Reassessing the Regulatory Role of the Fed: Grappling with the Dual Mandate and More?

Many observers have proposed new regulatory content, specifically macro prudential regulatory powers, which would vary prudential standards over time to rein in financial system risks before they become too inflated.  Others have pointed to problems in the existing structure of regulation, especially the need to divest the Fed of its day-to-day authority over regulation and supervision.

The Fed should be removed from the day-to-day micro supervision and regulation to avoid its politicization, which threatens the independence of monetary policy and the effectiveness of regulation. The macro prudential regulator (whether the Federal Reserve (Fed) or a council of regulators) should develop a formal modeling framework for measuring systemic financial risk, which it would defend publicly. That model would describe how time-varying financial risk is measured, and how moments of high risk are identified. The framework would delineate how minimum capital requirements, provisioning requirements, and reserve requirements would respond to significant perceived increases in system-wide risk. The existence of such a framework would help make macro prudential regulation credible.

Monetary policy should also be rules-based. The Fed should formally adopt as a benchmark some specific inflation target and a Taylor Rule associated with that target. If the Fed were charged with both monetary policy and macro prudential regulation, it would be unnecessary and counterproductive for it to use the fed funds rate as a tool to deal with systemic financial risk, as doing so would weaken the accountability of both monetary policy and macro prudential policy; macro prudential policy should be implemented through time-varying minimum capital and liquidity standards for banks.

Higher prudential regulatory standards should be imposed on larger, more complex financial institutions. Those standards should be set by the micro prudential regulator (not the Fed) on the basis of clear formulae and should reflect the fact that complexity is a continuum. The rules governing the resolution of large failed financial institutions should be reformed to make it easier for large institutions to fail, and thus prevent abuse associated with too-big-to-fail bailouts and the moral-hazard problems they engender. It is inappropriate to create a new discretionary resolution authority over nonbank financial institutions that would be placed in the hands of the Fed or any other regulatory agency. Doing so would encourage rather than avoid too-big-to-fail bailouts.

The proper approach to reforming resolution policy for large banks and nonbank financial institutions has two parts: (1) reform of the U.S. bankruptcy code to make it more effective in managing nonbank financial institutions' failures, and more credible in imposing losses on stockholders and long-term debtholders of failed financial institutions, and (2) the establishment of legally binding agreements among regulators - starting with an agreement between the U.S. and the U.K. - that would clarify cross-border claims on failed institutions' assets by subsidiaries located in different countries.

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