by Kermit Schoenholtz and Paul Wachtel
The Federal Reserve System was born of a financial crisis, the Panic of 1907, so it is not surprising that the global crisis which began one century later should lead to changes in the authority and responsibilities of the Fed. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates the most important changes at the Fed since the Great Depression. The legislation explicitly expands the goals for the Fed to include financial stability in addition to the traditional goals of price stability and full employment.
Consequently, the central bank will have enhanced responsibility for systemic risk assessment and regulation, and it will house and fund a new Consumer Financial Protection Bureau. Yet, in addition to expanding the powers of the Fed, the Dodd-Frank bill also significantly narrows the Fed's emergency lending authority and subjects this lending to greater scrutiny.
The actions of the Federal Reserve in the recent financial crisis highlighted the extraordinary powers that many central banks have to intervene in an economy in a crisis. Not surprisingly, the interventions led to a vigorous public debate about the choices the Fed made, the proper role of the Fed in a crisis, and the transparency of its actions. Although Dodd-Frank expands the Fed's responsibilities regarding financial stability, it also seeks to rein in an independent and powerful financial institution with unelected leadership and limited accountability.
The role of a central bank in financial crises is a topic with a long history. With the help of Walter Bagehot, the Bank of England learned in the 1860s and 1870s that proper behavior on the part of a lender of last resort is to furnish liquidity to the market by discounting freely when presented with good collateral, at a penalty rate of interest that incentivizes borrowers to repay. In the recent crisis, the Fed developed a range of facilities to deliver liquidity. The Fed intervened to an unprecedented degree, reacting quickly to create vast reserves and shoring up institutions in novel ways to prevent a wholesale collapse of the U.S. financial system.
But the Fed and some other central banks also went well beyond what Bagehot taught a century and a half ago. In addition to lending to the market, they lent to particular institutions in trouble, sometimes on dodgy collateral, thereby attracting great political criticism. Even in lending to the market, the Fed expanded its traditional role as lender of last resort to become an investor of last resort as well. One could argue that this was an appropriate means to prevent a widespread systemic collapse of the financial system. Yet, it was bound to add to concerns about the range of Fed powers.
Not surprisingly, Congress has turned its attention to ways to improve financial sector regulation and avert future crises. The changes to the role of the Fed that are introduced by the Dodd-Frank bill arise mostly out of serious thought about the role of central banks and the appropriate scope of their activity. But, there also are lingering reflections of the public anger triggered by the crisis and the Fed's role in it.
There are three aspects of central bank activities - monetary policy, financial institution regulation and systemic risk oversight. In our view, the strong linkages among the three functions are sufficiently compelling that, with proper oversight, the central bank should have broad authority in all three of them. The Dodd-Frank bill takes some steps in this direction. It gives the Fed a role in maintaining financial stability and sets the stage for its use of macroprudential tools to tame systemic risks. It does not diminish the Fed's responsibility for monetary policy. Finally, it leaves the Fed explicit responsibility for some aspects of bank regulation and, importantly, creates new supervisory authority over all financial institutions that are deemed officially to be systemically important.
A strong and independent central bank is indispensable for effective monetary policy. However, it also is an anomalous entity in a constitutional democracy that emphasizes accountability and the responsibility of elected officials. Fortunately, the Dodd-Frank bill leaves the independence of the Federal Reserve reasonably intact. Some specific challenges to central bank independence that were introduced in earlier Congressional discussion were misguided and potentially counterproductive expressions of public anger regarding the recent financial crisis. Anger is a poor basis on which to make effective reforms. The Dodd-Frank bill dropped the most egregious attacks on the Fed.
With regard to regulatory and systemic oversight, the Fed's enhanced powers to use macroprudential tools and the policy focus provided by its new Vice Governor for Supervision may help prepare both the central bank and the government for systemic risks.
However, the Dodd-Frank bill also prohibits or delays the use of selected Fed crisis management tools that played an important role in mitigating the recent crisis. In particular, aside from broad-based programs of liquidity provision, the Fed may no longer lend to individual nonbanks whose solvency is in doubt. Instead, the bill relies heavily on new, complex, and potentially unwieldy regulatory and resolution mechanisms to prevent and tame future crises.
It is far from clear that this new apparatus will prove effective in countering crises when they occur, and may even increase their likelihood. The Financial Stability Oversight Council is an umbrella group of policymakers with a staff housed in the Treasury that will seek to identify systemic risks and instruct the Fed to respond. This loose structure is untested and far from streamlined. It does not appear well suited to foster the strong leadership, clear chain of command, and timely interventions that have characterized successful policy responses over the long history of financial crisies. In addition, the bill's new resolution mechanism - which aims to protect taxpayers and impose the costs of financial failures on unsecured creditors -- may unintentionally increase the probability of a run by such creditors in response to a shock that weakens the financial system.
Ultimately, the combination of new restrictions on Fed emergency lending and the new structures for responding to systemic risk and financial crises will have to be judged when tested by events. If the new structures prove ineffective, the Dodd-Frank bill's elimination of emergency authority for some forms of Fed lending could make future crises even more devastating than the recent one.