Setting Up The Fed to Fail

The Secretary of the Treasury, Henry Paulson, has proposed some rather significant reforms to the Federal Reserve. These changes would allow the Fed to intervene and review the books of any company with significant financial business in the American economy. On the face of it, his proposal looks more like something from the New Deal than the Bush Administration, but that may be the very point.

The Executive may be setting up the Fed to fail.

Treasury Secretary Henry M. Paulson Jr. is trying to turn the complicated muddle that is the U.S. banking regulatory system into something more coherent. To that end, he would replace a sprawling set of regulators aiming to ensure the soundness of the nation's financial institutions -- including the bank-supervision arm of the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the National Credit Union Administration -- with a single Prudential Financial Regulatory Agency.
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But the Fed would give up its power to regulate the day-to-day affairs of banks, responsibilities that many in the institution view as essential to its role as guardian of the economy -- even as the central bank gains new powers to insert itself into the affairs of any business creating risk for the financial system as a whole.
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"The Fed's ability to deal with diverse and hard-to-predict threats to financial stability depends critically on the information, expertise and powers that it holds by virtue of being both a bank supervisor and a central bank," Chairman Ben S. Bernanke said in a January 2007 speech.

In the Treasury Department's plan, the Fed would lose the responsibility for day-to-day monitoring of banks' financial stability. It would gain a more loosely defined ability to monitor and correct risks to the entire financial system, whether they come from banks, investment firms or hedge funds.

To many people with ties to the central bank, that is a lousy trade.

"The Fed should not be enamored of this proposal at all," said Ernest T. Patrikis, a former senior official at the Federal Reserve Bank of New York who heads the banking regulation practice at the law firm Pillsbury Winthrop Shaw Pittman. "It takes away a lot of authority, power and involvement." - The Washington Post

Of all our regulatory institutions, none is more influential, or more successful, than the Fed. For all the complaints about how the Fed missed the boat on this or that, it has done a remarkably good job in balancing unemployment, inflation, and credit over the past twenty-five years. In fact, the Fed stands as an example of the good a neutral regulator sanctioned by the public can do.

The Executive cannot have that. A successful government institution runs counter to the entire governing philosophy of the current administration.

Missing from Secretary Paulson's proposal, and from the general debate over the current difficulties faced by our financial institutions, is any discussion of the failure of the market itself. Perhaps the Fed missed some early indicators, but when push came to shove, they acted quickly to avert panic. Before they did that, however, at least four or five market safeguards failed.

First, the mortgage lenders (public and private companies) failed. They turned a blind eye and approved mortgage applications which were clearly dubious. The FBI has even been pursuing criminal cases against fraudulent lenders for five years! And yet even with the FBI raising a clear warning flag, lenders continued to look the other way.

Next, the investment banks (Bear Stearns, UBS Warburg, and the like) failed by bundling mortgage-backed securities that were much riskier than first appeared. It is the job of investment banks to match investment vehicle prices with their relative risks, in this, they failed at their very job.

Next, the ratings companies (market actors themselves) failed. By approving higher bond ratings for mortgage-backed securities than were justified, they created a sense of confidence in securities which did not deserve it. This was a key failure, as bond rating agencies are supposed to be neutral, independent observers. It is their role to call "foul" on investments that promise more than they can deliver.

Then, bond insurers failed, as they did not do their own due-diligence on the bonds they were insuring, but simply trusted the ratings from the ratings companies, even though those ratings were known to be questionable.

Finally, all of the independent market actors above failed once the scope of the problem appeared. We must remember that one of the biggest strengths of the market is the speed with which it can react to new information and incentives. And yet, after clear indications things were going sour the players above did not act.

Each of them could have taken action to mitigate their own risks, and the attendant risks to the economy and the taxpayers. The bond insurers could have started incrementing the price of insurance once the amount of floated securities reached a significant number. The ratings companies could have started derating the bonds. The investment banks could have started reducing their exposure to these investments. The mortgage lenders could have stopped approving marginal applications.

It is only because all of these private actors did not address the problem that the Fed had to get involved. It was only after every market tripwire was ignored that the regulatory agency was given an opportunity to act. After all, since the repeal of Glass-Steagall Act, the Fed has been largely powerless to truly evaluate large financial institutions during their regular operations. It is only crises of the entire economy that warrant intervention.

In all the discussion over reforming financial oversight in America, blame and responsibility is being redirected to the government, when it is not the government that failed!

As such, we should be very leery of proposed changes to the Fed's role. Once out of power, we can be sure that conservative, anti-government voices will be waiting in the wings for the next financial crisis, in the hopes that a beefed-up regulatory regime will again "fail." This will serve to validate their operating assumption: that government can do nothing right. The argument will be, "See, we gave them more power, but it still failed. It is time for a complete dismantling of all financial regulations."

Our leaders in Congress should look upon any Administration proposal warily, and preserve the important and effective powers and role the Fed has had for decades. It is the proper role of Government to oversee the people's interests, we must not let it be setup to fail.