Why the Fed should regulate banks

By Felix Salmon
January 19, 2010
George Cooper asks whether or not banks should be regulated by the central bank, noting drily that "America sees salvation in replicating the failed British banking experiment while Britain sees salvation in returning to the equally discredited American model". He adds:

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George Cooper asks whether or not banks should be regulated by the central bank, noting drily that “America sees salvation in replicating the failed British banking experiment while Britain sees salvation in returning to the equally discredited American model”. He adds:

I am happy to make my small voice heard in support of Mr Volcker. He is right when he says “It simply doesn’t make sense, as then Fed Chairman Mariner Eccles complained during the Great Depression, that the efforts of the Federal Reserve to ease money be to some degree frustrated by overzealous banking regulators determined to restore bank capital and assure strong lending standards.” For this reason it is best to view monetary policy as requiring both interest rate and regulatory policy levers.

That said, it is pointless to give the central bank control of both levers if it is unwilling to use them or chooses to push them in opposite directions.

There’s no doubt that the current US administration in general, and Bernanke’s Federal Reserve in particular, is indeed currently pushing those levers in opposite directions. Monetary policy is very loose, while everybody is agreed on the need to tighten up banking regulations substantially.

Where I part company with Cooper is when he determines that this is necessarily a bad thing. If the Fed’s in control of both regulating banks and setting monetary policy, then it can put together an optimal combined approach, or at the very least take account of one while working on the other. We have to crack down on bank leverage? OK, then we might have to cut rates a bit more.

If by contrast the banks are regulated by some other institution entirely, the Fed has to second-guess what that institution is going to do in the future, and that’s never going to be easy.

During the credit bubble, it’s now clear, one of the Fed’s biggest failings was that it not only kept interest rates too low for too long, but also abrogated all responsibility over what Cooper calls the regulatory policy lever. It could have cracked down much harder on mortgage lending, but didn’t. There is a chance, however, that it can learn from its mistakes — especially if it’s given regulatory authority over non-bank lenders and other actors in the shadow banking system.

Anybody else given broad regulatory authority — and someone needs to have it — would need to work hand-in-glove with the Fed in any event, especially when it comes to questions such as the Fed paying interest on reserves. And there’s no particular architectural reason not to give the Fed those powers — objection to the idea comes overwhelmingly from the fact that this Fed has made so many mistakes that people don’t trust it to do the right thing in future.

But the fact is that if you try to build a bank regulator from scratch, it will take decades to find its feet and learn from its mistakes. The Fed, with any luck, has reached that point now. Let’s give it regulatory authority, and cross our fingers it uses them wisely.

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