Fed's 'Supercop' Role May Give It Headaches

By GREG IP
March 31, 2008; Page A1
WALL STREET JOURNAL

The Federal Reserve, criticized for regulatory lapses that allegedly aggravated the credit crisis, emerges at first glance as the big winner in Treasury Secretary Henry Paulson's proposed overhaul of financial regulation.

But Mr. Paulson's plan to make the Fed a supercop in charge of keeping the financial system stable is also problematic for the Fed and its chairman, Ben Bernanke. The Fed is being asked to do a job that may be beyond anyone's ability: Identify and avoid a crisis in advance.

"Supervising the very complex derivative products of the banks and of the rest of the financial system would be an enormous technical challenge," said Harvard University economist Martin Feldstein, a prominent Republican adviser who has criticized the Fed's supervision of banks leading up to the current crisis. "The institutions themselves -- paying very high salaries and having their own survival at risk -- got it wrong. Would the Fed get it right?"

Another issue for Fed officials is whether they lose authority even as they gain responsibility. Bank regulation is now spread among four agencies including the Fed, which alone oversees bank-holding companies such as Citigroup Inc., and shares supervision of state-chartered banks. Mr. Paulson says that's too messy, and wants to consolidate bank regulation in a single agency separate from the Fed.

Fed officials fear that without the continuous insight into banks' activity that comes from directly supervising them, they would lose a useful tool in managing crises.

The Fed was formed in 1913 in response to destabilizing bank panics. Among its primary tools is the ability to lend to banks from its discount window. Because that puts public money at risk, the Fed got a big role overseeing those banks.

Past Efforts

The Fed has fought off past efforts to wrest away that supervisory role, most recently during the Clinton administration. Instead, the Fed's authority has expanded. Sensing a new threat, Mr. Bernanke and other Fed officials have recently re-asserted the importance of maintaining their role in bank oversight.

Fed officials are not of one mind on the plan, and some sympathize with Mr. Paulson's broad aim of simplifying oversight. While they have misgivings about parts of the blueprint, Fed officials don't want a public spat over them, believing that the united front they have maintained with Treasury recently has been important to investor confidence. A Fed spokeswoman called the plan "an important first step" in modernizing regulation and said it "presents a timely and thoughtful analysis." For its part, Treasury appears to have responded to some Fed concerns, by for example punting the question of whether, in the intermediate term, it would lose oversight of state-chartered banks to a study.

Under the Paulson plan, which is unlikely to be adopted as proposed, the Fed would retain, for now, authority to write consumer-protection rules on things such as credit-card disclosures and the terms of high-cost mortgages -- despite accusations from consumer groups and Democrats that its failure to do so allowed many homeowners to get subprime mortgages they couldn't afford.

In Mr. Paulson's "optimal" scenario, the Fed eventually would surrender its supervision of state-chartered banks and bank-holding companies to the new agency and become a "market stability regulator." The Fed, Mr. Paulson said in an interview Saturday, "would have broad powers so they could go anywhere in the system they needed to go to preserve that authority."

In that role, it would be able to lend to any important institution while seeking information from them, which Mr. Paulson considers more reflective of a financial system spread among brokerages and other nonbanks as well as traditional, commercial banks.

Mr. Paulson had always envisioned this new role for the Fed, but events in the past month, including the near-collapse of Bear Stearns Cos., made it especially germane. For months, Bear Stearns had faced questions about its reliance on short-term funding and heavy exposure to risky mortgage-backed securities. Three weeks ago, other firms and investors suddenly became reluctant to do business with it.

That forced the Federal Reserve Bank of New York to extend Bear Stearns a loan via J.P. Morgan Chase & Co. on March 14, the first such loan in Fed history. On March 16, worried that a similar loss of confidence would engulf other firms, the Fed offered the same access to all investment banks.

The blueprint says the Fed should have the power to get information from and inspect investment banks that borrow from it.

New Mission

Yet it isn't clear if those tools are adequate to fulfill the Fed's proposed new mission of forestalling threats to the financial system's stability.

Neither Bear Stearns nor its regulator, the Securities and Exchange Commission, apparently foresaw the seriousness of the company's situation until it was less than 24 hours from a bankruptcy filing. It is unlikely the Fed, even with the additional access to information Mr. Paulson would grant it, would have known sooner. In 1998, the Fed was taken by surprise at the exposure of some banks it supervised to Long Term Capital Management, the giant hedge fund.

In the latest turmoil, it's not clear whether the Fed foresaw the severe strains faced by Citigroup, which has been forced to collect more than $20 billion in fresh capital from Middle Eastern and other investors. Citigroup suffered losses on mortgage-related investments and was forced to absorb liabilities of related entities that were formerly off its balance sheet. The Fed oversees the Citigroup holding company, while the Treasury's Office of the Comptroller of the Currency oversees its bank and the SEC oversees its investment bank.

To be sure, the Fed compares well to other supervisors, particularly Britain's, who last year experienced the first run on a British bank in over a century. No major U.S. bank has yet fallen below its minimum capital, much less failed. And Fed officials, led by New York Fed President Timothy Geithner, actively pressed firms to strengthen risk management before the crisis hit.

Fed officials believe banks' current problems stemmed not from a lack of oversight, since regulators knew the state of bank balance sheets intimately. Rather, both regulators and firms failed to realize how dramatically the value and ability to sell mortgage-related investments could evaporate and how banks' own funding needs could be impaired by general market turmoil.

Good Times

Even if regulators had perceived such risks, it's unclear they could have done much. "When times are good...it is very difficult for bank supervisors to convince bankers to heed warnings that they need to behave differently," Kansas City Fed President Thomas Hoenig said recently. When regulators urged banks to take more care with commercial real-estate lending in 2006, banks sent thousands of protest letters and Congress held hearings.

One question about Mr. Paulson's plan is what powers the Fed would have if it perceived a systemic risk. Once it is removed from day-to-day supervision of banks, it would have to consult with other regulators before ordering a bank to do something. The plan doesn't say whether the Fed could demand that a firm it considers a threat to the financial system increase the size of its capital cushion.