Institute for Financial Transparency

Shining a light on the opaque corners of finance


It is time to break-up the Fed

Donald Trump and the GOP need an easy, highly visible legislative victory.  Breaking up the Fed meets this criteria.

In the aftermath of the Great Financial Crisis, policymakers rushed out the Dodd-Frank Act.. This Act increased the Fed’s responsibilities.  However, policymakers did this without examining the Fed’s performance in the run-up to the financial crisis.

Had they done so, they would have seen the Fed failed as a bank supervisor and regulator.  This failure alone mandates breaking up the Fed. After all, why should the Fed be given a second chance given how much its failure hurt the global real economy and taxpayers?

Furthermore, this failure strongly suggests policymakers shouldn’t have rewarded the Fed with additional responsibilities.  After all, there is no reason to believe the Fed’s failure as a bank supervisor and regulator won’t be repeated with any new responsibilities.  To the extent these new responsibilities exist in the Dodd-Frank Act, they too should be stripped away.

What the Fed should be left with is responsibility for monetary policy and the payment system.

All of the Fed’s bank supervision and regulatory responsibility should be transferred to the FDIC.  There are many significant benefits from doing this including it reinforces market discipline on the banks.  Unlike the Fed, the FDIC is responsible for protecting the taxpayers and has the authority to close a bank.  The FDIC’s primary responsibility is minimizing the risk of loss by the taxpayer backed deposit insurance fund.  It achieves this initially through regulation and supervision, but more importantly by a willingness to step in and close a bank that threatens to cause a loss to the fund.

Shareholders and unsecured bank creditors are keenly aware they are likely to lose their entire investment should the FDIC step up and close the bank they are invested in.  As a result, shareholders and unsecured bank creditors have an incentive to exert discipline on bank management to limit its risk taking so the bank is never taken over by the FDIC.

For those who would argue that it is important to keep bank supervision and regulation together with monetary policy, I would point out there is no evidence showing this produces a better outcome.

In the run-up to the Great Financial Crisis, the Bank of England and the European Central Bank did not have supervision and regulation responsibility.  The Federal Reserve did.  Talk about a perfect controlled experiment.

If having monetary policy together with supervision and regulation resulted in better supervision and regulation, you would expect the banks in the US to have outperformed the banks in the EU and UK in avoiding the Great Financial Crisis.  A simple measure of this outperformance would be the banks were solvent in October 2008 and not in need of a taxpayer funded bailout.  This didn’t happen.  Former Fed Chairman Bernanke confirmed this in his comment that all but one of the large banks supervised by the Fed were insolvent.  Even the light touch, almost no regulation UK did as well.

There is also no proof having supervision and regulation together with monetary policy improves performance of monetary policy.  I looked but was unable to find a single article published by the staff of either the BoE or the ECB in the years immediately prior to the Great Financial Crisis saying “our monetary policy implementation has suffered, if not outright stunk, because the central bank doesn’t have bank supervision and regulation responsibility.”  This article doesn’t exist because central bankers know monetary policy can and should be conducted independently of bank supervision and regulation.

But wait a second, what about the central bankers’ new role as macro-prudential regulators?  Don’t they need responsibility for bank supervision and regulation to do this?

Macro-prudential regulation is one of these ideas that is much better in an economics classroom than the real world.  In theory, macro-prudential regulators are suppose to identify and then address every systemic risk to the financial system in order to prevent another financial crisis.

However, you know macro-prudential regulation won’t work if central bankers are the macro-prudential regulators.  What happens if the source of systemic risk is monetary policy?  If they are the macro-prudential regulators, does anyone expect the central bankers are going to admit their policies are a source of systemic risk let alone reverse these policies?

Historically, central bankers were involved in bank supervision and regulation because of the central bank’s role as lender of last resort.  This made sense in the 1920s when central banks needed to know if they were lending to solvent banks and receiving good collateral for their loans.

However, this doesn’t make sense in the 21st century.  We live in the information age.  If banks provide transparency, central banks can know everything they need to know about the bank and its collateral.  In fact, central banks should never lend against any collateral where the collateral also doesn’t provide transparency.

Transparency also allows central banks to know everything they need to know about a bank’s solvency, but this is less of an issue with the introduction of deposit insurance.  Deposit insurance makes the taxpayer the bank’s silent equity partner when it is insolvent.  Hence, the real issue the central bank faces is whether the borrowing bank is viable if it recognizes the losses on its exposures.  The FDIC will answer this question for the Fed because it will close any insolvent, non-viable banks.