Reassessing the fed's regulatory role.

• Author: Calomiris, Charles W.
• Position: United States Federal Reserve Board

As we contemplate the raft of regulatory reforms currently being proposed, it is important not only to consider the content of regulation, but also its structure. In particular, it is important to ask how the role of the Fed as a regulator should change, and how the targets and the tools of monetary and regulatory policy should adapt to new regulatory mandates. For example, some reform proposals envision a dramatic expansion of Fed regulatory authority, while others do not, and some proposals envision the Fed's using monetary policy to prick asset bubbles, while others do not. This article considers the desirability of various Financial reforms, the proper future role of the Fed, and the proper use of monetary and regulatory policy tools in light of proposed regulatory reforms. What regulatory and overall policy structure would help us best achieve legitimate policy objectives?

Reforms of regulatory content and structure should recognize that combining regulatory and monetary policy objectives within the Fed may be undesirable. The risks of adverse consequences from combining monetary policy mad regulatory authority within the Fed are real and threaten the effectiveness of both its monetary and regulatory policies. Experience and logic suggest that most regulatory and supervisory tasks should not be placed within the Fed. There are, however, legitimate arguments for charging the Fed with certain responsibilities--particularly, as a setter of time-varying macro prudential standards for the minimum capital or liquidity ratios of banks. If the Fed is charged with that role, however, it is important that the Fed exercise its responsibilities in a manner that reduces the risks of adverse consequences. The best means for doing so is for the Fed to adopt clear, transparent, and separate rules that guide its monetary policy targets and the variation over time in macro prudential standards.

The Problem with Concentrating Regulatory Powers within the Fed

The Federal Reserve currently is charged with two occupations: managing monetary policy and regulating banks (i.e., all bank holding companies mad some banks within them). Monetary policy involves varying the supply of Fed liabilities. The Fed does so during normal times primarily by varying its fed funds target, which results in changes in the amount of purchases or sales of Treasury securities. Recently, however, the Fed has employed new tools to achieve growth in its balance sheet, including aggressive lending to banks and others, varying interest paid on reserves, and setting quantitative objectives for various categories of purchases by the Fed of private securities (especially mortgage-backed securities).

With respect to monetary policy, the Fed has a "dual mandate" and is supposed to vary the supply of its liabilities to achieve a balance between two ultimate objectives: maximizing price stability (which many have come to equate with a long-term inflation target of somewhere upwards of 1 percent) mad minimizing cyclical fluctuations in unemployment. One way to balance these two objectives is described by the "Taylor Rule," which expresses the warranted fed funds rate as a function of (1) the long-run inflation target, (2) the current level of unemployment, and (3) the current level of inflation. The Fed departed dramatically from the Taylor Rule in 2002-05, mad today, the Fed's objectives with respect to price stability and unemployment are hard to discern or characterize through any "rule," as all objectives seem to have taken a back seat to the immediate objective of limiting short-term financial sector fallout by setting the fed funds rate to zero and announcing various guarantees or quantitative targets for the purchase or support of various categories of private securities. It is hard to know what sort of Taylor Rule the Fed has in mind for the future, if any. This makes it extremely hard to predict monetary policy, or to hold the Fed accountable to achieving its unannounced and unobservable goals.

The second occupation the Fed has been given is to regulate some banks (member banks that are not nationally chartered banks) and all bank holding companies. As revised under the Gramm-Leach-Bliley Act of 1999, that role now entails decisionmaking authority about what constitute allowable financial activities within financial holding companies that own banks, as well as more longstanding authority to decide which banks should be allowed to merge and on what terms, and the day-to-day supervision and regulation of the bank holding companies and the banks that it oversees.

As a regulator, the Fed is also charged with multiple objectives, which sometimes conflict with one another, although there are no Taylor Rules that have been derived to characterize tradeoffs among regulatory objectives. Those objectives include: ensuring the safety and soundness of banks by enforcing existing prudential regulations (including, for example, minimum capital requirements), consumer protection of bank customers, the enforcement of antitrust laws, and the enforcement of a host of other regulatory mandates on banks that include preventing money laundering, identifying potential terrorists, and ensuring that banks eater sufficiently to their local communities.

The expanding role of the Fed as a financial regulator in recent years is out of step with the global trend to separate monetary policy from regulatory policy. Virtually all developed economies have separated their monetary authority from their financial regulatory authority. Such a separation is desirable, as it limits the politicization of monetary and regulatory policy; pressures from special interests in the regulatory arena have led to poor regulatory...