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By Ronald Fink
A prominent former U.K. financial services regulator said on Friday that the Federal Reserve cannot adequately oversee both individual banks and monetary policy.
In a column published by Project Syndicate, former Bank of England deputy governor and Financial Services Authority chairman Howard Davies wrote that the Fed shouldn't be entrusted with both monetary policy and regulatory oversight of banks, contrary to what Fed chairman Ben Bernanke recently told Congress.
As part of legislation to overhaul the financial system, Senate Banking Chairman Chris Dodd of Connecticut last year proposed stripping the Fed of its authority to oversee banks. And while that proposal was rejected by the committee, it has yet to vote on a bill.
However, Davies said the dual role that the central bank currently occupies poses an untenable conflict of interest. And he warned that that conflict threatens the Fed's independence, because the bank must be held more accountable to the public for bank oversight than it has been in the past in light of the financial crisis and the need for taxpayer-funded bailouts that resulted from it.
The problem, according to Davies, is that the overall job of setting interest rates and serving as a lender of last resort needs to be free of political interference. Yet the role of bank regulator requires public accountability because the Fed must intervene in the management of private institutions.
"Supervisors make decisions that, in effect, have an impact on private financial returns and property rights," Davies explained. "They must operate within tight legal constraints, and with rigorous accountability frameworks, involving the government and the legislature."
But that requirement raises the likelihood of political interference in the bank's job of setting interest rates and serving as a lender of last resort, the former regulator explained.
"The problem is how to establish two different types of accountability for two different functions," Davies continued. "Is it possible to maintain a rigorously independent chairman when it comes to interest rates, and a tightly accountable chairman when he is making supervisory decisions?"
Since the former regulator contends that would be extremely difficult to do, he favors hiving off the regulatory job to a separate authority that would combine the current supervisory functions of the Comptroller of the Currency, Office of Thrift Supervision, and regional Fed banks.
Bernanke and other Fed officials have testified that such an arrangement would hurt the central bank's ability to serve as a lender of last resort by limiting its access to information about individual banks. And they have cited the case of Northern Rock's failure as an example of why the U.K.'s separation of the two roles under the Bank of England and FSA shouldn't be emulated.
Others, however, have said Northern Rock's failure isn't relevant to this question, since the U.K. bank's failure stemmed from its exposure to the U.S. real estate market.
Davies suggested that the problem cited by Bernanke and other supporters of the Fed's dual role could be avoided if the supervisory office reported to the Fed, and that the issue was outweighed by other concerns.
"This regulatory architecture would leave the Fed free to speak openly about the development of the financial system as a whole, without worrying about the implications for individual institutions in its care," he concluded.
Finally Davies warned President Obama that Bernanke's Senate confirmation for a second term as Fed chairman doesn't put the problems with the bank's role to rest.
"If [President Obama] proceeds with plans to give [the Fed] more functions, [problems] will persist," Davies wrote. "To protect the Fed's independence, which is a global public good of the highest importance, he should cut back the Fed's authority to its core role."
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