on financial regulations.” This was as of February 22, 2012. In the process, the Fed was “reshaping the U.S. financial industry by directing banks on how much capital they must hold, what kind of trading they can engage in and what kind of fees they can charge retailers on debit-card transactions.” Unlike other regulatory agencies, not even the Fed governor’s votes were made public. Considering the contact that Fed officials had with their regulated banks on these issues and the Fed’s ties to banking itself, the lack of public meetings (only two on the 47 votes) suggests an opportunity for a conflict of interest to operate below the radar in the interest of the banks while the public holds the risk.

On the Volker Rule, which is the part of the Dodd-Frank law that prohibits banks from proprietary trading using their own funds because doing so is too risky for a bank too big to fail, Fed officials met with bankers at JP Morgan Chase sixteen times, Bank of America ten times, Goldman Sachs nine, and Barclays and Morgan Stanley seven each. On the Dodd-Frank provision on regulating derivatives—something a dissenting Fed governor claims has exemptions that are too wide—Fed officials met with JP Morgan Chase fourteen times, Deutsche Bank and Goldman Sachs twelve each, and Bank of America, Barclays, Morgan Stanley and Wells Fargo eleven each. Even just in relying on these banks for information and feedback, the Fed risks getting biased input on which to make judgments.

Bank of America, for instance, may insist that it must trade on its own books or it will fail. Other things equal, a Fed governor would vote against the Volker Rule. Morgan Stanley may insist that the regulation of commodity derivatives would put farmers who rely on the futures market at risk. Moreover, the bankers could insist that an exemption would not be abused, or they could coordinate their own pressure with a farming lobby and U.S. senators from farm states. The bankers’ intent is obviously to minimize the cost to them in the regulations that are put in place. The public interest, or risk to the public, is beside the point.

The banks played a similar role in the late 1990s as they lobbied the White House and Sen. Phil Gramm to keep derivatives unregulated. That unseen monster winded up biting us in the ass in 2008. Therefore, putting the public interest at risk is not just part of some theory; giving the regulated too much influence in the writing of regulations involves a conflict of interest that can literally result in the collapse of the global financial system. A public-level perspective, rather than that of a firm or industry, must be primary among regulators or the system itself is put at risk.

Pointing to the lack of public meetings in the Fed’s approach as a regulator, Sheila Bair, former chair of the FDIC, stated, “People have a right to know and hear the discussion and hear the presentations and the reasoning for these rules. All of the other agencies which are governed by boards or commissions propose and approve these rules in public meetings.” Fed officials point out that open meetings tend to be scripted and even perfunctory. As if to state good intentions are sufficient, Fed chair Bernanke said in a 2010 speech, “As an agent of the government, a central bank must be accountable in the pursuit of its mandated goals, responsive to the public and its elected representatives and transparent in its policies.” However, a central bank is closer to its banks in many ways that it is to the public or its elected representatives. In fact, a central banks is supposed to be buffered from political influence. While this makes sense in terms of monetary policy, regulating is a separate function and a democratic deficit there is problematic.

I think the public meeting issue is a red herring. The real problem lies in a central bank going beyond monetary policy and acting as a bank for the banks to also be a regulatory agency. That the Fed’s regulatory process differs from those of the “real” agencies suggests that the Fed officials do not even seen the Fed as such an agency. As Bernanke said, “a central bank is . . .” This is the Fed’s identity. It is distinct from a regulatory agency. Accordingly, Congress should establish a separate regulatory agency to cover the banks, leaving the Fed officials to concentrate on their core functions in operating a central bank. It is not as if Bernanke “got it right” leading up to September 2008. Even in 2007, he did not think the declining housing market would cause much of a problem. He had no idea that the swap and derivative markets were about to implode. This is not a good basis on which take on additional responsibilities, particularly writing new banking regulations. In other words, it is not like much would be lost were banking regulation written and enforced by a regulatory agency rather than the Fed. In addition, such an agency would not be so closely tied to the banks as the Fed is, as hinted at by its myriad of meetings with them. Such an agency would not be explicitly distanced from political pressure as the Fed is.

There is nothing wrong with elected lawmakers and executive branch officials making sure that the laws they have passed and are enforcing, respectively, are being operationalized and enforced by regulators who keep the public interest foremost in mind. As a central bank, the Fed is neither under the U.S. President in the executive branch nor under Congress. Meanwhile, Fed officials are very close to the banks they regulate. The problem of accountability that is in the Fed’s independence from the two branches added to the conflict of interest of the Fed being so close to the banks it regulates sets the public up for the sort of thing we saw in September 2008. That crisis did not come out of nowhere, and the reasons for it go beyond the housing market. At the very least, relying so much on an “agency” (and chair!) that failed to anticipate September 2008 and then geared a bailout to the banks rather than to the millions of foreclosed borrowers (hint: conflict of interest!) to write and enforce additional banking regulations on an industry that does not want them is beyond stupid; it is suicide. Meanwhile, the issue is presented as one of public meetings, which are scripted anyway and do not prevent the Fed from meeting with its bankers.

Are we really so superficial and narrow-minded? Quoting from Forest Gump, stupid is as stupid does. Hearing that line several times in the movie, I finally thought to myself, that makes absolutely no sense, but then, well, maybe I’m just stupid. If so, at least I’ve got lots of company in the Wall Street Journal—or maybe it is incredibly smart for the financial press to “sidebar” the issue to public meetings while the Fed, which is close to the banks (having even allowed bonuses amid bailouts), continues in the driver’s seat as both central bank and the (non-executive branch) banking regulatory agency. Maybe stupid is as stupid does applies to the rest of us. It is definitely the prefect motto for my hometown, whose hockey team is suitably called the Ice Hogs.

Victoria McGrane and Jon Hilsenrath, “Fed Writes Sweeping Rules From Behind Closed Doors,” The Wall Street Journal, February 22, 2012.