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Fed May Gain More Financial Oversight
Some Worry Plan Would Give Bank Too Much Power

By Neil Irwin and Binyamin Appelbaum
Washington Post Staff Writers
Monday, January 26, 2009

Congress is moving to create strong new oversight of the financial sector that would likely give the Federal Reserve authority to examine the workings of a wide range of companies in an attempt to address one of the key failures that led to the financial crisis.

But the initiative, which could be finalized in the House by spring, is raising concerns about whether it would muddy the Fed's traditional mission and concentrate too much power in a single federal body.

The legislation envisioned by House Financial Services Committee Chairman Barney Frank (D-Mass.) would put the Fed, or less likely another government agency, in charge of protecting the stability of the entire system, Frank and other congressional sources said.

An abundance of federal agencies regulate the financial industry. But no agency is responsible for understanding or containing risks affecting the financial system as a whole. In fact, none even has a complete picture of the financial markets.

The danger was highlighted by last year's meltdown of insurance giant American International Group. In the days before the government was forced to bail out the firm, no federal official comprehended the magnitude of the threat the company's troubles posed to the economy.

Under Frank's legislation, the new regulator would likely be given the power to gather information about the inner workings of banks, investment firms, insurance companies, hedge funds and any other entity big enough or so intertwined with other companies that it creates the risk of a systemic collapse. These companies would have to provide detailed information about how they manage risk, their derivative contracts and the extent to which they use borrowed money.

"We need to give some regulator the power to restrain risk-taking that is excessive," Frank said. He said he intends to move quickly, explaining that the Obama administration is eager to be able to show the Group of 20 finance ministers progress on financial regulation at a meeting in early April.

President Obama, during his campaign, spoke approvingly of overhauling financial oversight. Though he has not specifically endorsed the idea of making the Fed a financial system regulator, his administration has sent clear signals to Congress that they should proceed on that path. The idea was first widely discussed last spring as part of a blueprint for regulatory reform issued by then-Treasury Secretary Henry M. Paulson Jr.

"Someone needs to have all of the information," said Scott Talbott of the Financial Services Roundtable, an industry group that represents 100 of the largest financial companies and that supports the plan.

Many elected officials, financial experts, industry groups and consumer advocates agree there is a need for a "systemic risk" regulator that would watch for threats to the health of the financial system and that there is no clear alternative to empowering the Fed. But there is also widespread concern that the new responsibility could stretch the agency too thin and conflict with the Fed's basic responsibility for managing the nation's money supply.

The Fed was created by Congress nearly a century ago as an independent entity, insulated from political pressure, so it could take the unpopular step of slowing the economy to combat inflation. But as a regulator, the Fed operates more like an ordinary government agency, with extensive review and oversight by congressional authorities.

Government and private-sector officials worry that by taking on more regulatory responsibilities, the Fed could expose itself to more second-guessing by political officials.

"We don't want to wake up five to 10 years from now and find we have very much undermined the Fed's independence in setting monetary policy," said Ed Yingling, chief executive of the American Bankers Association.

At the same time, some financial experts warn that the expanded responsibilities could bias the Fed in favor of large financial companies, because these are the firms that could endanger the financial system by virtue of size and reach of their activities. The Fed is charged with enforcing various consumer protection laws -- such as the Truth in Lending Act, which specifies the disclosures that lenders are required to make -- and critics say the agency is ignoring this job. In the past, Frank and Sen. Christopher J. Dodd (D-Conn.), chairman of the Senate Banking Committee, have threatened to remove the Fed's consumer protection powers.

Moreover, there is concern that too much regulatory power would be concentrated in the hands of a single agency. The Fed supervises bank holding companies, a category that in recent months has come to include not just every major bank, but also the likes of Goldman Sachs, Morgan Stanley, American Express and auto finance company GMAC. The Fed is also lending hundreds of billions of dollars to entities of all types to try to combat the financial crisis.

To limit the Fed's power, some experts suggest that it should focus exclusively on safeguarding the overall financial system, ending its role as a regulator of individual firms.

The Fed is responsible for overseeing the safety and soundness of about 860 banks.

Steven Davidoff, a law professor at the University of Connecticut, says banking regulation should be moved to an agency that "can be monitored by Congress and is more responsive to public requirements."

"The Fed collaborates more closely with the financial industry, and because of that, it may be too close to the financial industry and so you may want some distance," Davidoff said. "Also, how powerful do you want the Fed to be? It shouldn't have complete power" over banks.

The basic idea is simple. The systemic risk regulator would be a "free safety" or a "super-cop" defending the financial system. The agency would have the power to demand information from any company -- banks, investment firms, insurance companies and hedge funds.

Less clear is how the new entity would interact with the existing regulators watching over particular companies. Frank acknowledged that he does not have answers for some of the most difficult concerns.

For instance, if the new regulator viewed a company as posing risks to the overall financial system, how much power would the agency have to order changes? Could it compel a hedge fund -- a lightly regulated pool of private capital invested for wealthy individuals and institutions -- to use a lower ratio of borrowed money?

Hedge funds have strongly resisted regulation, although the Managed Funds Association, which represents them, said last week that it is open to discussion of a new financial system having a role with them, but not supporting or opposing the idea outright pending more details.

And could the new regulator usurp the decisions of other regulators, such as the primary regulator of banks and investment firms, or the state insurance regulators who oversee most divisions of large insurance companies, though generally not their parent companies?

By deeming firms vital to the health of the financial system, would the regulator actually embolden them to take greater risks? "The problem is that once you brand somebody systemically important, you're telling the world that you have to rescue them if they fail," said Hal S. Scott, a Harvard Law professor and director of the Committee on Capital Markets Regulation, a group of academics and finance industry leaders. "It puts a 'too big to fail' stamp on their forehead."

John Dearie, executive vice president at the Financial Services Forum and a former Fed employee, said there is a "compelling logic" to empowering the Fed. "It has unique powers and tools that enable it to reach into the financial market and actually affect circumstances within the financial markets," he said. "It is the only institution that can really manage a systemic crisis."

Others remain unconvinced.

"There is agreement that we need a systemic regulator," said Rep. Spencer Bachus (Ala.), the ranking Republican on the Financial Services Committee. "Whether the Fed, which has committed trillions of taxpayer dollars in loans and guarantees, is the best choice for that role remains to be seen."

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