For all the mystique surrounding its monetary policy powers, the Federal Reserve is also a regulatory agency. In fact, it's the heavyweight of Washington's financial watchdogs. The outsized role of the Fed has, if anything, been increased by the process of financial reform, in ways that should be a central consideration in the selection of the next Federal Reserve chair.
Before the financial crisis, the Federal Reserve already played a central role in financial regulation. The Fed had primary oversight over bank holding companies, the industry's largest entities. That made it the primary regulator of Citigroup, as well as of HSBC, the largest subprime lender, and Countrywide, the third largest subprime lender. The Federal Reserve also had primary authority for implementing and enforcing consumer protection laws on high-cost subprime mortgages.
It's clear that the Federal Reserve, like just about all of the federal financial regulators, fell down badly on the job in the buildup to the financial crisis. Not only did it fail to act to stop the abusive and irresponsible lending that fueled the housing bubble, it failed to consider the ways in which excessive leverage and complex derivatives would multiply the impact of a housing collapse, turning it into a global financial catastrophe.
At the same time, there were limits on the Fed's pre-crisis authority. Large banks could escape its oversight by choosing a different regulator (as Countrywide eventually did in 2007). In addition, the Fed had no jurisdiction over freestanding non-banks that had become central to the financial system, including major investment banks such as Lehman Brothers. The Fed also faced procedural obstacles in gaining full regulatory power over non-bank subsidiaries of bank holding companies.
The Dodd-Frank Act takes a dual approach to Federal Reserve authority. In the area of consumer protection, the dismal record of the Fed – and other safety and soundness regulators – in preventing exploitative and dangerous consumer lending convinced lawmakers that we needed a single agency with the focused mission of consumer protection. Thus, Congress removed many of the Fed's consumer protection powers and transferred them to the Consumer Financial Protection Bureau.
But in the area of regulating systemic financial risk, Congress significantly expanded the Federal Reserve's powers and essentially confirmed its lead role as the primary watchdog of overall financial stability. Now more than ever, the Federal Reserve is the central regulator of the financial system. The Dodd Frank Act expanded the agency's role as the primary supervisor of:
- Bank holding companies. The Fed had this role before Dodd-Frank, but the Dodd-Frank Act made it impossible for bank holding companies to shop around for a more lenient supervisor, and also expanded supervisory powers in other ways.
- Large non-banks determined to be systemically significant. The Fed will now supervise large entities central to the financial system even if they are not banks.
- Important financial utilities. The Fed now plays a key role in supervising organizations central to the "plumbing" of the financial system, such as clearinghouses or payment systems.
This expanded jurisdiction came with a substantial increase in rule-writing responsibilities. Responding to the problems revealed by the financial crisis, Congress directed the Fed to improve the system of prudential regulation for large institutions by:
- Increasing minimum capital levels (or, to put it another way, maximum permitted levels of borrowing and leverage) for large bank holding companies, and deciding just how much those levels should increase with bank size.
- Setting new standards in critical areas that include liquidity, counterparty debt exposures, risk management and risk concentration.
- Designing and supervising regular "stress tests" of key financial institutions to be sure they are prepared for potential financial disruptions.
- Exercising discretionary power to break up a "too big to fail" bank or to limit its activities, including activities in key commodity markets
In these areas, it is the Fed that writes the rules and supervises their enforcement. And it has vast discretion to do so. While the Financial Stability Oversight Council has advisory input, these rules are almost completely under the Fed's control. There is little or no space for appeal, for example, by anyone who might consider its rulemaking or enforcement lax.
In other realms of Dodd-Frank implementation (including the Volcker Rule's ban on proprietary financial speculation by banks), the Fed plays an influential role in a joint decision-making and enforcement process with other agencies. These other agencies still play a key role in supervision, including through oversight of important subsidiary entities within bank holding companies. The U.S. financial regulatory framework remains quite fragmented in many ways. But the Fed's expanded powers clearly give it primary responsibility for ensuring the overall stability of the financial system.
This central regulatory role of the Fed, especially post-Dodd Frank, should be a key consideration in the appointment of the next Federal Reserve chair. In appointing the next leader of the Federal Reserve, President Obama will also be appointing the person who should be the lead watchdog of Wall Street.
Marcus Stanley is policy director of Americans for Financial Reform, a coalition of more than 250 civil rights, consumer, labor, business, investor and other groups working for a strong, stable and ethical financial system.
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