Paul Tucker asks the question “how much influence should central banks have in a democracy”.  My answer is central banks should have only a fraction of the influence they do today.

This shouldn’t surprise anyone who has read my posts or listened to me speak.  I have consistently said since the acute phase of the Great Financial Crisis breaking up the Fed will enhance financial stability and the performance of our economy.

Let me explain why this is true.

Our financial system is based on two mutually reinforcing concepts:  transparency and buyer beware (caveat emptor).  Investors know in exchange for disclosure so they can know what they own they are responsible for all losses.  This gives investors the incentive to limit their exposures based on the risk of the investment.  As the risk of the investment changes, so too does the amount investors are willing to have as an exposure.    This adjustment of the investors’ exposures is known as market discipline.

The Fed interferes with both concepts and the benefits that flow from them when it comes to the banks.

In the 1930s, when the SEC was established.  It approached the Fed to talk about disclosure requirements for the banks the Fed was supervising.  The Fed supported the idea disclosure of the bank’s financial statements with related footnotes is adequate.

Hmmmm…..

If financial statement disclosure is adequate, why do bank examiners look at a bank’s exposure details?  Because it is the only way to know how much risk a bank is taking and whether it is solvent or viable.

Bankers are fully aware of this too.  Please recall how the bankers huddled in JP Morgan’s library and used exposure detail disclosure to stem the Panic of 1907.

Of course, with deposit insurance now in place, the bankers were only too happy to have their supervisor exempt them from market discipline by letting them hide the risk they were taking.

Fast forward to the acute phase of the Great Financial Crisis hit.  Investors wanted to know if the banks were viable or solvent.  The response wasn’t to provide each bank’s exposure details so investors could answer these questions themselves.  Rather, the Fed championed bailing out the banks and then participated in stress tests where it proclaimed each bank passed.

Why would we design a financial system and grant an exemption to the banks/bankers?  We didn’t, but the Fed has taken it upon itself to grant this exemption.

Breaking up the Fed is actually very easy when the banks provide the transparency necessary to qualify for a label from the Transparency Label Initiative.

Breaking up the Fed can be done in such a way that it reinforces how our financial system is designed.  To do this requires transferring 100% of the Fed’s bank supervision and regulation function to the FDIC.  Investors know the FDIC closes banks to protect the deposit fund.  The risk of loss of their investment at the hands of the FDIC gives investors an additional incentive to exert market discipline on the banks and restrict the banks’ risk taking.

Breaking up the Fed also requires removing from it any role on the financial stability oversight council or in macro-prudential regulation.  This is an explicit recognition that monetary policy is in fact a source of financial instability.  A source of financial instability that is in direct conflict with having any role on the stability council or in macro-prudential regulation.