- The Washington Times - Tuesday, March 23, 2010

One thing now seems certain to come out of Congress’ plodding financial reform effort: The Federal Reserve, after being castigated for much of the past year for overlooking major problems that led to the global financial crisis, will receive more power to try to prevent such crises in the future.

Both the House-passed reform bill and a measure being pushed by Senate banking committee Chairman Christopher J. Dodd would put the Fed in the driver’s seat — with varying degrees of advice and consultation with other regulators — for supervising the largest banks and financial firms such as American International Group Inc., whose risky practices led to the near collapse of the financial system. The Fed also would be charged with breaking up big firms as necessary to prevent crises, or moving to close them if they become insolvent.

The Fed’s upgraded status comes as a surprise to many observers, after legislators from both parties berated the central bank and threatened its chairman, Ben S. Bernanke, with congressional investigations and even an ouster.

Top lawmakers now appear to be pulling in their horns in an apparent acknowledgment that the Fed acted largely within its powers to try to prevent a broader financial crisis in late 2008. Congress may now have little choice but to entrust the central bank with an even more explicit role.

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“They were asleep at the switch” like most other bank regulators, and people in Congress “got irritated about that,” said Dan Seiver, a finance professor at San Diego State University. Moreover, the unprecedented $182 billion Fed bailout of insurance giant AIG was “ugly” and “could have been handled better, and a bunch of people in Congress are mad about that.”

But the Fed redeemed itself by acting swiftly and responsibly to save the economy from an even worse fate that would have resulted had the financial system been allowed to unravel without Fed intervention, Mr. Siever said, and apparently that view came to dominate the thinking of the banking committees.

Amid all the anger last year, “I don’t think the Fed got enough credit for preventing another Great Depression,” Mr. Siever said. “That’s very important” in evaluating the central bank’s overall response to the crisis.

Mr. Dodd, Connecticut Democrat, has been a scathing critic of the Fed at times, calling its supervisory performance “abysmal.” He originally proposed taking away all regulatory responsibilities so the Fed could focus on guiding the economy through monetary policy.

But Sen. Bob Corker, the Tennessee Republican who negotiated the Fed portions of the latest Senate bill with Mr. Dodd, cited the central bank’s success at preventing an even deeper recession in giving his vote of confidence to Mr. Bernanke earlier this year.

“While he probably hasn’t made all the right calls, I’m not aware of anyone involved in the financial crisis that has,” Mr. Corker said. Banking groups also have defended the Fed as the agency best positioned to handle financial emergencies and regulate with an eye to preventing them.

The bill sailed through the full Banking, Housing and Urban Affairs Committee on a party-line vote Monday afternoon after Republicans withdrew hundreds of planned amendments at the weekend, instead saying they would negotiate on the bill in preparation for a Senate floor vote.

There are many reasons, both historical and practical, why Congress might continue to vest the greatest financial powers in the Fed, even if those arguments were rarely voiced during the battles in Congress last year.

The Fed is the only federal agency that interacts each day with global financial markets, both through its open market window in New York, where it buys and sells various debt instruments to regulate the money supply and level of interest rates, and through its weekly purchases of Treasury securities for its own account and on behalf of other global central banks.

The Fed chairman also regularly attends meetings of the Group of 20 economic powers and Group of Seven industrialized powers, where key decisions are made about coordinating financial and economic policy among the countries and financial centers where major banks operate. Those international connections will be critical in helping the Fed discover and prevent market problems.

Moreover, the Fed remains the lender of last resort for U.S. banks and for the economy at large. During the crisis, the Fed used rare Great Depression-era authorities to open its emergency lending window to Wall Street brokers for the first time. It bought everything from mortgage bonds to commercial paper, a kind of short-term debt issued by corporations such as General Electric, to prevent those critical markets from collapsing and pulling down the economy.

Thomas F. Cooley, a professor at New York University’s Stern School of Business, said anger at the Fed last year led congressional lawmakers to propose reforms that would have prevented the Fed from being able to rescue the economy as it did in 2008 from “a cascading failure of financial institutions and a collapse of financing for businesses and households alike.”

“Maintaining the Fed’s role as an effective lender of last resort is vitally important,” he said, and it must continue to be able to lend in an emergency at its discretion without its decisions being immediately politicized.

The Fed’s bank regulatory responsibilities also are closely interconnected with its mission as guardian of the economy and financial markets, Mr. Cooley said. While the Senate bill would greatly increase the Fed’s authority to regulate “too big to fail” banks and other financial institutions with assets of more than $50 billion, it would take away the Fed’s responsibility for supervising thousands of state-chartered banks and bank holding companies.

Like Mr. Bernanke, Mr. Cooley argues that the central bank should continue to have a role in regulating small banks because it is the lender of last resort for the entire banking system. Mr. Bernanke and other Fed officials say their day-to-day interactions with such banks give them insights into market trends and developing problems — knowledge they need to make the right decisions in times of emergency.

At a recent House hearing, Mr. Bernanke argued against turning the Fed into “essentially the ‘too big to fail’ regulator.”

“We don’t want that responsibility,” he said. “We want to have a connection to Main Street as well as Wall Street.”

The Obama administration, however, has kept the pressure on Congress. In a speech Monday at the American Enterprise Institute, Treasury Secretary Timothy F. Geithner called the debate a “defining moment” in the nation’s financial-regulatory history.

According to prepared remarks, he said the Obama administration “will not accept a bill” that does not “provide strong protection for consumers, strong constraints on risk taking by large institutions and strong tools to protect the economy and taxpayers from future crises.”

Thomas M. Hoenig, president of the Fed’s Kansas City Reserve Bank, objected to the decision by Senate negotiators to greatly augment the Fed’s power to regulate the same New York institutions such as Citigroup whose risky activities escaped its notice and led to massive taxpayer bailouts, while taking away responsibilities that did not contribute to the crisis — its supervision of hundreds of small community banks outside of New York.

“It is a striking irony to me that the outcome of the public anger directed toward Washington and Wall Street may lead to the further empowerment of both Washington and Wall Street in regulating financial institutions,” Mr. Hoenig said.

Like many of the Fed’s 12 reserve bank presidents, Mr. Hoenig has been engaged in an unusual lobbying campaign to persuade legislators to maintain the Fed’s independence and authorities it deems critical to its mission.

Former Fed Chairman Paul A. Volcker, an adviser to President Obama, also strongly defended maintaining the Fed’s role as bank regulator, as well as giving the Fed new powers over the largest and most globally connected firms.

But Alan Greenspan, his successor, cast doubt on how much any regulator can do to prevent another financial emergency. He argues that financial market bubbles, like the housing and credit bubble that led to the 2008 collapse, cannot be prevented, so the central bank’s role primarily must be to cushion the fall and help mop up the mess afterward.

“Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible,” he said in a presentation to the Brookings Institution. “Assuaging their aftermath seems the best we can hope for. Policies … should focus on ameliorating the extent of deprivation and hardship.”

Mr. Greenspan said it would take an unwieldy army of bank examiners to even begin to spot problems ahead of time because financial firms have grown so large and complex, but such a massive bureaucracy would succeed only in stifling innovation and growth.

Right now, regulators have limited resources and have to “guess which of the assertions of pending problems or allegations of misconduct” should be investigated and regulated.

“This dilemma means that, in the aftermath of an actual crisis, we will find highly competent examiners failing to have spotted a Madoff,” Mr. Greenspan said, referring to convicted Ponzi scheme operator Bernard Madoff.