NEW YORK (Reuters) - President Barack Obama’s proposal for a regulatory overhaul of the financial industry vastly expands the reach of the Federal Reserve, yet fails to make policy-makers more accountable for their actions.
Critics argue that the new legislation fundamentally misses the problems that led to the financial crisis. It was a lack of enforcement by supervisors, they say, not insufficient rules, that fostered a cowboy culture of rampant risk-taking on Wall Street.
“Obama is letting the Fed and everyone else off the hook by saying that the problem was with the regulations and not the regulators,” said Dean Baker, co-director of the Center for Economic Policy Research in Washington.
“If regulators know that even if they totally fail on the job, they will face no career consequences, then at some future point, when there is a choice between confronting the financial industry or just going along, the regulators will just go along,” said Baker.
Former Fed Chairman Alan Greenspan recently admitted that he overestimated the ability of markets to police themselves. But the central bank’s current leader, Ben Bernanke, has avoided much of the blame even though he was a Fed governor at the height of the housing boom.
Instead, he has won widespread praise from investors for his handling of the crisis, at least once it began.
“He’s done a good job,” said Michael Feroli, economist at JP Morgan. “He has played a bad hand well.”
What has critics wary of an expanded Fed role is that top central bankers, including Bernanke, had dismissed the possibility that U.S. home prices could fall on a national basis. In reality, property values have plummeted more than 30 percent from their 2006 peak, and even more in hard-hit states like Florida, California and Nevada.
In the summer of 2007, when subprime mortgage defaults were rising, the Fed argued that the problem was “contained” to those high-risk mortgages. But the problem soon ballooned until it required trillions of dollars of emergency measures to support big banks.
RGE Monitor’s Nouriel Roubini, now famous for his early bearishness about the financial crisis and economy, said those missteps should not be taken lightly. “Early on they got it totally wrong,” he said.
With little in the way of accountability for the Fed’s policy blunders, it may be difficult to ensure the same mistakes do not get repeated.
In the aftermath of the crisis, the Fed has argued the problems stemmed from financial entities outside its jurisdiction, like mortgage brokers and the nation’s big investment banks. But officials were not exactly loud about flagging this lack of authority when times were good, even though they knew the central bank would have to serve as a lender of last resort if things went wrong.
Plenty of the symptoms of the crisis were visible in commercial banks directly under the Fed’s authority. Banks like Citigroup Inc, Countrywide Financial and Washington Mutual engaged in increasingly risky lending practices.
The president’s new plan gives the Fed an explicit mandate to monitor risks to the broader financial system from large financial conglomerates, a task commensurate with the institution’s traditional role.
As Treasury Secretary Timothy Geithner has argued, the Fed is the organization that works most closely with financial markets and is therefore best positioned to understand its risks.
Some feel uncomfortable with a broader role for the Fed primarily because of the Fed’s closeness to the banking sector. The Fed is not technically a public entity. Each of the Fed’s 12 branches are overseen by a nine-member board of directors, two-thirds of whom are elected by the bankers in the district.
“The Federal Reserve has massive conflicts of interest that make it ill-suited for its present regulatory functions and certainly for an expanded regulatory reach,” said Robert Auerbach, a professor of public affairs at the University of Texas at Austin. “The officials leading the Fed today preside over an organization that is run in substantial part by the bankers they regulate.”
The Fed’s defenders say this is not entirely a fair charge. The central bank has a deep repository of economic expertise, with thousands of staffers around the country consistently tracking key economic trends and statistics.
Yet the very magnitude of the country’s financial crisis, the worst since the Great Depression, suggests that some big errors of judgment occurred despite myriad warning signs.
Central bankers largely ignored mounting evidence of fraud in the housing arena and touted the benefits of “financial innovations” such as derivatives instruments — the very securities that would bring the banking system to its knees.
Baker, who long warned of a looming housing crisis, said the central bank’s meek reaction was a primary cause of the crisis: “The Fed had all the authority it needed to burst the housing bubble and prevent this disaster. They opted not to do it. This was a disastrous failure.”
Reporting by Pedro Nicolaci da Costa; Editing by Padraic Cassidy