The Fed Shouldn't Regulate What It Doesn't Understand

Fed Chairman Bernanke is making one of his semi-annual appearances before Congress this week to testify on monetary policy. Yesterday, he appeared before the Senate Banking Committee and today he will face the House Financial Services Committee. As the recently-released minutes from the last Federal Open Markets Committee reveal, there is reason to be concerned about the current accommodative monetary policy, which may bring "excessive risk-taking and adverse consequences for financial stability." There is also reason to be concerned about the Fed's expansive regulatory policy.

Dodd-Frank gave the Fed new powers over institutions it previously did not regulate. Among the Fed's new charges will be the non-bank financial companies, such as insurance companies and large hedge funds, designated by the Financial Stability Oversight Council as systemically important. Dodd-Frank also paved the way for the Fed to assert greater control over foreign banking organizations, but the law should not have added to the Fed's regulatory task list. To the contrary, one could argue that the Fed should stick to monetary policy and not be a regulator at all. At a minimum, it should not be regulating financial institutions that it doesn't know or understand.

However, the Fed is instead starting to make the case that Dodd-Frank was not generous enough when it expanded the Fed's jurisdiction. In a speech earlier this month, New York Federal Reserve Bank President William Dudley suggested making the Fed the backstop for a broad group of non-bank financial entities, such as broker-dealers and money market funds. In exchange, Dudley hinted that the Fed would regulate these entities and perhaps their activities would be limited to those deemed to "clearly create social value." Boston Federal Reserve President Eric Rosengren also has raised the possibility of "a framework where, under certain conditions, liquidity facilities would be regularly made available for broker-dealers during periods of high stress."

The natural tendency of the Fed is, as we have seen with its supervision of bank holding companies, to keep institutions alive at all costs. This model-which coddles large incumbents and dissuades new entrants-should not be exported beyond the banking system. As SEC Commissioner Daniel Gallagher explained in a speech last week, "we must keep a healthy distance between capital markets regulation, which rightfully assumes no taxpayer safety nets, and bank regulation."

In a regulatory system that prizes financial stability over customer-oriented innovation, the Fed's push for more government guarantees and more regulatory authority are not surprising. With government backstops for part of the financial system firmly in place, it was only a matter of time before there would be calls to extend the safety net and attendant banking-style regulation to the rest of the system, lest something that happens outside the safety net cause problems at institutions within the safety net.

Before going down this path, however, it is worth remembering that the more the government guarantees, the less the market conducts its own monitoring. When the government insists on standing by with a safety net, it destroys the market's ability to reward firms that make good decisions and punish those who don't. As Mr. Dudley acknowledged: "firms might take less care in managing liquidity and capital if they know they have a lender of last resort backstop and [might] be subject to less counterparty and creditor discipline."

If the Fed succeeds in covering the whole financial system with a banking-style combination of taxpayer backstops and regulatory monitoring, we'll have a financial system that is private-sector in name only. The only silver lining is that when the next crisis hits, there won't be any question about whom to blame.