“There are serious potential conflicts of interest…the central bank used its authority under the Federal Reserve Act to provide assistance to financial institutions that were having liquidity problems. Many of these firms – bank holding companies, banks and their nonbank subsidiaries – are regulated directly or indirectly by the Fed. Their failure could have been seen as regulatory failure by the Fed…

…Did the Fed provide financial assistance to avoid this criticism, or because it was best for the economy and the financial system?”, Peter J. Wallison, “The Fed Needs More Than an Audit”, Wall Street Journal

Opinion

The Fed Needs More Than an Audit

The central bank’s expansive regulatory powers should be subject to congressional and executive branch oversight.

Federal Reserve Chair Janet Yellen at the central bank in Washington, Oct. 30.

Federal Reserve Chair Janet Yellen at the central bank in Washington, Oct. 30. Reuters

By Peter J. Wallison

With Republicans soon to hold majorities in the House and Senate, many commentators are speculating that the Federal Reserve will receive much more critical attention in 2015. In September, a large bipartisan majority in the House passed a bill to have the Government Accountability Office audit the Fed’s activities, including its monetary policies. The bill went nowhere thanks to Senate Majority Leader Harry Reid , but it could have significant support in next year’s Republican Senate.

Fed Chair Janet Yellen has expressed a legitimate fear that the Federal Reserve Transparency Act would endanger the Fed’s independence on monetary matters. But the Fed has now accumulated so much regulatory power that it can no longer claim the right to avoid congressional oversight. If the central bank hopes to maintain its monetary independence over time, it will have to surrender its regulatory authority.

There are serious potential conflicts of interest between the Fed’s regulatory and monetary roles. This became clear during the financial crisis, when the central bank used its existing authority under the Federal Reserve Act to provide assistance to financial institutions that were having liquidity problems. Many of these firms—bank holding companies, banks and their nonbank subsidiaries—are regulated directly or indirectly by the Fed. Their failure could have been seen as regulatory failure by the Fed. Did the Fed provide financial assistance to avoid this criticism, or because it was best for the economy and the financial system? It’s a painful question to consider, but the fact that it can legitimately be asked suggests the problem—and a reason why the Fed should not have both monetary and regulatory powers.

In 1999 the Gramm-Leach-Bliley Act gave the Fed “umbrella” authority to oversee the capitalization and activities of insurers and broker-dealers that were subsidiaries of bank holding companies. That made the central bank the closest thing to a “systemic regulator” of the U.S. financial system, with the ability to oversee the work of other financial regulators such as the Securities and Exchange Commission.

The Fed clearly failed in this role before the 2008 financial crisis, but in typical Washington fashion the 2010 Dodd-Frank Act enlarged the Fed’s powers. It now has authority to supervise all of the large nonbank financial firms that are designated as systemically important financial institutions by a council of regulators.

While enlarging the central bank’s authority in 2010, Congress never asked whether the Fed’s mandate to promote both stable prices and full employment—itself a situation rife with conflict—led it to pull its regulatory punches. Now Congress is wondering whether the Fed is a captive of the banks. To fight this charge, the Fed is trying to show that it is a tough regulator, flexing its regulatory muscles by telling banks that it doesn’t like some of the loans they are making—such as leveraged loans in corporate acquisitions. This comes perilously close to credit allocation and is especially troubling if it is motivated by an effort to maintain the Fed’s regulatory authority and monetary policy independence.

Apart from whipsawing the financial system so the Fed can make a political point, this practice and other excessive regulation adds significant operating costs for banks and others, causing them to withdraw from lines of business that regulatory costs make less profitable. These costs are also a burden on competition; large banks can bear them more easily than can smaller competitors. That’s why in 2013 Jamie Dimon, chairman of J.P. Morgan Chase , the largest bank in the U.S., referred to more regulation as a “bigger moat” against competition.

Because the Fed’s operating funds come primarily from interest on the government securities it holds, the central bank does not receive congressional scrutiny in the appropriations process. Nor are its expenditures examined by the Office of Management and Budget in preparing the president’s annual budget. Both reviews are ways for Congress and the president to control regulatory overreach.

At a minimum, as long as the Fed retains its regulatory authority, it should be required to provide Congress with a budget for its regulatory activities, to show each year how it met the prior year’s budget, and to explain why it should be permitted to allocate more to its regulatory functions in the year to come. In this review, the Fed should describe its regulatory policies in detail and explain and justify its plans for the future.

These steps would substitute for the authorization and appropriations reviews that occur each year for most other agencies. If there is an annual audit, it should tell Congress, the president and the public whether the funds that the Fed is using for regulation are being used efficiently. This would restore a small degree of accountability.

Before Congress acts on audit legislation that will certainly complicate the agency’s effort to retain its independence on monetary policy, the Fed should offer to support the consolidation of its regulatory authority into a separate federal financial regulatory body. That was recommended in the Ronald Reagan and George W. Bush administrations. The Federal Reserve has always resisted these proposals, but that may no longer be either advisable or possible.

Mr. Wallison is a senior fellow at the American Enterprise Institute. His latest book, “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again,” will be published in January by Encounter Books.

Posted on December 2, 2014, in Postings. Bookmark the permalink. Leave a comment.

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