Curbing Fed's excesses key to enhancing banking transparency

In the coming months, the Federal Reserve is likely to be endowed with greater regulatory powers and an increased ability to interfere in the open markets. Most importantly, it will cement the wall of opaqueness in its decision-making.

All of this comes at a time when the Federal Reserve is increasingly being held responsible for aiding in the creation of the subprime crises. Over and beyond the banks, hedge funds, real estate brokerages and even the average consumer, the Fed monetary policy was substantively responsible for the easy credit and the resultant unchecked credit infused asset bubble.

Particularly from 2002 to 2005, when the Fed reduced the Fed Funds rate to levels below "optimum" — supposedly, on the fears of a potential deflation. Resultantly, according to Janet Yellen, president of the San Francisco Fed, this contributed to an overheating of the economy.

To make matters worse, as is more evident, policies by the Fed and the US Treasury stoked the fires of aggressive risk-taking by providing an almost zero-regulatory constraint in the over-the-counter derivatives market.

This resulted in non-transparent deal making, increased risk-taking and led to astounding levels of leverage. In essence, the Fed seems to have performed badly, if not failed, on both its critical tasks — to help create a stable price environment and contribute to the creation of a dynamic regulatory architecture.

Recently, a new law entitled the Federal Reserve Transparency Act was recently rendered toothless. The original bill intended to curb the Federal Reserve's actions, to bring greater audits and to make internal discussions more public.

Instead, a new bill has been introduced plans to create a superfund which would allow the Federal Reserve substantive powers to impose leverage constraints and formulate capital requirements. This time, as the argument goes, the Fed will get it right hereafter.

Over the years, and particularly now, the Federal Reserve is an institution that arouses strong reactions. Some on the Libertarian Right have called for its abolishment, while every politician in Washington has accused it — at some point or the other — of it being the bulwark against greater transparency in the financial system.

Sense of the absurd

So a certain sense of the absurd is inescapable when one learns of the Congress's efforts to provide the Federal Reserve with more power.

The power to choose which firms are too big to fail, the power to regulate rules for risk, the power to continually purchase bad loans and debts off banks they deem "important for the system" (Bear Stearns, but not Lehman Brothers?), the open market activities in the foreign exchange market, the power to delay informational flow onto the public after the Federal Open Market Committee (FOMC) meetings. (The FOMC debates and ultimately recommends the critical federal funds rate.)

All of this has led to a number of very prominent bankers, academics and even Federal Reserve officials themselves to question the system. From Charles Plosser (of the Philadelphia Fed), William Poole (of the St Louis Federal Reserve), Thomas Hoenig (of the Kansas City Fed) et al.

On the face of it, as Poole suggests, the "bailout" and refusal to let major banks go bust, coupled with the implied soft-budgetary constraints, are no different from bank policies of the Soviet Union and Communist Eastern Europe.

While the charge might be a bit unfair — rarely did banking crises in the erstwhile Czechoslovakia threaten to bring the global financial system down — at a conceptual level there is a ring of truth to it.

Systematic risk

So now what? It is our belief that much as the extraordinary circumstances in the 1930s were instrumental in the creation of the Fed to manage the banking failures, we need a special agency that oversees all systemic risk. One far removed from the conventional monetary policy functions, from the inescapable pressures of Wall Street's jockeying and jostling.

In this environment where the regulator-in-chief seemingly plays handmaiden to Wall Street, it is difficult to believe that the Fed will actively act against inflation fears with sufficient alacrity and regulate the inescapable "innovation" that will come out from Wall Street in the years to follow in the coming years.

Failure to actively intervene draws attention to the wisdom in Thomas Jefferson's words when he said: "I believe that banking institutions are more dangerous to our liberties than standing armies."­

The columnist works for a major European investment bank in New York City.