The House Financial Services Committee is holding a hearing today which seeks to find an answer to precisely that question. Testifying on its first panel were two men who should know quite well about the Federal Reserve's role: current and former chairmen Ben Bernanke and Paul Volcker. As you might guess, they agree that the Federal Reserve should supervise banks. I didn't find their arguments particularly compelling.

This question is especially important right now, since Senator Dodd's proposed financial reform would reduce the Fed's bank supervisory to only about the 40 largest banks. It's also an important question because the financial crisis appeared to suggest that the Fed hadn't done a very good job of supervising banks. After all, the banking industry came dangerously close to collapse. Many of the members of the committee brought up this particular criticism, to which Bernanke didn't have a very convincing reply, other than conceding that the Fed should have done better.

Here's part of his prepared testimony summing up why he believes the Fed should retain this duty:

The Federal Reserve's involvement in regulation and supervision confers two broad sets of benefits to the country. First, because of its wide range of expertise, the Federal Reserve is uniquely suited to supervise large, complex financial organizations and to address both safety and soundness risks and risks to the stability of the financial system as a whole. Second, the Federal Reserve's participation in the oversight of banks of all sizes significantly improves its ability to carry out its central banking functions, including making monetary policy, lending through the discount window, and fostering financial stability.

Large Banks

Let's start with Bernanke's first point. What about large financial firms? Shouldn't the Fed be in charge of their supervision? Indeed, now both the House and Senate versions of financial reform call for that. Of course, this also implies that, at least at this time, no legislation being seriously considered by Washington would remove the Fed's supervision of large banks. So I'd begin by noting that I don't think this claim is particularly controversial right now.

But that doesn't mean the consensus is necessarily right. I do agree that the Fed is "uniquely suited" to oversee these big firms. But I'm far less convinced that it's the only potential regulator that could handle this duty. A new or existing regulator could be given the resources necessary to accomplish this task. The Fed could retain emergency lending programs without also being in charge of regulating large institutions. It could also conduct monetary policy without regulatory authority.

Banks of All Sizes

I think the argument that the Fed must regulate smaller banks is even weaker. While the Fed does need to understand how banking on a whole is functioning, that doesn't necessarily mean it needs regulatory power over the entire industry. Surely, whatever regulator is in charge of these banks could supply the Fed with the industry data it needs to analyze the macroeconomic trends in the market.

And really the same goes for big banks, but for smaller banks this point seems even more obvious. Why does the Fed need to regulate a regional bank in, say the Pacific Northwest, if its regulator supplies the Fed with all of its trends in loan origination, delinquency, savings accounts, checking activity, etc.? Since it doesn't pose a systemic risk, there's no reason the Fed need be too worried about whether it fails either.

When it comes to function, I'm kind of a purist. I'd like to see the central bank focus on its monetary policy function and have a bank regulator focus on its supervisory function. Unless there's some stronger argument out there that I'm missing, I just can't see the need for the Fed to have a role as a bank regulator. I think this goes up for all banks, but this argument is even stronger for those that don't pose any systemic risk to the financial system.

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