Why the Fed won’t be good at bank regulation

By Felix Salmon
May 6, 2011
Kindred Winecoff has an informed view of the question raised by Jesse Eisinger this week -- whether central banks should also be bank regulators.

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Kindred Winecoff has an informed view of the question raised by Jesse Eisinger this week — whether central banks should also be bank regulators. He wrote his thesis on the topic — he’s promising to put it online soon — and importantly he didn’t just look at the question on a theoretical basis, he also ran the empirical numbers. And the results, he says, are clear:

I find that where monetary authority and regulatory authority were split, banking systems had higher capital ratios than when they were unified. The coefficients are substantively large and statistically significant at the usual levels. The results are robust to the inclusion of controls and alternative specifications.

The takeaway is that institutional design is important here. If you give one institution conflicting mandates — one to act counter-cyclically, and one to act pro-cyclically — then at the relevant margin one of those two has to give.

The counter-cyclical mandate, of course, is monetary policy — if a country is plunging into recession, the central bank will cut rates to boost the economy and help banks make more money. But bank regulation is pro-cyclical: if banks look as though they’re running into trouble, a tough regulator will ask them to raise more capital, which in turn hurts their profitability.

The clever thing about Winecoff’s paper is that he found two natural experiments. It’s not hard to find countries where central banks lose their regulatory authority — that kind of thing happens pretty regularly from time to time. But he also found countries where central banks lost their control of monetary policy, which is much rarer — by looking at the central banks of countries which joined the euro.

In the case of the US, I’m not completely convinced that this means we should strip regulatory authority from the Fed and give it to someone else — mainly because it’s very hard to think of any other agency which would do better. The Fed didn’t exactly cover itself in glory with respect to bank regulation in the run-up to the crisis, but agencies like the SEC, OCC, OTS, FDIC, etc did even worse. And setting up a brand-new bank regulator from scratch is fraught with its own problems — not least that it would have conflicts with all those other shops.

But Winecoff does give me every reason to be pessimistic about the Fed’s zeal when it comes to bank regulation. It’s probably never going to be great at that part of its job — and the results, if and when there’s another crash, are not going to be pretty.


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While the Fed’s supervisory role has certainly gotten short shrift to monetary policy, I don’t share Winecoff’s cynicism that this paradigm is a structural feature that will persist for as long as the central bank plays both roles. But improving the Fed-as-regulator can’t begin until we reject the premise that prudential regulation is necessarily pro-cyclical. The Fed ought to view prudential regulation as another tool in its belt–one that can be wielded more delicately and in a more targeted manner than rate targets and QE. A light touch when times are rough, but strict in those heady periods when risk premia evaporate. Basel is wise to this thinking. It remains to be seen whether the Fed is too.

Posted by Sandrew | Report as abusive

The Fed should regulate banks that borrow money from it, just like any other bank that sets rules for borrowers. For instance, if you use any of the Fed’s services, you shouldn’t be allowed to make really stupid loans, like no money down, no docs ARMs to people who obviously won’t be able to make the payments.

Even insurance companies regulate personal and corporate behavior, because they tell you what you can and can not do if you want insurance. Why shouldn’t a central bank be allowed to set rules for banks that borrow from it, even overnight?

Posted by KenG_CA | Report as abusive

But bank regulation shouldn’t be pro-cyclical. It should operate anticipatorially. The time to raise loss ratios is when losses are low; waiting until they appear is backward looking, a problem with monetary policy as well.

Posted by MyLord | Report as abusive

Additional data point: in Australia, deposit taking institutions are regulated by the Australian Prudential Regulation Authority (established after the Wallis Inquiry, ’98). The so called ‘Big Four’ banks have some of the highest levels of Tier One Capital on Earth (as a percentage of total capital.)

Posted by crocodilechuck | Report as abusive