July 10, 2014

Legislation to Reform the Federal Reserve on Its 100-year Anniversary

Testimony Before the House Committee on Financial Services Committee
Key materials

Chairman Hensarling, Ranking Member Waters, and members of the Committee, thank you for the opportunity to be here today. I welcome the chance to discuss some of the potential effects of this legislative proposal to reform the 100-year-old Federal Reserve. I will focus my remarks on the portions of the proposed legislation that relate to the Federal Reserve’s role as a regulator and supervisor of financial institutions—an area in which its ambitions outstrip its capabilities. Reform is needed to curb the Federal Reserve’s expansive regulatory approach, which threatens to increase instability in the financial system. Reform should include increased congressional oversight, enhanced transparency, greater internal discipline, and a larger role for public participation. 

Why Reform Is Needed

The Federal Reserve now actively seeks to secure for itself an increasingly large and interventionist role in regulating and supervising financial institutions, rather than concentrating on monetary policy. This aggressive and expansive regulatory approach relies on government control of the financial system, undermines private firms’ ability to manage themselves, and threatens to destabilize—rather than to secure—the financial system. Attempts to oversee the Federal Reserve’s regulatory functions clash with its deep traditions of opacity and independence developed in the monetary policy context. 

The Federal Reserve’s Expansive Regulatory Role

The Federal Reserve’s regulatory powers are far-reaching. Dodd-Frank expanded the Federal Reserve’s regulatory jurisdiction, and Board and regional bank officials frequently make the case for further expansion. The Fed’s stable of regulated entities includes banks, bank holding companies, foreign banking organizations, savings and loan holding companies, supervised securities holding companies, financial market utilities, and systemically important financial institutions. The Federal Reserve chairman, through her membership on the Financial Stability Oversight Council, participates in selecting the financial market utilities and systemically important financial institutions that are subject to Federal Reserve regulation.

The Federal Reserve has embraced an assertive post-crisis regulatory and supervisory approach. As has become the vogue among central bankers, the Federal Reserve has turned to macroprudential regulation, an approach that highlights financial stability. The Federal Reserve views itself as a sort of central planner charged with ordering the activities of private participants in the financial system to preserve systemic stability. Because the objectives are not limited to the stability of any particular institution, financial institutions may be directed to take steps that are for the purported good of the system, even if those steps are not in the best interests of the institution in question. Chair Janet Yellen recently explained that macroprudential policy is often a superior substitute for monetary policy in the pursuit of financial stability, but that “adjustments in monetary policy may, at times be needed to curb risks to financial stability.” This linkage raises questions about whether the Federal Reserve may try to use monetary policy tools to cover up supervisory missteps. 

To drive bank behavior in its favored direction, the Federal Reserve uses—among other tools—the Dodd-Frank Act stress tests (DFAST) and the Comprehensive Capital Analysis and Review (CCAR), which includes quantitative and qualitative components. The Federal Reserve’s use of stress testing, which grew out of crisis-era initiatives to determine how much capital banks needed are well intentioned, but the Federal Reserve’s nontransparent approach to stress testing is flawed. For example, it does not publicly divulge the supervisory models pursuant to which it assesses banks. 

Rather than dealing with business realities, banks must guess at the supervisory hypotheticals and qualitative criteria against which they will be assessed. The consequences of getting it wrong are severe—a negative result on the stress test harms a bank’s reputation and stock value. Given the high stakes, trying to figure out what is of concern to the regulators becomes a higher priority than identifying and managing actual operational, business, and market risks. 

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