Cleansing the Temple: Can Financial Reforms Straighten out One of America's Most Byzantine Institutions, the Federal Reserve?

By Fernholz, Tim | The American Prospect, June 2010 | Go to article overview

Cleansing the Temple: Can Financial Reforms Straighten out One of America's Most Byzantine Institutions, the Federal Reserve?


Fernholz, Tim, The American Prospect


In 2008, many Americans were surprised to discover that they live in what an earlier article in these pages called the "Republic of the Central Banker." The Federal Reserve, an institution whose opacity rivals only its reach, was forced by crisis to exercise its powers more publicly and more broadly than it had in a generation.

Under the current chair, Ben Bernanke, and before him, Chair Alan Greenspan, the Fed failed in nearly all its responsibilities. It did nothing to pop a burgeoning asset bubble in the housing markets and related derivatives. It refused to prevent that bubble by restricting pernicious lending practices despite ample regulatory authority on the books. The banks under the Fed's supervision took extraordinary risks and blew themselves up.

When the crisis came, though, the Fed acted quickly to stabilize the financial system with a massive leveraging of its balance sheet, deploying loan guarantees and discounts to keep lending alive even as it dropped interest rates to zero. In the face of pressure from Congress, it even belatedly enacted consumer protections on the mortgage and credit-card markets.

Do these actions demonstrate that the Fed has learned from its mistakes? Should the Fed's more recent behavior mitigate the need for reform?

Not at all. It is clear that without the pressure of a crisis, the Fed would not act to preempt disaster. It is time to rethink what we expect from our central bank and how its different functions work in concert and in tension. Unfortunately, present congressional efforts to overhaul the bank could leave the institution even more convoluted as reformers clash with moderate Democrats who are skeptical of more regulation, Republicans who oppose it outright, and the Fed's own attempts to defend its turf.

THE PROBLEMS START with the basics of the Fed's outmoded and undemocratic structure. Just consider the geographic spectrum of the Fed's regional branches: five banks east of the Appalachian Mountains--including one in Richmond, Virginia, barely 100 miles from Washington--and only one bank west of the Rockies. Each of those banks is run by a president and board of directors selected largely by the private banks they are meant to regulate. At its most absurd, this involved a Goldman Sachs banker being tapped to represent the public interest at the New York Federal Reserve.

Reformers want to change the structure of those boards, but legislation proposed by Senate Banking Committee Chair Chris Dodd allows the president of the United States to select only the head of the New York Fed (other regional Fed presidents would still be appointed by boards selected by bankers). The bill bars bankers from serving on the boards but not from picking who does. Mandating real public representation on these boards and limiting conflicts of interest is the only way to ensure that the Fed has the independence it needs from the political process and financial interests.

The Fed also lacks transparency, keeping its ledgers secret from the public eye. With the central bank's balance sheet rapidly expanding due to its rescue efforts, critics in Congress have demanded more accountability in the form of an independent audit. An audit bill passed in the House's financial committee by a bipartisan vote of 43-26, but it is vehemently opposed by the Fed and isn't included in the Senate's discussions of financial reform. It's hard to explain, though, how knowledge of what the Fed is doing is a detriment to its independence.

Similarly, there's no clear reason why the Fed should be responsible for both regulatory supervision and monetary policy. In fact, the central banks of the Unit ed Kingdom and the European Union have no regulatory role at all. While monetary policy requires independence from politics, regulation requires independence from industry--but at the Fed, banks have essentially been picking their own supervisors. An equally salient point is that consolidation in prudential regulation is critical to avoid the kind of race-to-the-bottom regulatory arbitrage we saw in the run-up to the financial crisis.

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Cleansing the Temple: Can Financial Reforms Straighten out One of America's Most Byzantine Institutions, the Federal Reserve?
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