If given broader regulatory authority, the Fed will probably face new challenges in executing its traditional responsibilities and in preserving its independence against political pressure.Risk management ; Federal Reserve System ; Federal Reserve System - Independence

Sharon K. Blei

English

Research Papers in Economics

D
rawing upon long-dormant emergency 
powers as lender of last resort, the Fed-
eral Reserve has taken unprecedented steps to 
shore up the financial system.  If, as a result of 
these precedents, the Federal Reserve’s role as 
a regulator is expanded, the central bank will 
probably face new challenges in executing its 
traditional responsibilities and preserving its 
independence against political pressure.  Thus, 
changes in the role of the Federal Reserve 
should be carefully considered, bearing in 
mind the importance of its role in monetary 
policy and the payment system—and the 
importance of protecting these functions from 
political and financial pressures.
The Fed Responds to Crisis
The challenges presented by the subprime 
meltdown and the subsequent strain in global 
financial markets have dramatically reshaped 
the financial landscape in the U.S.  Since 
the onset of the crisis in August 2007, the 
country has witnessed a series of prominent 
bank failures: Countrywide, IndyMac and 
Washington Mutual (by far the largest com-
mercial bank failure in American history); 
the demise of America’s five major investment 
banks; the bailout of mega-insurer American 
International Group (AIG); and the decline of 
mortgage titans Fannie Mae and Freddie Mac.  
Faced with these extraordinary developments, 
the Federal Reserve—to which all eyes were 
turned for rescue—took upon itself the mis-
sion of managing and containing the crisis.
Assuming responsibility not only for those 
banks under its supervision, but for the 
financial system as a whole, the central bank 
drew upon long-dormant emergency powers 
and took bold steps:  It enhanced financial 
institutions’ access to liquidity by deploying 
an array of new short-term liquidity facilities; 
expanded reciprocal currency arrangements 
with foreign central banks; engineered and 
backed JP Morgan’s takeover of ailing invest-
ment bank Bear Stearns; agreed to lend to 
Fannie Mae and Freddie Mac; provided an 
emergency credit line to AIG; and worked  
out with the U.S. Treasury an ambitious  
$700 billion emergency rescue package for  
the American financial services industry.
Thus, the Federal Reserve, established 
nearly a century ago as lender of last resort 
to tackle financial panics, emerged in a new, 
broader guise—that of the nation’s financial 
system savior.
A Systemwide Regulator?
Why has the Federal Reserve assumed 
this extended role?  The reasons appear to 
be multiple.  First, the Federal Reserve is the 
lender of last resort and has a monopoly over 
the supply of liquidity to the financial system.   
This role provides the central bank with both 
the tools and the expertise for managing and 
containing systemic disruptions.  Second, the 
Federal Reserve plays a key role in providing 
payment services and overseeing the payment 
system, the integrity of which is essential to 
financial stability.  The Federal Reserve also 
enjoys an unmatched reputation for technical 
skill and nonpartisanship, the ability to wield 
moral suasion and a unique “primus inter 
pares” (first among equals) status among 
federal regulators, placing it in the prime 
position for leading national rescue efforts.  
In the global arena, its close relationship with 
foreign central banks and its high interna-
tional acclaim enable the Federal Reserve to 
coordinate multinational endeavors to shore 
up crumbling financial markets.  Faced with 
the dramatic developments in the financial 
system, the Federal Reserve answered a call  
no other federal agency was better-suited— 
or willing—to answer. 
To date, regulators of financial institutions 
in the U.S. have been mandated to focus on  
the prudential issues, namely, business con-
duct and financial conditions of individual 
institutions.  The recent financial shakeout 
vividly demonstrates the need for a system-
wide, “macro-prudential” approach to finan-
cial regulation.  Unlike micro-prudential 
regulation, which focuses on the financial 
condition of single institutions, the system-
wide approach’s field of vision is the financial 
system as a whole, focusing on common 
exposures, linkages and interdependencies 
among financial institutions. 
It has been suggested that a systemwide 
regulator, entrusted with the responsibility for 
maintaining financial system stability, should 
be able to either collect or access the informa-
tion required for the evaluation of the systemic 
risks associated with certain industry-wide 
practices, common exposures or default by 
a financial institution, and should be able 
to wield both the authority and the tools to 
intervene when needed.  In the eyes of many, 
the Federal Reserve is the natural candidate 
for the role.  A “blueprint” for regulatory 
overhaul released by the U.S. Department of 
the Treasury last March (the Paulson plan) 
recommends mandating the Federal Reserve 
as “market stability regulator.”
1
Whether formalized or not, the Federal 
Reserve’s extended role in financial oversight, 
alongside its long-existing roles in maintain-
ing price stability and promoting economic 
performance, raises important challenges.  
One such challenge is the potential con- 
flict between micro- and macro-prudential 
regulatory objectives.  Micro-prudential 
regulation is pro-cyclical by nature—both 
central bank
By Sharon K. Blei
14   The Regional Economist  |  January 2009ENDNOTES
 1 See the Treasury Department.
 2 See Volcker.
REFERENCES
Bernanke, Ben S.  “Reducing Systemic Risk.” 
Presented at the Federal Reserve Bank of 
Kansas City’s annual economic symposium 
in Jackson Hole, Wyo., Aug. 22, 2008.  See 
www.federalreserve.gov/newsevents/speech/
bernanke20080822a.htm 
Treasury Department blueprint for a modern-
ized financial regulatory structure (March 
2008) can be found at www.ustreas.gov/press/
releases/reports/Blueprint.pdf.
Volcker, Paul A.  Testimony before the Joint 
Economic Committee, May 14, 2008.  See 
jec.senate.gov/index.cfm?FuseAction=Files.
View&FileStore_id=3b13d743-490b-4c41-
ba36-8d86688d93a6.
because capital requirements and account-
ing rules enhance the pro-cyclicality already 
inherent in credit markets and also because 
prudential regulators tend to be stricter in 
times of economic weakness and laxer dur-
ing expansion.  The systemwide approach 
to regulation, on the other hand, aims to 
stabilize systemic shocks to financial markets 
and is, therefore, counter-cyclical by defini-
tion.  Regulatory measures that are desirable 
from a micro-prudential point of view may 
seem, therefore, detrimental from a systemic 
standpoint.  (For example, taking corrective 
action against a financial institution might be 
well-justified as far as prudential regulation 
goes, yet undesirable from a system-wide per-
spective, since doing so may further deterio-
rate that institution’s financial condition and 
increase the risk it poses to the system.)
Acquiring the information essential to 
executing the role of systemwide regulator—
namely, real-time data about a vast array 
of financial institutions, their financial 
condition, structure and the contractual 
linkages between them—presents additional 
challenges.  First, there are the technical dif-
ficulties and non-negligible costs associated 
with collecting and processing such complex 
data—both to supervisors and institutions.  
Then, there’s the need for close collaboration 
with other regulators (public, private and 
even foreign), who may not be willing  
to cooperate.
Whither Independence?
Another major concern is that broader 
responsibilities over the financial system 
might subject the Federal Reserve to excessive 
political pressure and, thereby, compromise 
its independence in the conduct of monetary 
policy.  Independence against narrow politi-
cal and commercial pressures, that is, being 
relatively immune to the danger of “captivity” 
by interested parties, is crucial to the Federal 
Reserve’s monetary policy role.  Politicians 
have always sought influence on the Federal 
Reserve, especially at times of economic 
turmoil; they have pressured it to favor certain 
sectors or industries or to lower interest rates.
An extended role in financial regulation 
could arouse an even greater appetite for 
influence among politicians.  In addition, 
such a role entails using taxpayer money 
and affecting the allocation of credit in the 
economy and, thus, would inevitably lend 
fiscal and political nuances to the central 
bank’s actions; that, in turn, would spur 
demands for greater transparency and closer 
congressional scrutiny.
Testifying before the Congress’ Joint Eco-
nomic Committee last May, former Federal 
Reserve Chairman Paul Volcker remarked that 
broadening the Federal Reserve’s authorities 
beyond the supervision of commercial banks 
and their bank holding companies would be 
“a way of destroying the Federal Reserve in the 
long run because it does need independence.”  
Volcker further wondered whether “such a 
large responsibility [should] be vested in a 
single organization, and should that organi-
zation reasonably be in the Federal Reserve 
without risking dilution of its independence 
and central bank monetary responsibilities?”
2
Volcker’s query broaches yet another 
challenge facing the Federal Reserve, that of 
balancing its re-interpreted role in the finan-
cial arena with its monetary responsibility.  
Monetary policy instruments—the interest 
rate, reserve requirements, short-term liquid-
ity facilities and the discount window—can 
potentially affect both price and financial 
system stability, yet in opposite directions.  
Whereas tight monetary policy may combat 
inflationary pressure, it may also reduce the 
availability of credit and may jeopardize bor-
rowers’ creditworthiness, thus, potentially 
weakening the credit market.  Hence, in the 
short run, there may be tradeoffs between 
achieving the goal of price stability and 
maintaining a healthy credit market.  Having 
played the role of banking supervisor since its 
establishment in 1913, the Federal Reserve is 
no stranger to this tradeoff. 
Further Thoughts
If the Federal Reserve is given a system-
wide role in financial regulation, the many 
challenges it might present to the central 
bank would call for reassessment of its differ-
ent functions and objectives and for careful 
planning.  Sound conceptual and structural 
regulatory foundations, successful imple-
mentation of a financial stability mandate 
and continuous adaptation to the ever-
changing financial environment would pave 
the way to a safer economic future. 
Sharon Blei is an economist at the Federal Reserve 
Bank of St. Louis.
The Regional Economist  |  www.stlouisfed.org   15

Reducing Systemic Risk.” Presented at the Federal Reserve Bank of Kansas City’s annual economic symposium in Jackson Hole,

Testimony before the Joint Economic Committee,

If Fed becomes super regulator, politicians would be its kryptonite

http://stlouisfed.org/publications/re/2009/a/pdf/super_regulator.pdf

If Fed becomes super regulator, politicians would be its kryptonite

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