FED FOCUS-With broader powers, Fed to face greater scrutiny

By Reuters Staff
June 25, 2010

By Pedro Nicolaci da Costa

WASHINGTON, June 25 (Reuters) – As officials at the Federal Reserve may soon discover, more isn’t always better.

On the face it, the results of the landmark regulatory reform bill finalized on Friday should have policymakers at the U.S. central bank running victory laps around Congress.

Despite self-professed regulatory shortcomings in the run-up to the worst financial crisis in modern history, the Fed has emerged from legislative reform efforts with its powers greatly enhanced.

But with financial markets still fragile and a debt crisis in Europe showing no sign of easing, the Fed’s beefed-up authority to oversee broad risks to the financial system could come back to haunt it.

Unlike in the recent crisis, where regulators shared the blame, any renewed market meltdown might be laid squarely at the Fed’s feet, even though it may still have to tussle with other agencies over how best to protect the financial system.

Moreover, the central bank’s decisions, which could include tough calls like whether or not to break up a firm deemed to threaten financial stability, would likely draw heavy scrutiny from politicians.

“There is a very real risk that these expanded powers will make the Fed more subject to outside political influences,” said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and former research director at the Atlanta Federal Reserve Bank.

“The broader the mandates, the more potential for conflicts of regulatory goals to arise, and of course, one of the quid pro quos of the new powers will be more interaction with Congress,” Eisenbeis said.

Despite strengthening the role of the Fed, the legislation does not completely eliminate the problem of having a wealth of different regulators who at times may work at cross purposes.

At the heart of the new supervisory structure is a systemic risk council headed by the Treasury. The Fed will be only one of the agencies on the council, though arguably the most powerful one.

“I do not expect it to work well and there is a risk the Fed will wind up being blamed for a group failure,” said Anil Kashyap, a professor at the University of Chicago’s Booth School of Business.

TARGET PRACTICE

In this go-round, the Fed’s ability to skirt dramatic reform has been remarkable. When the overhaul debate began, the central bank and its chairman, Ben Bernanke, were at the epicenter of blame.

Lawmakers in both the House of Representatives and the Senate assailed Fed policymakers for being too soft on mortgage lenders and too cozy with bankers, and for failing to spot the threat to the broader economy from a massive housing bubble.

For a time, Bernanke’s nomination for a second term seemed at risk of failing to win needed Senate approval. In the end, the Senate backed him with the narrowest ever margin of votes for a Fed chief.

The central bank had to lobby hard against efforts to restrict its oversight role. Top senators initially had wanted to strip the Fed of all supervisory powers and force it to focus solely on monetary policy.

After giving in on that front, they still sought to take away its power to oversee small- and medium-sized banks, and to put it on a tighter political leash by making the president of the New York Fed a presidential appointee. Both of those efforts failed as well.

Not that the Fed got off completely scot-free.

Lawmakers put in provisions to subject the Fed’s emergency lending to congressional audits and require lagged disclosure about borrowing at the central bank’s discount window. However, they decided against a plan to dissect monetary policy.

In addition, bankers serving on the boards of regional Fed banks were stripped of their role in helping decide who leads their institution.

“They haven’t turned it around completely,” said Paul Wachtel, a professor of economics at New York University’s Stern School of Business. “Some of the legislative proposals have them subject to increased specific scrutiny.”

Still, under the new law, the Fed would not only continue to oversee deposit-taking banks, but it would also regulate other complex non-bank firms that could threaten the entire financial system. ((For a factbox on provisions impacting the Fed, see [ID:nN24187754]))

OPEN SEASON

Some analysts are dismissive about the possibility the Fed’s sails might be trimmed by future attempts at reform. They suggest the central bank’s strength is founded on the heavy campaign donations of a supportive securities industry.

“The powers that be at the Fed, and the powers they represent … will always and everywhere find a way to justify their existence, expand their power, and dodge even the most obvious bullets with their names on it,” said Rob Parenteau of research and advisory firm MacroSrategy Edge.

Others, however, say the central bank better watch its back. One possible source of trouble is a new consumer financial protection agency, which will be housed at the Fed but will not be accountable to its board.

More pressing, the ongoing debt crisis in Europe and its potential ramifications for U.S. financial institutions could again test the central bank.

“The Fed will need to beef up its ability to investigate sources of systemic risk,” said Glenn Hubbard, a former advisor to President George W. Bush who now teaches economics at Columbia University. “(That’s) something it should already be doing, but its very sanguine attitude at the onset of the financial crisis suggests a need for improvement.”

(Additional reporting by Mark Felsenthal; Editing by Andrew Hay)

((pedro.dacosta@thomsonreuters.com; +1 202 354-5820; Reuters Messaging: pedro.dacosta.reuters.com@reuters.net))

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