Opinion | The Fed is the wrong bank regulator

It makes more sense to take bank regulation away from the Fed and give it to an agency that will make it their telos.

Evidence of this problem is clear in the Fed’s April report on its failing as a bank regulator in the collapse of Silicon Valley Bank. SVB took massive bets that interest rates would remain low. A strong regulator would have required SVB to hedge those risks. Hedging costs money and that would have reduced the bank’s profits and its management bonus pool. But it would have protected the bank when interest rates rose.

One would think the Fed would have been most attuned to the possibility of interest rates rising, as they set rates. But the Fed stopped including interest rate increases in their stress tests of banks similar to SVB in 2015 and didn’t require the bank to hedge.

The deeper problem, though, is that regulation is just not the Fed’s top priority. The SVB report lists the Fed’s five key functions: Monetary policy is listed first. Regulation of individual banks clocks in third, below the Fed’s role in protecting financial stability, and above its role in operating and regulating payment systems. Little wonder First Republic, another massive bank, failed this week.

Ironically, the Fed’s power over the banks is a result of its success in managing monetary policy. Fed Chairman Paul A. Volcker tamed inflation in the 1980s. Alan Greenspan followed with his handling of interest rates during the productivity boom of the 1990s and early 2000s. These successes gave the Fed tremendous clout, which it used to support deregulation in the banking sector that led to the megabanks it now regulates.

An example of the Fed’s regulatory failings: Congress gave the Fed regulatory authority over subprime mortgages in 1994. Greenspan didn’t believe in this type of regulation so the Fed did nothing. Subprime mortgages managed to blow up the entire global financial system, including the megabanks (though to be fair a lot of other regulators messed up, too). When the dust settled, Congress doubled down on the Fed, giving it even greater authority under the Dodd-Frank Act (full disclosure: I helped draft that law working both for Sen. Christopher J. Dodd and Treasury Secretary Timothy Geithner).

When President Donald Trump rolled back parts of Dodd-Frank, with bipartisan support, the Fed once again gained authority, this time in the form of discretion on when to apply tougher rules and when to use a lighter touch. First Republic and Silicon Valley Bank were two banks the Fed had discretion over and we see what happened. The Fed’s SVB report says it “failed to take forceful enough action” on SVB, and correctly identifies an issue with the regulator’s “consensus-driven culture that smooths over complex issues.” In bank regulation the ability to challenge consensus is necessary, whereas the Fed’s monetary policy culture promotes consensus as a top goal.

The Fed deserves credit for a report that acknowledges its own failings and promises reform. Michael Barr, the Fed’s vice chair for bank supervision, inherited this mess and the report he oversaw is an honest assessment. The issue, though, is that the regulator can’t be fixed from within. Monetary policy will remain the telos and bank regulation will fight to be second fiddle.

There is another way. The United States has many financial regulators, too many frankly. Agencies such as the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. have bank regulation as their telos. These agencies should take the lead on this important area of policy. Aligning the responsibility to regulate banks with the mission to do so will create a more stable and resilient financial system.

Congress needs to fix this problem. Rather than debating whether to turn the regulatory ratchet back up, Congress should move bank supervision from the Fed to agencies whose top priority is regulation. Dodd’s original proposal of what ultimately became Dodd-Frank, moved regulation of banks such as SVB out of the Fed. The Federal Reserve used its power to block that shift. After another round of failures, the Fed should get less deference.