THE MYTH OF FEDERAL RESERVE REGULATION

From The Nader Letter

May 1997

Much of the Federal Reserve’s power is based on a storehouse of myths that have been carefully nurtured by successive Fed Chairmen over the years.

No myth is longer lasting than the often repeated claim that the Federal Reserve Board must have power over bank regulation in order to properly carry out monetary policy.

Federal Reserve Chairmen always trot out this myth when Congress makes one of its periodic efforts to reform and strengthen protections for taxpayer-backed deposit insurance funds by consolidating regulatory functions in a single agency that would concentrate its resources on bank supervision.

Currently, the Federal Reserve is pumping up this legend to promote proposals which would give it the major share of any new regulatory powers that may be voted in connection with the so-called bank modernization legislation now pending in Congress..

Ironically, on the eve of Federal Reserve Chairman Alan Greenspan’s last appearance before the House Banking Committee to promote Fed’s claim to more power, the new Labor government in Great Britain announced that it was taking regulatory powers away from England’s central bank (The Bank of England) and transferring them into an agency devoted full time to financial supervision.

That took a lot of air out the Fed’s frequently voiced suggestion that virtually all central banks play dual roles as regulators and monetary-economic czars.

In fact, the decision by the British government brought its central bank in line with those of a number of major nations throughout the world. Among the countries which firmly separate monetary policy and bank regulation include Austria, Belgium, Canada, Denmark, Finland, Germany, Japan, Norway, Mexico, Sweden and Switzerland.

These countries recognize that there are inherent conflicts of interests between the two roles. Good objective regulatory decisions that protect the bank insurance fund and the taxpayers do not always coincide with a central bank’s concept of what promotes its whims on monetary and economic policy.

During the sharp drop in the stock market in 1987, the Federal Reserve was busy filling potholes in the economy. Continental Illinois National Bank exceeded legal limits on extensions of credit to one of its ailing subsidiaries, First Options. Continental’s primary regulatory agency — the Office of the Comptroller of the Currency — cited the violation and ordered the bank to cease and desist in further loans to the subsidiary.

But, the Federal Reserve, agonizing over monetary policy and the drop in the stock market, decided that its purposes were best served by propping up the affiliate. As a result, it let the holding company parent — over which it had jurisdiction — extend more credit to First Options, effectively negating what the Comptroller had decided was the proper move to enforce safety and soundness regulations.

The Fed often defends its role as a regulator on the grounds that the regulatory functions give it important access to information needed for monetary policy. But, this ignores the fact that all of the proposals for a consolidated regulatory agency provide for ongoing sharing of examination data with the Fed.

During testimony before the Senate Banking Committee in 1977, the Vice Chairman of the Federal Reserve — J. L. Robertson — debunked the theory that the bank regulatory functions were important to the Fed’s formulation of monetary policy. Here is what he told the Senators:

“The Board of Governors and the members of the open market committee…don’t use the access to these reports of examination….They don’t know anything more about it than the man in the Moon…To say the members of the Federal Reserve Board need to have that information in order to formulate monetary policy is, I think, a fallacious statement.”

Robertson told the Committee that whatever the Open Market Committee needed to learn from examination reports for monetary policy purposes could be obtained easily from the Comptroller and the FDIC or from an agency created by consolidation of the existing agencies.

A more recent Fed vice chairman — Alan Blinder — who left the Board of Governors last year similarly minimizes the Fed’s role in bank regulation, telling an interviewer:

“President Clinton didn’t send me here because he thought I was an expert on bank regulation. When you get down to the nitty gritty of 4 (c) (8) [holding company] applications, Truth in Lending or RESPA, I have a hard time seeing any synergies with monetary policy.”

There are a lot of questions about the wisdom of the deregulatory legislation pending before the Congress, but none looms bigger than proposals which would confer special status on the Federal Reserve as an umbrella overseer of a new world of banking, financial services and, possibly, industrial companies.

Leaving aside the conflicts between the role of regulator and the maker of economic policy, major questions have been raised about how well the Federal Reserve performs as a regulator. After all, this is the crew that let the international rogue bank — BCCI — infiltrate the U. S. banking system undetected until foreign regulators blew the whistle.

Four years ago, the General Accounting Office (GAO) conducted a thorough review of the quality of bank examinations carried out by the Federal Reserve. The GAO found major defects in the process, noting that the lack of minimum inspection standards at the Federal Reserve “has resulted in a superficial approach to the bank holding company inspection process.”

“Federal Reserve Board inspections did not evaluate the risks posed by intercompany transactions between insured bank subsidiaries and nonbank affiliates,” the GAO charged. “As a result, potentially harmful transactions which could lead to financial deterioration at the insured bank subsidiary may go undetected.”

Yet, some members of Congress as well as financial writers often depict the Federal Reserve as a tough flawless regulator. This is but another of the many myths that keep the performance of the Federal Reserve from objective analysis by the media and the Banking Committees of the Congress.

Congress should go behind the myths, and take a hard look at how well the Federal Reserve and the other regulators perform and determine what kind of regulatory structure is really needed for consumers and taxpayers before continuing with its obsession to find new profit centers for the banking and financial services industries.