Senate bill brings new powers, new pressures for Fed

By Neil Irwin
Washington Post Staff Writer
Tuesday, May 25, 2010; A17

The Federal Reserve, a target of bipartisan bashing during the past two years, has emerged a big winner in the financial overhaul passed by the Senate, but the broader powers granted by the legislation expose the central bank to new risks.

The Senate bill represents a remarkable turnaround for the Fed. Many on Capitol Hill had wanted to punish the central bank for failing to prevent the financial crisis. An earlier version would have stripped the Fed of responsibility for overseeing most of the nation's banks, and there was strong support in both houses of Congress for audits of the Fed's monetary policy decisions.

Neither of those provisions made it into the legislation approved last week, and the central bank is set to gain broad authority to oversee Wall Street.

The new powers, however, could be a mixed blessing for Fed Chairman Ben S. Bernanke and his successors. The central bank will have its credibility on the line when the next crisis arises and could be more exposed to political pressures because of its broader reach.

Firming up mission

The exact impact of the far-reaching Senate legislation on the Fed is hard to predict, and it will change further as the Senate bill is reconciled with the House version passed last year. But the final bill will clearly reinforce the primacy of the Fed in preventing financial firms from taking risks that endanger the U.S. economy as a whole.

Under both bills, Fed leaders would identify firms whose size, complexity or interconnectedness makes them in need of extra oversight and, if a newly established council of financial regulators agreed, the Fed would begin supervising those companies. When a large, complex financial firm is on the verge of failure, the central bank would play a role in shutting it down, outside the bankruptcy process.

The Fed's long-standing official mission has been to ensure maximum employment and stable prices. In practice, the Fed has also made the pursuit of a stable financial system a goal; it was founded as a response to the financial panic of 1907.

But the legislation, people inside and outside the Fed acknowledge, would make stabilizing the financial system more explicitly a part of the central bank's mission. The open question is whether it would give the Fed the power it needs to meet that responsibility. As the past decade has shown, Fed officials have had plenty of blind spots and shown lack of foresight. And even if the central bank's leaders did their jobs perfectly, financial crises have existed for as long as capitalism has, and no legislation is likely to prevent them entirely.

All of which leaves the Fed's credibility exposed the next time the financial system shudders -- and central banks rely on their credibility to instill confidence in the economy.

"This has the potential to be pretty dangerous for the Fed," said Anil Kashyap, an economist at the University of Chicago Booth School of Business. "It seems to me the Fed could be left with the appearance that it's in charge of everything, but in fact not really be in charge."

Indeed, the Fed won't have its success entirely within its own hands. Both the House and Senate versions of financial regulation overhaul give a major role to a nine-member Financial Stability Oversight Council, which is to help determine where risks in the financial system lie.

While the Fed failed to identify the risks that a housing bubble posed for the financial system during the past decade, Fed officials argued early on that regional banks were becoming excessively exposed to commercial real estate and thought that other regulators were dragging their heels in developing a joint effort to address the problem.

On the other hand, it could be almost as dangerous if Americans -- and financial markets -- assume that the Fed will intervene whenever something bad happens in the financial world. That could lead to more irresponsible risk-taking by investors rather than less. Fed leaders are hoping that having the involvement of the council will help play down any assumption that the central bank will step in at the first sign of market distress.

Better prepared for crisis

Fed leaders say the legislation gives them the tools they need to combat crises.

"Will we have another financial crisis in the future?" Richard W. Fisher, president of the Federal Reserve Bank of Dallas, said in an interview. "The answer is yes, because capitalism is inherently unstable and that's the nature of financial and economic history. But will we be better prepared for it in order to manage it? The answer is yes, absolutely."

The Fed's heightened focus on the financial system could affect its core responsibility for managing the nation's money supply to steer the economy toward low unemployment and low inflation.

Monetary policy works best when it's not influenced by short-term political concerns, economists widely believe. But financial regulation is inherently more intertwined in politics.

The recent past shows the hazards for the Fed. When the central bank bailed out Bear Stearns and American International Group in 2008, it led lawmakers to question the Fed's wide-ranging authority and perceived lack of oversight.

That led to wide support for legislation proposed by Rep. Ron Paul (R-Tex.) to allow Government Accountability Office audits of central bank activities, including monetary policy -- an idea that had few backers before the crisis. That measure remains in the House version of the bill but was removed from the Senate version in a last-minute compromise.

The Senate bill still includes provisions that Fed leaders view as a threat to their independence from politics. One provision -- which Fed leaders vehemently oppose -- would make the president of the Federal Reserve Bank of New York a presidential appointee, politicizing a job that has long been considered technocratic.

"There will be more political involvement in the Fed," said Allan H. Meltzer, a Carnegie Mellon Tepper School of Business professor and a leading historian of the Fed. "Congress is not very good at thinking long-term about price stability. And how do you define what a systemic-risk regulator is? If you're a congressman from Oklahoma, and a big company in your district fails, for you that's a systemic risk. You're going to ask the Fed for help."

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