Should the Fed Be Fat or Skinny?

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Includes: BAC, C, GS
by: 472711

Over the past month and a half, the U.S. Congress has held a series of hearings to debate the Obama Administration’s proposal to overhaul the American financial regulatory structure. The fates of the SEC, CFTC, and other regulators have been discussed and the failures of consumer protection railed upon. The debate, though, has not yet satisfactorily answered an important question: What are the implications of placing consolidated supervisory authority for the most systemically important banks and non-banks in the Federal Reserve?

In other words, should the Fed be fat or skinny? I believe it should be skinny.

Senate Banking Chairman Chris Dodd himself told the Fed chair earlier this year, “Chairman Bernanke, I’d say your plate is full. As this Committee works to modernize our nation’s financial regulatory structure, the question is whether we should be giving you a bigger plate—or whether we should be putting the Fed on a diet.”

Simply put, a fatter Fed could lead to regulatory “capture” as it forms a cozy relationship with large financial firms, and possibly lead to looser monetary policy to benefit struggling banks. A skinnier Fed could focus more on monetary policy, and leave regulatory responsibilities to an efficient, consolidated supervisor of all banking, securities, and insurance firms.

The White House proposal for a fatter Fed—to vest systemic risk regulation in the central bank—is to address the problem, as the Treasury Department white paper asserted, that “no regulator saw its job as protecting the economy and financial system as a whole.” By deeming the Fed the ultimate supervisor of the nation’s largest financial services firms—those systemically important firms that operate in the banking, securities, and/or insurance markets—the Obama Administration has decided that the central bank is in the best institutional position to ensure sound business conduct and to cooperate with other regulators around the world.

Globally, however, developed countries have moved towards skinnier central banks, stripping them of much of their regulatory mandates. As banks and non-banks have increased their global operations and activities across different financial markets, they have generally preferred consolidated supervision; it’s more efficient, effective, and easier to interact with a single regulator responsible for all major financial markets. Since the mid-1980s, dozens of countries have decided to form consolidated supervisors that oversee all financial firms.

Yet, as I discovered while writing my undergraduate thesis, U.S. policymakers do not face the same pressures to consolidate supervision and regulation. Foreign banks’ share of the GDPs of other developed countries is much higher than in the United States. A higher level of internationalization in a country’s financial sector means politicians worry about losing firms to other countries. The U.S. does not face the same competitive pressures because the domestic financial services industry is so large and deep. Moreover, the U.S. financial sector is not as highly conglomerated; the proportion of large, interconnected firms relative to our GDP is less than the conglomeration witnessed in many other developed countries.

But, a severe crisis makes options available that might not otherwise be considered. Due to the federalist political system, the benefits of regulatory arbitrage—playing federal and state regulators off each other—seem to be particularly large in the U.S. And it is precisely these large, interconnected firms, such as Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and Bank of America (NYSE:BAC), which are most important to the stability of the global financial system because of their size and the reach of their operations.

An efficient, consolidated supervisor of all financial services firms would make sense for the United States. A department of the supervisor could primarily focus on systemically-important firms, doing the job now proposed for the Fed. Banks and non-banks would be better able to understand rules and regulations coming from a single supervisor. Distinctions on the cost of compliance and regulatory burden could be made to lessen the requirements for community banks and credit unions. Pooling financial regulatory expertise would increase information-sharing about risk across the system.

Yet, Congress seems to be hewing closely to the Administration’s proposal. What are the consequences of a fatter Fed? As the regulator of huge banks and non-banks, the Fed would be drawn into ever-closer relationships with them. In the past, the Fed has been a useful convener of the nation’s largest financial players, as in the New York Fed’s handling of the Long-Term Capital Management collapse in 1998. It proved the usefulness of this convener role again last fall when bringing Wall Street together to prevent a collapse of global finance. Mindful of his actions, Bernanke has rightly expressed outrage that firms had to be bailed out on the backs of taxpayers. After all, these are extraordinary times.

In ordinary times, though, a fat Fed as systemic risk regulator may have an even cozier relationship with large firms—a relationship that politicians could fear and smaller banks may resent. Across the Atlantic, for much of its history, the City of London enjoyed a wink-and-nod relationship with the Bank of England. The fear of firms’ “capturing” the central bank is one important reason that many developed countries decided to create consolidated financial supervisors instead.

Bernanke defends a fatter central bank, countering that the Fed’s expertise, daily monitoring of markets, and relationships with the banking sector make it the most effective regulator of the country’s largest banks and non-banks. These are indeed significant positives.

But, regulatory “capture” of the Fed could influence its monetary policy making. As David Singer and Mark Copelovitch find in a study of 23 industrialized countries from 1975 to 1999, inflation rates are significantly lower in countries where the (skinnier) central bank does not have regulatory responsibility. (This finding applies to countries like ours with floating exchange rates and large domestic financial sectors.)

Bernanke and Geithner have testified that the Administration’s systemic risk regulatory proposal is only an incremental extension of the Fed’s current supervisory authority. (It’s just one more cookie!) They would likely add that countries with central banks without a regulatory mandate, such as England, are experiencing financial crises just as bad as or worse than ours. Notably, their statements only sometimes discuss the underlying huge budget and trade deficits and exceeding loose monetary policy that enabled the crisis.

This question of the Fed’s institutional fitness has not been answered yet. A viable alternative to the Administration's proposal exists: a skinnier Fed focused on monetary policy working independently of a national-level consolidated supervisor of all financial services firms.

Disclosure: No positions