Why The Fed Should Oversee the Entire Financial System

Last Updated Sep 21, 2009 1:34 PM EDT

Editor's Note: Economist Mark Thoma is guest-blogging for the Macro View this week.
Senator Christopher Dodd of Connecticut, head of the Senate Banking Committee, is now preparing legislation to reform the financial system by creating a single regulator to oversee the financial system. Since this legislation is likely to serve as the basis for negotiating a final bill, it represents an important step in the reform process.

The proposed legislation would combine the financial oversight responsibilities of the Federal Reserve, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation, and the Comptroller of the Currency into a single agency.

This goes beyond what the Obama administration has proposed. The administration's proposal as presented by Treasury Secretary Timothy Geithner combines the Comptroller and the Office of Thrift Supervision into one agency, but regulatory authority would still be split among several agencies. The legislation emerging in the House as a consequence of Congressman Barney Frank's efforts is similar to what the administration has proposed.

I also favor the consolidation of regulatory authority into a single agency, but where I differ from the Dodd proposal is over where that authority should be located.

Why a single regulator is a good idea
When there are multiple regulatory agencies, financial firms can, in essence, shop around for the agency with the weakest provisions. They can do this, for example, by using subsidiaries or third party arrangements that allow them to funnel funds through less regulated markets.

Under the right conditions, competition among regulating agencies would lead to a socially desirable level of regulation. But competition among regulatory agencies suffers from a market failure, and when a market fails, it no longer produces the outcome that society prefers.

In this case, for example, suppose a regulatory agency is considering whether it should remove a particular regulation, perhaps as part of a regulatory review. The benefit to the agency is that more financial firms will want to be under the control of this agency since its regulations aren't as strict as before, and as firms redefine themselves and move under the agency's jurisdiction, the power and authority of this agency will grow. In addition, the decreased regulatory scrutiny will generally fall on a fairly narrow but powerful set of financial firms, and they can use their political power to further reward the agency, as well as penalize it if it tries to increase regulatory scrutiny.

However, this benefit from reducing regulation--the increase in the power and authority of the key decision makers within the agency-does not benefit society and its presence causes the agencies to impose too few regulations at the margin. It can also lead to a downward spiral in the degree of regulation as the agencies compete with each other for more and more power and authority.

However, when there is only one regulatory agency, the incentive to reduce regulation in order to widen the regulator's domain and increase power is no longer present. The agency already has jurisdiction over the entire financial industry, so reducing the degree of regulation will not increase the number of firms under its control any further.

Since I believe that "regulation shopping" was one of the factors that led to the deregulatory climate that helped to inflate the housing bubble, I believe that a single authority is needed to help with this problem.

The Federal Reserve's advantages
Unlike in the Dodd proposal, however, I think regulation of the entire financial sector should be one of the duties of the Federal Reserve. The Dodd proposal would locate the regulatory authority outside of the Federal Reserve System.

There are two reasons I support having the Fed as the single regulator. First, the agency in charge of regulating the financial system needs to be independent. For the Fed, there's a well-established tradition about what independence means, and that tradition has served us fairly well. The Fed also attempts to represent public, private, financial, and business interests, and though there is room for improvement in this area, this is also an attractive feature of the Fed's institutional structure. If we start all over with a separate agency, can we be assured that such independence and representation of interests will be present, and if it is, that it will persevere?

Second, the Fed's responsibility for conducting monetary policy causes it to collect lots of information about financial firms, and it has access to financial information in real time that other agencies do not. Thus, there are considerable complementarities between the Fed's role in setting monetary policy and its role as a regulator, and there are times--particularly in crises-- when regulation is an important branch of monetary policy. If the Fed has to gain the cooperation of a separate agency in order to conduct the monetary policy it deems necessary in a crisis, this could hamper its ability to respond as needed.

While there is certainly room to criticize some of the things the Fed has done (or failed to do) in the past, that does not imply that another agency would have done any better. Creating a separate authority that may not have the many advantages outlined above that reside with the Fed does not necessarily improve the chances of avoiding similar mistakes in the future. I trust that the Fed can learn from the past as well as anyone else, and so I disagree with the Dodd proposal to locate the regulatory authority elsewhere. Consolidating authority is a good idea, but giving the authority to a separate agency, while not a disaster by any means, is not the best way forward.