Stripping the Federal Reserve of its supervisory role over banks is sure to be the most controversial aspect of Senator Chris Dodd’s financial reform proposal.
It isn’t an absurd idea to draw a clearer line between monetary policy and bank regulation. But underlying Dodd’s analysis is a flawed premise about banker control of regulators.
Dodd apparently wants to take away the Fed’s role of supervising banks because too many bankers sit on the boards of the Fed’s regional banks. The idea is that because they sit on the boards, they are able to exercise undue influence over the Fed when it comes to banking regulation.
There are four errors at work in this analysis. To begin with, it imagines that the most serious threat of having the banks on the board of the regional Fed banks has to do with bank regulation. Far more serious, however, is the outsized influence of big banks on monetary policy. After all, banking regulation may pull at the sleeves and hems of the largest banks, but monetary policy is where the real fabric of bank profits lies. And, of course, monetary policy directed to benefit bankers is far more dangerous to the American economy than almost anything that falls under the category of regulation.
A second problem is that Dodd appears to be taking too narrow of a view of regulatory capture. While the role of banks on the Fed boards permits them to exercise influence, lots of businesses are able to control their regulators without such obvious means at their disposal. It’s not at all clear that Fed is any more captured than most other government agencies, including the SEC. At least with the Fed, we can see the influence operate more or less openly.
Perhaps even more importantly, Dodd’s proposal rests on an unsupportable assumption that captured banking supervisors produce worse quality regulations than autonomous regulators. But the same dynamics that we fear coming from the banking sector—insularity, ignorance, self-dealing—would operate in a more autonomous regulator. The difference would be that instead of the ideologies, error, and corruption of bankers, regulations would be dominated by the ideologies, errors, and corruption of regulators. To the extent we try to reduce this problem by making the regulator subject to greater political controls, we risk introducing self-dealing by politicians and special interest control.
Dodd and his ilk also seem to under-value having outsiders influence regulatory and supervisory structures. The bureaucratic structures, ideologies and cognitive habits of regulators can blind them to serious errors and blind-spots. In our recent financial crisis, it appears that the Secretary of the Treasury only learned of the imminent collapse of AIG when it was brought to his attention by investment banker JC Flowers. Without endorsing the regulatory response of a bailout, it is at least possible to say that regulators have had better information through this crisis due to extensive contacts with bankers.
A regulatory structure open to regulatory arbitrage and capture is obviously not ideal. If you think of a better one, let us know.