Should the Fed Stay in Regulation?

One of the central issues in the postcrisis effort to reform our regulatory infrastructure is who should do the regulating. The answer to some in Congress is none of the above:

“… under consideration is a consolidated bank regulator, one aide [to Alabama Senator Richard Shelby] said. The idea is supported by [Connecticut Senator Christopher] Dodd, who proposed eliminating the Office of Thrift Supervision and Office of the Comptroller of the Currency, and moving their powers, along with the bank-supervision powers of the Federal Reserve and the Federal Deposit Insurance Corp., to the new agency.

“Negotiators are still deciding how to monitor firms for systemic risk, including how to define and measure it, what authorities to give a regulator and which agency is best suited to get the power, a Shelby aide said.”

As reported in The New York Times:

“The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation’s financial system, officials said Wednesday…”

Though the idea of a council to provide regulatory and supervisory oversight is still contentious (the Times article offers multiple opinions from Federal Reserve officials) the formation of a council is not necessarily the same thing as removing the central bank from boots-on-the-ground, or operational, supervisory responsibility. In other words, there is still the question of how to monitor systemic risk and which agency is best suited to get the power.

Earlier this week I made note of a new International Monetary Fund (IMF) paper by Olivier Blanchard, Giovanni Dell’Aricca, and Paulo Mauro, taking some issue with the proposal that central banks consider raising their long-run inflation objectives. Though that part of the paper seemed to attract almost all of the attention in the media and blogosphere, the discussion in the IMF article expanded well beyond that inflation target issue. Included among the many proposals of Blanchard et al. was this, on systemic risk regulation and the role of the central bank:

“If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both.

“The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. ‘Communication’ debacles during the crisis (for example on the occasion of the bailout of Northern Rock) point to the problems involved in coordinating the actions of two separate agencies. And the potential implications of monetary policy decisions for leverage and risk taking also favor the centralization of macroprudential responsibilities within the central bank.”

Consistent with the even-handedness of the Blanchard et al. paper, the authors did not come to this conclusion without noting the legitimate issues of those who would separate regulatory authority from the central bank:

“Against this solution, two arguments were given in the past against giving such power to the central bank. The first was that the central bank would take a ‘softer’ stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. The second was that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation.”

But, they conclude:

“The alternative, that is, separate monetary and regulatory authorities, seems worse.”

I wonder, then: Would a regulatory council of which the Federal Reserve is a member, combined with operational supervisory responsibilities housed within the central bank, be a tolerably good response to Blanchard’s and his colleagues’ admonitions?

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