Time to Reform the Fed

Conflict arises over its roles as regulator and lender of last resort

TREASURY Secretary Lloyd Bentsen has proposed legislation consolidating bank regulation functions into a single new national banking commission, which would take over the day-to-day responsibilities now shared by the Treasury's Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation (FDIC), Office of Thrift Supervision (OTS), and the Federal Reserve Board.

Under Mr. Bentsen's proposal, the new commission would examine banks and set legal standards for mergers and new financial services, products, and activities. Representatives of the Fed, the OTS, and the FDIC would sit on the commission's new advisory board, giving each agency access to confidential financial data and the opportunity to express its views as part of the overall regulatory process.

Most members of Congress and officials of the various banking agencies agree that regulatory consolidation is badly needed. Only the Fed's entrenched Washington bureaucracy resists change, even though reform would ultimately benefit the nation's financial system. The Fed is determined to fight the Clinton administration and members of Congress, such as House Banking Committee Chairman Henry B. Gonzalez (D) of Texas, who support a unified banking agency.

Since Bentsen made his proposal, the Fed has begun a covert lobbying and disinformation campaign to block the reform effort. Former Fed Chairman Paul Volcker, among others, has begun to warn of terrible consequences if the Fed is taken out of the business of supervising banks. The Fed even managed to recruit unlikely allies in the corporate community to run Op-Ed articles supporting a ``hands off'' posture for Congress regarding the Fed. It is some measure of the tangled state of affairs in Washington that congressionally chartered agencies such as the Fed can spend tax money to defend their bureaucratic turf against the wishes of elected officials.

Despite the Fed's protestations, there are a number of sensible arguments for getting the central bank out of the business of supervising banks. Foremost is the conflict of interest between the Fed's role as regulator and as lender of last resort. Events of the past decade show that it is suspect financially and dangerous politically for the agency that determines the solvency of a federally insured bank to be in a position to make loans to that institution.

With the FDIC Improvement Act of 1991, Congress sought to curb Fed discount window loans and other expedients used to keep insolvent banks afloat. During hearings on this important legislation, members of Congress criticized senior Fed officials in Washington for ``playing God,'' in the words of Mr. Gonzalez, by keeping such banks open through a combination of secret loans and forbearance on supervisory requirements.

Congress never empowered the Fed to bail out private banks, based on a concept known in financial markets as ``too big to fail.'' The morally suspect practice of propping up banks has cost taxpayers billions of dollars in losses to the FDIC, while rewarding bad management practices at certain large institutions.

Consider a few examples of Fed-inspired bailouts: Continental Illinois (1984), First City (1987 and 1991), First Republic (1988), MCorp (1989), National Bank of Washington (1989-90), Madison National Bank (1991), Bank of New England (1990-91), Southeast Bancorp (1991), and Citicorp (1990-91). In each case, the Fed bent accounting rules and subverted normal supervisory standards on the one hand, while employing discount window loans and other less obvious means to keep the moribund banks alive.

Who benefits when Fed mandarins decide to bail out a bank? Given that virtually all of the depositors in larger banks are fully covered by FDIC insurance, what public good is achieved? Since the average insured bank deposit in the US is well below $10,000, neither the Fed nor the large banks concerned have ever satisfactorily answered this question.

The real beneficiaries of bailouts for large banks are two closely linked constituencies: the management of some large, badly managed institutions, which use insured deposits to make ill-advised real estate loans at home or advance credits to third-world countries; and their political patrons in Washington, who seek political contributions from larger banks and use loans to authoritarian third-world countries to advance dubious foreign-policy objectives.

Until the US allows banks, especially large banks, to fail when insolvent, there will be no true accountability for bad management.

The Fed's role as a politicized bank regulator on the one hand and an objective arbiter of monetary policy on the other raises a more subtle political point. In 1990, the Republican-appointed Federal Reserve Board launched a vast monetary expansion that had two goals: the reelection of President Bush and the temporary salvation of some of the country's largest banks.

Secret loans and ``investments'' of late 1990 and early 1991 kept several big banks afloat, but the Fed's monetary expansion of the past 36 months represents a larger effort to rebuild capital levels severely depleted by bad loans to Latin America, commercial real estate developers, and misguided corporate takeover schemes.

Mr. Bush lost, but the Fed did lift the fortunes and stock prices of some of the nation's worst-managed banks on a cushion of easy money - albeit at a price. Using low interest rates that are negative in inflation-adjusted terms, the Fed created the present artificial boom in stocks generally and bank stocks in particular, but has already laid the groundwork for the next financial bust. By trying to counteract the broader economic ill effects of burgeoning federal deficits and bad management decisions by the big banks in New York, the Fed supposedly has become a source of increasing instability in the American financial system.

Whether one looks at the Fed bending the rules to save individual banks or the election-related macroeconomic manipulations of the central bank, Congress clearly needs to seriously investigate and intelligently overhaul the role of the Federal Reserve. When Fed officials warn against dire consequences of changing the Fed's institutional structure, members of Congress should respond by asking how we might tell the difference. The Opinion/Essay Page welcomes manuscripts. Authors of articles will be notified by telephone. Authors of articles not accepted will be notified by postcard. Send manuscripts by mail to Opinions/Essays, One Norway Street, Boston, MA 02115, by fax to 617 -450-2317, or by Internet E-mail to OPED@RACHEL.CSPS.COM.

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