The Worden Report: The Fed as a Regulatory Agency

According to theWall Street Journal, the Federal Reserve “has operated almost entirely behindclosed 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 Fedtoward greater transparency in its interest-rate policies and emergency-lendingprograms. The complaint of a dearth of public meetings misses, however, notonly the scripted nature of such displays, but also the more fundamentalquestion of whether a central bank buffered from political pressure should playsuch a salient role as regulator. At the very least, the democratic deficit anda lack of accountability may be exacerbated by the Fed’s greater role as aregulator of banks—particularly after the major investment banks becomecommercial banks, and thus subject to the Fed’s regulations.

“While manyAmericans may not realize it,” the Journal continues, “the Fed has taken on amuch larger regulatory role than at any time in history. Since the Dodd-Frankfinancial overhaul became law in July 2010, the Fed has held 47 separate voteson 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 howmuch capital they must hold, what kind of trading they can engage in and whatkind of fees they can charge retailers on debit-card transactions.” Unlikeother regulatory agencies, not even the Fed governor’s votes were made public.Considering the contact that Fed officials had with their regulated banks onthese 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 interestto operate below the radar in the interest of the banks while the public holdsthe risk.

On the VolkerRule, which is the part of the Dodd-Frank law that prohibits banks fromproprietary trading using their own funds because doing so is too risky for abank too big to fail, Fed officials met with bankers at JP Morgan Chase sixteentimes, Bank of America ten times, Goldman Sachs nine, and Barclays and MorganStanley seven each. On the Dodd-Frank provision on regulatingderivatives—something a dissenting Fed governor claims has exemptions that aretoo wide—Fed officials met with JP Morgan Chase fourteen times, Deutsche Bankand Goldman Sachs twelve each, and Bank of America, Barclays, Morgan Stanleyand Wells Fargo eleven each. Even just in relying on these banks forinformation and feedback, the Fed risks getting biased input on which to makejudgments.

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. MorganStanley may insist that the regulation of commodity derivatives would putfarmers who rely on the futures market at risk. Moreover, the bankers couldinsist that an exemption would not be abused, or they could coordinate theirown pressure with a farming lobby and U.S. senators from farm states. Thebankers’ intent is obviously to minimize the cost to them in the regulationsthat are put in place. The public interest, or risk to the public, is besidethe point.

The banks playeda similar role in the late 1990s as they lobbied the White House and Sen. PhilGramm to keep derivatives unregulated. That unseen monster winded up biting usin the ass in 2008. Therefore, putting the public interest at risk is not justpart of some theory; giving the regulated too much influence in the writing ofregulations involves a conflict of interest that can literally result in thecollapse of the global financial system. A public-levelperspective, rather than that of a firm or industry, must be primary amongregulators or the system itself is put at risk.

Pointing to thelack 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 thediscussion and hear the presentations and the reasoning for these rules. All ofthe other agencies which are governed by boards or commissions propose andapprove these rules in public meetings.” Fed officials point out that openmeetings tend to be scripted and even perfunctory. As if to state goodintentions are sufficient, Fed chair Bernanke said in a 2010 speech, “As anagent of the government, a central bank must be accountable in the pursuit ofits mandated goals, responsive to the public and its elected representativesand transparent in its policies.” However, a central bank is closer to itsbanks in many ways that it is to the public or its elected representatives. Infact, a central banks is supposed tobe buffered from political influence. While this makes sense in terms ofmonetary policy, regulating is a separate function and a democratic deficitthere is problematic.

I think thepublic meeting issue is a red herring. The real problem lies in a central bankgoing beyond monetary policy and acting as a bank for the banks to also be aregulatory 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 assuch an agency. As Bernanke said, “a central bank is . . .” This is the Fed’sidentity. It is distinct from a regulatory agency. Accordingly, Congress shouldestablish a separate regulatory agency to cover the banks, leaving the Fedofficials 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 in2007, he did not think the declining housing market would cause much of aproblem. He had no idea that the swap and derivative markets were about toimplode. This is not a good basis on which take on additional responsibilities,particularly writing new banking regulations. In other words, it is not likemuch would be lost were banking regulation written and enforced by a regulatoryagency rather than the Fed. In addition, such an agency would not be so closelytied to the banks as the Fed is, as hinted at by its myriad of meetings withthem. Such an agency would not be explicitly distanced from political pressureas the Fed is.

There is nothingwrong with elected lawmakers and executive branch officials making sure thatthe laws they have passed and are enforcing, respectively, are beingoperationalized and enforced by regulators who keep the public interestforemost in mind. As a central bank, the Fed is neither under the U.S.President in the executive branch nor under Congress. Meanwhile, Fed officialsare very close to the banks they regulate. The problem of accountability thatis in the Fed’s independence from the two branches added to the conflict ofinterest of the Fed being so close to the banks it regulates sets the public upfor the sort of thing we saw in September 2008. That crisis did not come out ofnowhere, and the reasons for it go beyond the housing market. At the veryleast, relying so much on an “agency” (and chair!) that failed to anticipateSeptember 2008 and then geared a bailout to the banks rather than to themillions of foreclosed borrowers (hint: conflict of interest!) to write andenforce additional banking regulations on an industry that does not want themis beyond stupid; it is suicide. Meanwhile, the issue is presented as one ofpublic meetings, which are scripted anyway and do not prevent the Fed frommeeting with its bankers.

Are we really so superficial andnarrow-minded? Quoting from Forest Gump, stupidis as stupid does. Hearing that line several times in the movie, I finallythought to myself, that makes absolutely no sense, but then, well, maybe I’mjust stupid. If so, at least I’ve got lots of company in the Wall StreetJournal—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 (havingeven allowed bonuses amid bailouts), continues in the driver’s seat as bothcentral bank and the (non-executive branch) banking regulatory agency. Maybe stupid is as stupid does applies to therest of us. It is definitely the prefect motto for my hometown, whose hockeyteam is suitably called the Ice Hogs.

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