Under the Treasury's Plan, Fed Would Lose a Key Power

By Neil Irwin
Washington Post Staff Writer
Tuesday, April 1, 2008

Conventional wisdom has it that the Federal Reserve is a big winner in the Treasury Department's plan to overhaul how the financial system is regulated.

But the Fed would give up its power to regulate the day-to-day affairs of banks, responsibilities that many in the institution view as essential to its role as guardian of the economy -- even as the central bank gains new powers to insert itself into the affairs of any business creating risk for the financial system as a whole.

Treasury Secretary Henry M. Paulson Jr. is trying to turn the complicated muddle that is the U.S. banking regulatory system into something more coherent. To that end, he would replace a sprawling set of regulators aiming to ensure the soundness of the nation's financial institutions -- including the bank-supervision arm of the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the National Credit Union Administration -- with a single Prudential Financial Regulatory Agency.

The Fed has indicated neither explicit support nor opposition to the Treasury plan. But leaders of the central bank have in the recent past vigorously opposed stripping their institution of its role supervising bank holding companies.

"The Fed's ability to deal with diverse and hard-to-predict threats to financial stability depends critically on the information, expertise and powers that it holds by virtue of being both a bank supervisor and a central bank," Chairman Ben S. Bernanke said in a January 2007 speech.

In the Treasury Department's plan, the Fed would lose the responsibility for day-to-day monitoring of banks' financial stability. It would gain a more loosely defined ability to monitor and correct risks to the entire financial system, whether they come from banks, investment firms or hedge funds.

To many people with ties to the central bank, that is a lousy trade.

"The Fed should not be enamored of this proposal at all," said Ernest T. Patrikis, a former senior official at the Federal Reserve Bank of New York who heads the banking regulation practice at the law firm Pillsbury Winthrop Shaw Pittman. "It takes away a lot of authority, power and involvement."

It would be hard to understand threats to the financial system, Patrikis said, without having a staff that is constantly scrutinizing the inner workings of banks.

Thousands of employees at Federal Reserve regional banks spend their days examining the nuts and bolts of the financial system. They collect and analyze information on bank holding companies' management structure, business lines, risk controls and vulnerabilities -- responsibilities that would be shifted to the new regulator.

In his 2007 speech, Bernanke laid out several examples of times when such deep, on-the-ground knowledge has helped the Fed deal with financial crises. For example, after the Sept. 11, 2001, terrorist attacks, Fed examiners went to the backup sites of large banks affected and immediately reported back to top Fed officials on the damage done to the financial system and how to fix it.

And after the stock market crash in 1987, the Fed used its relationships with the banks it regulates to encourage the extension of credit to investment firms, helping avert a continued rout and damage to the larger economy.

Bernanke also argued that understanding banks helps the Fed better decide how to set interest rates to try to balance strong growth with low inflation. That is because Fed policy operates on the credit system. When it cuts rates, banks make that cheaper money available to ordinary Americans to stimulate the economy.

From the Treasury Department's point of view, an overhaul is needed because the system of banking regulation has too much redundancy. With many agencies, firms being regulated face bureaucratic headaches and regulators may feel less need to be accountable.

The current patchwork has evolved since the Civil War, offering different rules and different regulators to nationally chartered banks, state-chartered banks, thrifts and credit unions. All these institutions started with different purposes and roles in the financial system but increasingly do similar work.

That mix of institutions can create problems because information is compartmentalized in different bureaucracies. It may have contributed to the current financial crisis. Because each agency was focusing on applying a narrowly tailored set of rules, rather than examining the big picture, conflicts of interest among mortgage brokers, banks and the investment firms that package mortgage loans got little attention from regulators.

"The problem wasn't necessarily too much regulation or too little," said Ross Levine, a Brown University professor who studies the banking system. "The problem was regulators did not adapt to financial innovation and make sure that information was transparent. No regulator looked broadly at the conflicts of interests being created."

In this fragmented system, financial companies can engage in "regulatory arbitrage," expending vast amounts of effort deciding what kind of charter to operate their businesses under, in effect choosing what sort of rules apply to them.

But there are some advantages to the current system, too. With a mix of regulators, mistakes by one agency can be partly made up for by others. And there is a long history of powerful financial regulators behaving improperly, either through overt corruption or by becoming too beholden to the industry they oversee.

Even if Congress approves some version of the Treasury plan, it will be an enormous bureaucratic task to implement it.

"It's easy enough to say that the current system doesn't make any sense, that it's a crazy quilt of regulators," said David O. Beim, a finance professor at Columbia Business School. "But it's very difficult to put institutions together. People howl and protest; there is turf to be protected. It is painfully difficult to merge institutions that don't want to merge."

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