Thursday, June 18, 2009
THE ORIGINS of the Federal Reserve System lie in the financial panic of 1907, when the United States averted economic collapse only because J.P. Morgan improvised emergency private-sector loans to troubled Wall Street firms. Washington's response was to create the Fed as a politically independent "lender of last resort," with the authority to supervise banks. And although the Fed failed its first big test, the Great Depression, it has generally used its twin powers of money creation and bank regulation more wisely since then. Three decades ago, the Fed under Chairman Paul A. Volcker rescued the United States from murderous inflation, albeit at great short-term cost in economic growth. So it is natural that, in the current crisis, President Obama would assign the Fed some heavy lifting in the financial regulatory reform plan he unveiled yesterday.
Under the plan, the Fed's authority to order corrective action at riskily managed bank holding companies would be extended to any financial firm -- including insurance firms or investment bank subsidiaries -- so large and "interconnected" that its failure could bring down the financial system. The Fed would be responsible both for identifying a potential AIG and Bear Stearns and for imposing stricter capital requirements on them. In dire situations, the Fed could push such firms into a new form of government-run emergency resolution.
This new approach to the "too big to fail" problem grants one of Fed Chairman Ben S. Bernanke's fondest wishes. It addresses the situation that Mr. Bernanke and the Treasury Department faced in September 2008, when Lehman Brothers collapsed but the government had no legal alternative to bankruptcy. The proposal raises questions, however. A government list of systemically important firms is tantamount to a list of government-backed firms -- though the plan mitigates this risk by requiring them to hold more capital. The biggest challenge could be to the Fed's independence: The broader its control over the financial sector, the more it will get lobbied, directly or indirectly. Any political capital the Fed spends on its regulatory function is capital it might not have to defend monetary policy.
Already, the Fed's massive interventions in the economy have drawn fire in Congress, which is probably why the Obama administration did not give it even more power. Indeed, the Fed would have to consult with a new Treasury-headed Financial Services Oversight Council made up of other regulatory agency leaders. And, in perhaps the biggest concession, the Fed would have to check with Treasury before exercising its emergency power to expand its balance sheet. As the Obama plan moves through Congress, many will no doubt ask why the Fed can be counted on to spot systemic risks when it did not use its power to help rein in such highfliers as Citigroup. There may also be questions about the role of past monetary policy in enabling Wall Street's excessive risk-taking. Regulation is important, but sound monetary policy is equally crucial to systemic stability. Congress should make sure that any new powers granted to the Fed are consistent with the independent fulfillment of its primary mission.