Should The Fed Be The Systemic Risk Regulator?

An article from the Washington Post today credits unnamed sources saying that the Obama administration is leaning towards creating a single agency to regulate banking. Additionally, these sources reveal that the Federal Reserve will take on systemic risk regulation -- it will regulate institutions that are so large their collapse would have a catastrophic effect on the overall economy. AIG and Citigroup come to mind. Giving the Fed this power sounds like a disastrous idea to me.

First of all, why choose the Fed? Presumably because it's equip to handle the task. It's got powerful tools at its disposal. Its governors also understand financial institutions and macroeconomics as well as anyone. It seems like a natural choice, unless you really think about it.

One obvious problem with the Fed is that it is not exactly the government. It's got that whole quasi-public, quasi-private feel, where the government gives it lots of power and lots of discretion to use that power how it pleases. Personally, I'd prefer an agency with greater transparency and public accountability to determine the fate of some of the nation's largest institutions.

But there's a graver problem. There has been much talk about what a systemic risk regulator would actually do. Nobody really knows. Would it prevent firms from becoming so large and complex that they could pose a systemic risk in the first place, or would it just make sure large and complex institutions never fail? For reasons mostly having to do with competitive advantage stemming from the government insuring large firms' safety, I'd prefer the former. I suspect, however, the Fed might prefer, and be more equip to handle, the latter.

One of the Fed's chief purposes is to keep the banks healthy. (Don't ask them about how that's been going lately.) Its allegiance always has been, and probably always will be, to the banks. On some level, you can think of the Fed as kind of an anti-FDIC. The FDIC resolves banks that fail, the Fed tries to prevent them from failing in the first place.

That goal of preventing an institution from failing can certainly be a noble one. If macroeconomic factors could jeopardize an otherwise sound institution, then the Fed should certainly do its part to try to lessen the blow of those shocks. However, if an institution is being kept alive after behaving immorally or irresponsibly, or in spite of poor leadership that drove it into the ground, then the Fed should have let the FDIC do its thing.

A systemic risk regulator might have to make difficult choices. Should Citigroup be kept alive or be allowed to fail? Or should it be broken up into more manageable pieces? Because keeping banks going is a part of the Fed's duties, asking it to make decisions that could potentially allow financial institutions to fail or to be harmed in a break-up seems like an obvious conflict of interest.

Choosing the Fed for the duty of systemic risk regulation because it could do the job is a lot different choosing the Fed because it should do the job. I have trouble understanding why Washington would not, instead, assign this duty to a new regulator, an existing regulator without a conflict of interest or even a panel made up of representatives from several regulators. After all, there are plenty of experts to go around and another regulator could be provided any necessary tools it might need.

Of course, this is all assuming that it's even possible to mitigate systemic risk in the first place. Not everyone is convinced.