The Fed should stay out of the bank-supervision business

By Steven Pearlstein
Saturday, February 27, 2010; A10

As the Senate begins to focus on how to fix financial regulation, one of the remaining unresolved issues is what role the Federal Reserve should have in supervising banks.

The correct answer? None at all.

The Fed and its supporters make three main arguments for retaining a significant role.

One: that the Fed hasn't done any worse than the other financial regulators.

Two: that only the Fed has the experience and sophistication to oversee large and complex bank-holding companies that could potentially pose a risk to the entire financial system if they get in trouble.

Three: that the Fed depends on the insight it gains from bank supervision to perform its monetary policy tasks.

The first thing to say about these arguments is that they blithely ignore a rather fundamental issue, which is why not consolidate the day-to-day supervision of all banks in a single agency, irrespective of a bank's size or the range of activities it engages in? If the Fed would be the best bank regulator, then give it the entire responsibility; if not, then don't. Continuing to divide the task among multiple agencies makes no sense and merely opens the door for the industry to engage in the kind of regulatory arbitrage that helped create the current mess.

It is also a mistake for the supervision of the biggest banks to fall to the country's lender of last resort. You can bet that would send a clear signal to the banks and the financial markets that these institutions will be treated as too big or too important to be allowed to fail. That way lies more bailouts.

It is arguably true that the Fed's record as a bank supervisor was no worse than the alphabet soup of other regulators (OCC, OTS, FDIC), but that hardly inspires confidence. Our purpose should not be to decide which of the failed agencies was least bad but to blow them up, as necessary, and start afresh with a new agency with a new culture, new leadership and a stronger mandate to focus on protecting the public rather than the industry it is meant to regulate.

The reality is that the Fed's primary focus is and will always be on monetary policy. Bank supervision will continue, as it has been, as a secondary activity that not only receives less attention from the top but will be sacrificed at those rare but crucial moments when the two missions might conflict. Indeed, by arguing that the Fed needs the insights gleaned from bank supervision to be more effective in making monetary policy, the Fed essentially acknowledges this hierarchy in its priorities. Bank supervision is important enough that it ought to be somebody else's top priority.

The Fed's culture of secrecy is also at odds with its supervisory function. The Fed attitude has always been that the public can't be trusted with knowing the details of what it does. Over the years, the Fed has steadfastly refused to publicly call out banks, individually or collectively, for poor underwriting, anti-consumer behavior or clever schemes for circumventing regulation. The view at the marble palace is that central banks should not be in the business of undermining public confidence in the financial system with criticism of industry practices or actions that suggest something might be amiss. Even now, the Fed refuses to make public its own internal review of the mistakes it made that contributed to the recent crisis.

The Fed is and always will be dominated by economists, which in practical terms means people who fundamentally trust that markets are efficient and self-correcting. As such, they are inclined not to intervene in the normal operations of markets or market participants. This conflicts directly with the very essence of financial regulation, which is to second-guess markets to protect them, and us, from their excesses. As we should have learned from Alan Greenspan's tenure as Fed chairman, economists who worship markets and distrust government don't make for great regulators. But if you think the Fed has absorbed this lesson, consider this: The man recently chosen to head the Fed's bank supervision unit was Greenspan's longtime adviser on regulatory matters.

I admit that there are people at the Fed who, because of their knowledge, experience and sophistication, are uniquely qualified to supervise the big banks. But that doesn't mean those people have to continue as Fed employees. They should be recruited to an entirely new regulatory agency, along with the best employees from all the other existing agencies and fresh talent brought in from the outside.

Finally, it should tell you everything you need to know that, in lobbying to retain its bank supervisory powers, the Fed's allies include the big Wall Street banks. Do you really think those banks would be fighting to preserve the status quo if they thought the Fed would turn around and suddenly become more aggressive in its supervision? And, if the Fed succeeds in retaining its authority, how likely do you think it is that the Fed will be willing to turn on its political allies and protectors with tougher rules, higher capital standards and more aggressive examinations?

The Fed is in many ways a superb organization with lots of smart, hard-working employees. It has been a good steward of monetary policy and performed superbly during financial crises. It surely ought to have a central role in the new uber-regulator charged with reducing risks across the entire financial system. But just as surely, the crucial job of day-to-day bank supervision would be done better somewhere else.

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