Chris Dodd’s financial regulatory reform plan goes too far in my view in stripping away powers from the Fed. It makes sense to take away the Fed’s ability to bail out individual companies under 13.3 once there is a special resolution entity in place to manage financial failures. But taking away the Fed’s banking supervision role risks robbing it of an information flow vital to deal with financial stability threats. And giving systemic risk powers to a new agency is a recipe for confusion or worse.

Why? Because an economy with a systemic risk or macroprudential regulator and a separate central bank would be like a car with two drivers. Both systemic risk constraints and monetary policy work through the same credit channel. The difference is that one is targeted and the other broad based.

If one institution has both sets of powers it could decide when faced with a shock or incipient bubble whether it makes sense to deploy a) targeted risk limits or b) general monetary policy or both in some combination. If the two sets of powers belong to two different agencies the coordination problem will be intense and likely lead to suboptimal policy. There would also be no accountability - both agencies could pass the buck when things go wrong.

I think macroprudential powers belong in the central bank. But if that is not politically possible better compromise on a systemic risk council that delegates operational control to the Fed.

Tags: banking regulation, fed, financial regulation, macroprudential regulation

November 10, 2009 8:03pm in North America, asset bubbles, federal reserve, interest rates | Comment