Fed Gains New Powers in Senate Financial Overhaul
Business + Economy

Fed Gains New Powers in Senate Financial Overhaul

As the Senate moves toward passing a sweeping overhaul of financial regulation this week, the surprise winner in that bill is the Federal Reserve. Despite bitter attacks from both the right and the left for its role in bailing out major banks, as well as a populist movement to “end the Fed,’’ the central bank is likely to end up with more power than it has right now.

  • A proposal to “audit the Fed,’’ authored by Senator Bernard Sanders, Independent of Vermont, has been turned into a one-time audit that will focus on the Fed’s emergency measures during the crisis and will carefully avoid the central bank’s core business of setting monetary policy.  Sanders defended his compromise, noting that it specifically instructs the Government Accountability Office to investigate conflicts of interest in the bank bailouts and to reveal which companies received emergency loans.
  • Instead of being stripped of its role as a bank regulator, the Fed would be firmly in charge of regulating all “systemically important’’ financial institutions – large banks, but probably also major insurance companies and any other major financial institutions considered “too big to fail.”
  • The Fed will also have regulatory power over thousands of smaller community banks, though it will share that authority with other regulators.
  • The central bank may even retain an indirect role in consumer protection – even though most experts agree that the Fed badly failed to use its existing authority to clamp down on reckless mortgage lending.

Some experts warn that the Fed’s enhanced responsibilities – well beyond its core mission of setting interest rates — could undermine its cherished political independence and aloofness.

Congress Makes a 180° Turn

Fed Chairman Ben Bernanke had to fight hard to win Senate confirmation for a second term in January, and was the target of often bitter tirades from Democrats as well as Republicans for being too slow to recognize the dangers of the housing bubble and too willing to help out Wall Street when the crash came in 2007 and 2008. Bernanke spent months patiently building bridges to lawmakers, and eventually won support for both him personally and the Fed as an institution.

“Did you think Congress was ready to dismantle the international financial capitalist system?’’ asked Sanders, a fierce critics of the Fed and its chairman, Ben S. Bernanke.  “Of course not.”

The turnaround could hardly be more amazing.  Last November, the Democratic chairman of the Senate Banking Committee, Christopher J. Dodd of  Connecticut, called the Fed’s regulatory record “an abysmal failure’’ and proposed to strip it of all its regulatory powers.

In the House, Republicans and Democrats have pounded the Fed for being secretive and coddling Wall Street firms during the bailouts of American International Group, Bank of America and other financial giants.  More than 300 House lawmakers supported a tough measure to let Congress “audit’’ the Fed in almost all areas of policy – a move that Fed officials said would jeopardize the central bank’s autonomy in fighting inflation. Yet the Senate bill that Dodd is now guiding to final passage leaves the Fed clearly in charge.

As currently written, the bill would create an autonomous “consumer protection bureau’’ within the Federal Reserve.  The bureau would receive its funding from the Fed, but its director would be named by the president and would not answer to the Fed’s chairman.

That provision could change.  Congressional Democrats and the White House still want to create an entirely independent consumer financial protection agency.  Republican lawmakers, meanwhile, are trying to reduce the agency’s power and tie it more closely to existing bank regulators. But Frederic R. Mishkin, a former Fed governor, said the central bank would be better off giving up its responsibilities for consumer protection.

“You want to stick to your core mission, and consumer regulation is not a core mission of the Federal Reserve,’’ Mishkin said.   Consumer protection, he said, is “very politicized’’ and would inevitably lead to second-guessing from Congress that could undermine the Fed’s political independence. Regardless, Fed officials appear content with the results of the bill.   Most feel they dodged a bullet by persuading lawmakers to limit congressional audits, which would be carried out by the Government Accountability Office.  They are also relieved that the legislation would leave the Fed with broad power to scrutinize and regulate the nation’s biggest financial institutions.

How did it happen?

Vincent Reinhart, a former director of monetary affairs at the Fed and now a senior fellow at the American Enterprise Institute,  said politicians may have not wanted an alternative. “One reason the Fed comes out of this unscratched is that politicians like having the Fed as a buffer,’’ Reinhart said.  “They realize that the Fed can make decisions that they either can’t make for themselves or wouldn’t want to make.  Besides, if you take powers away from the Fed, who are you going to give them to?”

To be sure, many important details are still being fought over.  Senate Democrats are planning to vote on Wednesday or Thursday to end debate and move to a final vote.  But before then, lawmakers are expected to vote on at least a half-dozen important amendments. Two of the biggest lobbying fights are over proposals to prohibit banks from engaging in proprietary trading for their own accounts and from trading any financial derivatives that are used to hedge against risk.

Playing with the Bank’s Money

Proprietary trading has been a huge source of profits for banks, especially Wall Street giants like Goldman Sachs and JPMorgan Chase.  That is a term to describe when a firm actively trades stocks, bonds or other financial instruments with its own money instead of its customers’ money. Many Democratic lawmakers are pushing to enact an immediate ban, while financial firms are lobbying fiercely for the regulators to study the idea first.

Lawmakers are also bracing for a battle over a provision in the Senate bill that would flatly prohibit banks from trading in derivatives like interest-rate swaps.   Banks argue that they use derivatives as part of their normal effort to hedge against changes in interest rates and other uncertainties, rather than as a form of speculation.   Though the provision was drafted by Senator Blanche Lincoln, Democrat of Arkansas, Democrats are divided about it and the Obama administration is against it. Under a compromise proposed by Dodd late Tuesday, the Senate would keep the sweeping prohibition but delay its implementation for two years while it's studied.

Regardless of the details, the Federal Reserve is likely to be at the center of all new efforts to regulate “systemic risk’’ and to rein in Wall Street firms deemed “too big to fail.” Both bills would create a new “Financial Stability Oversight Council” to monitor systemic risk across the financial system and to oversee the shut-down of major institutions that are failing.  The council would be chaired by the Treasury secretary and include representatives from each of the financial regulatory agencies.

The Federal Reserve would have the specific job of regulating all bank-holding companies, both the giant ones considered too big to fail and smaller community banks.   Fed examiners would able to delve  deeply into the operations of each bank, and Fed officials are already expanding their use of detailed new “stress tests’’ on the big banks to determine whether they need more capital.  Fed officials and other bank regulators are also planning much higher capital requirements on banks considered “systemically important” or too big to fail.

In a new twist, the Fed would also be allowed to delve into the non-bank subsidiaries of big banks. That is likely to include special financial vehicles that may not appear on a bank’s normal balance sheet. And if the new council of regulators decides by a two-thirds vote that a major insurance company or any other “non-bank” financial company is “systemically important,’’ Fed officials would have the wide powers to regulate those in the same way.  For practical purposes, that would expand the central bank’s authority to cover an insurance giant like AIG and possibly major stock exchanges and clearinghouses.  Both the House and the Senate bill would reduce the Fed’s power in one important area: bailing out individual institutions.

During the financial crisis, the Fed invoked a long-standing provision of the Federal Reserve Act known as Section 13(3) that allows it to take almost any action it wants in the event of “unusual and exigent circumstances.”  The Fed invoked that provision to justify scores of emergency lending programs as well as individual bailouts for institutions ranging from AIG and Citigroup to Bank of America. The House and Senate bills would prohibit Fed bailouts of individual companies, and the Fed would have to provide Congress with voluminous information about any special lending programs aimed at broader groups.

UPDATE:  An earlier version of this story said the Senate bill would give the Federal Reserve jurisdiction over bank holding companies with more than $50 million in assets.   As currently amended, the bill would have the Fed regulate all bank holding companies – the small ones as well as the giant “systemically important” ones.’