Bank supervision and the Federal Reserve

In testimony today before Congress, Fed Chair Ben Bernanke outlined his reasons why the Federal Reserve is uniquely suited to be the regulatory supervisor for U.S. banks.

Bernanke offered two reasons why the Fed is the natural agency for financial supervision. First,
he suggested that some supervisory responsibilities are essential in order for the Fed to carry out its primary monetary policy functions:

[The Fed's] involvement in supervising banks of all sizes across the country significantly improves the Federal Reserve's ability to effectively carry out its central-bank responsibilities. Perhaps most important, as this crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has as both a bank supervisor and a central bank. Not only in this crisis, but also in episodes such as the 1987 stock market crash and the terrorist attacks of September 11, 2001, the Federal Reserve's supervisory role was essential for it to contain threats to financial stability.

Insofar as the Fed is expected to fulfill its function as a lender of last resort through the discount window, surely it needs detailed knowledge of the borrower's financial situation. And actionable information on the financial system's health and stability is just as surely essential for knowing when and how fast to change interest rates.

Second, Bernanke observed that no other agency has the Fed's breadth and depth of relevant expertise:

Federal Reserve staff members have expertise in macroeconomic forecasting for the making of monetary policy, which is important for helping to identify economic risks to institutions and markets. In addition, they acquire in-depth market knowledge through daily participation in financial markets to implement monetary policy and to execute financial transactions on behalf of the U.S. Treasury. Similarly, the Federal Reserve's extensive knowledge of payment and settlement systems has been developed through its operation of some of the world's largest such systems, its supervision of key providers of payment and settlement services, and its long-standing leadership in the international Committee on Payment and Settlement Systems.

The Fed employs hundreds of extremely bright and very well-informed economists. On my visits to the Federal Reserve, I've been amazed at how well the staff work together to assimilate information and perspectives. In my experience, you can ask any one of them a question about pretty much anything, and although the person you're talking with may not know the answer, he or she will know the name of the person within the Fed who does know. I've interacted with lots of different institutions over the years, and have never seen another one that functions so effectively as a single, cohesive neural processor. Certainly the objective record of Federal Reserve forecasts is pretty impressive; see for example the assessments by Christina and David Romer and Faust and Wright.

Doubtless others will be skeptical, trotting out the Fed's spectacular underestimation of financial problems during 2005-2007. That criticism is of course well taken, and both the Fed and the economics profession as a whole have much more work to do in terms of recognizing exactly what should have been done differently. But let's be practical. What other institution did a better job? Where in Washington today do you see an agency with the intellectual resources to get this right? Simply squawking that we need a change is not constructive leadership; it's political finger-pointing and CYA.

Indeed, it's striking that many of those who were instrumental in relaxing the oversight on Fannie Mae and Freddie Mac now believe that a regulatory body more directly under their political control could do a better job than the Fed. In the mean time, the FHA continues even today to dig us into a deeper hole.

Notwithstanding, the debacles of Fannie and Freddie and the perhaps soon-to-come trainwreck from the FHA also illustrate the primary concern I have about giving the Fed more supervisory authority. The more power the Fed is given in such matters, the greater the political pressures will be from the outside to satisfy certain constituencies, and the less the Federal Reserve will resemble the remarkable institution that Bernanke and I described above.