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The Fed's New Role

This is a guest post from Harvard professor Hal S. Scott.

Some commentators contend the Obama administration’s regulatory reform proposal would create a “Fed dictatorship.” To be sure, the proposal increases the responsibilities of the Fed in important respects. But a closer look reveals that it undermines the Fed’s ability to be an effective monitor of systemic risk.

Under the Obama proposal, some of the Fed’s lender-of-last resort authority is subject to a veto by the Treasury Department. But it stands to reason that the Fed should retain emergency lending authority for nimble, adequately collateralized short-term liquidity to revitalize frozen markets and curb systemic crises. In contrast, longer-term “bailout” programs — ones without collateral that place taxpayers at risk — should be for the account of, and be administered solely by, the Treasury Department. This form of lending should not be done by the Fed, whether or not subject to a veto.

The Obama proposal rightly gives the Fed expanded regulatory responsibility in areas where systemic risk is paramount — for example, in clearing and settlement and payment systems. However, this power should be extended to capital regulation, where the Fed should have exclusive power to set capital requirements.

The most problematic aspect of the new proposal is the scope of the Fed’s supervisory power. Due to the administration’s unwillingness to create a consolidated supervisor, the Fed is left with the rather unimportant task of supervising all state banks and bank holding companies on a consolidated basis, whether these entities are large or small. In addition, the Fed is given expanded jurisdiction over systemically important institutions (SIIs), bank holding companies — they will not be able to supervise their regulated subsidiaries, as well as the holding company — and other financial firms.

SIIs are to be determined with input from the new Financial Services Oversight Council. That very designation is itself problematic since SIIs will be very difficult to define and their status could change from time to time — even as much as daily for hedge funds with trading strategies making them more interconnected from one day to the next. The Fed is likely to be outpaced by the markets. Further, designation of a firm as an SII will be an implicit government guarantee against failure, which will increase moral hazard and distort competition. It would be far preferable to leave all prudential supervision to one agency — and not the Fed. This would centralize expertise, reduce costs, and avoid a public SII determination. All that prevents the establishment of this agency is the turf battles of industry, regulators, and the Congress.

--Hal S. Scott is a professor and director of the Program on International Financial Systems Harvard Law School.

By Tim Lawson  |  June 25, 2009; 8:00 AM ET
Categories:  Regulation  
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