The U.S. Federal Reserve as a Regulator of Banks: An Institutional Conflict of Interest

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 was to be 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 claimed 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.

Morgan Stanley may have insisted that the regulation of commodity derivatives would put farmers who rely on the futures market at risk. Moreover, the bankers could have insisted 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 was obviously to minimize the cost to them in the regulations that are put in place. The public interest, or risk to the public, was 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 was presented as one of public meetings, which were scripted anyway and did not prevent the Fed from meeting with its bankers.

Source:

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

Related books: 

Essays on the Financial Crisis

Institutional Conflicts of Interest

Limiting Bank Size: Crude But Advisable

In February 2012, Tyler Cowen claimed in the New York Times that people across the political spectrum were “talking about splitting up America’s large banks.” At the time, I could discern no such talk, although this does not mean that it was not going on. As the Dodd-Frank financial reform law was being written in 2010, the option of splitting up banks like Bank of America, Goldman Sachs, and JP Morgan Chase was quietly but assiduously kept off the front burners. It is difficult to believe that the big banks would have relaxed in their efforts to relegate such threats in early 2012 as if the passage of the legislation in 2010 meant that more astringent options were no longer possible. In his article, Cowen includes some other questionable claims. Reading between the lines, he seems to have been “playing by the rules” in support of the big guys.

Even as Cowen notes that “before its collapse, Lehman had a capitalization of about $60 billion, compared with the $143 billion capitalization of JPMorgan Chase [in early February 2012],” he goes on to characterize breaking up the biggest banks as penalizing size rather than failure. In doing so, he is conflating a regulation with the market mechanism. Whereas the latter is supposed to penalize failure, there is nothing wrong with a regulation limiting size, as it is often correlated with market (and political) power at the expense of competition (and democracy). Moreover, limiting size is not to penalize it. As Cowen himself admits, “banks are usually wealthier, nimbler and smarter than their regulators, at least when it comes to finding loopholes in the regulations or making their moves more opaque.” Limiting the power of bankers by limiting their respective bank’s assets makes perfect sense in protecting the regulators from being unduly pressured from their regulatees.

Furthermore, Cowen conflates bailing out a big bank with bailing out its parts after a spin-off as if a small bank failing were somehow as damaging as a big one going down. He argues that “if the resulting parts of a divided bank cannot turn a profit, the split-up may prompt the very bailout it was trying to avoid.” This is not true, as “the very bailout” to be avoided pertains to that of the big bank rather than any of its parts.

Cowen also assumes that the smaller banks would necessarily be bumping their heads against the maximum size allowed. He argues that “the incentives for the new, smaller banks would be unhealthy. Those banks could make mistakes or take on bad risks without being punished very much in terms of capitalization or revenue, because of their legally capped size. Even if they made big mistakes, these banks would probably be pushing on the frontier of maximum allowed growth.” In other words, he assumes that a limit on size would somehow eclipse any remaining market mechanism. Perhaps he is assuming an overly astringent limit, such as 50 employees. There is a lot of room for limits below a $143 billion capitalization without eviscerating the market mechanism.

In fact, Adam Smith would doubtless maintain that a market with smaller competitors functions better in terms of competition “rewarding” good performance and “penalizing” incompetence. It is as if we are so used to corporate capitalism that we assume that Adam Smith’s version cannot work. I would argue that Smith’s version is actually superior with regard to the market mechanism. Because that mechanism can “freeze up” rather than price-adjust for added risk, we should not rely exclusively even Smith’s competitive market. Given the downsides of the market mechanism itself, limiting the size (and thus power) of the participants is certainly justified. It is not “penalizing size.” I do not believe that Cowen has a firm grasp on either the market mechanism or the nature of government regulation.

Source:

Tyler Cowen, “Break Up the Banks? Here’s an Alternative,” The New York Times, February 11, 2012.