Craig N. Hardt Dodd-Frank and the Future of the Federal Reserve System SIPAU6013

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Dodd-Frank and the Future of the Federal Reserve System

The Federal Reserve System (“the Fed”) exists at the center of global financial markets as the

central bank of the world’s richest nation, and the sole issuer of what has become the world’s de

facto reserve currency.1 In its role as the United States’ central bank, the Fed is the fiscal agent of

the United States government and is responsible for maintaining the nation’s payments system.

Importantly, the Fed sets monetary policy in its effort to stabilize the American economy. It has

also adopted the roles of “lender of last resort” and prudential supervisor of the banking sector.2

The financial crisis underscored the Fed’s centrality in the United States’ economy. When the

housing market crash led to a severe disruption in credit markets, the Fed provided emergency

liquidity to the financial system through the creation of a series of specialized lending facilities.

The Fed also controversially lent directly to specific financial institutions due to concern that the

failure of these institutions could cause the financial system to collapse. While these emergency

actions were justified by the Fed’s responsibility for preserving macroeconomic stability, they

led to increased scrutiny of the Fed’s seemingly unlimited power to intervene in the economy.

Subsequently, financial reform led to a reevaluation of the role of the Fed and has altered the

legal framework under which the Fed operates, increasing its powers in some areas while

reducing it in others.3

In this paper, I will analyze how and why the passage of Dodd-Frank changed the legal

responsibilities and authority of the Federal Reserve. In doing so, I begin with a historical review

1 Alan Meltzer, ”US Policy in the Bretton Woods Era”, Speech at Washington University in St. Louis, April 8, 1991.

2 Pauline Smale, “Structure and Function of the Federal Reserve System” CRS Report RS20826 November 10, 2010

3 Thomas F. Cooley, Kermit Schoenholtz, George David Smith, Richard Sylla, and Paul Wachtel, “The Power of

Central Banks and the Future of the Federal Reserve System” in Regulation Wall Street: The Dodd-Frank Act and

the New Architecture of Global Finance. Hoboken, N.J.: Wiley, 2011.

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of the evolution of central banking in the United States, including an analysis of what previous

legislative changes meant for the Fed’s role within the American financial system. I will

conclude with an examination of the potential advantages and disadvantages of the new legal

framework within which the Fed operates.

Structure and Evolution of the Federal Reserve System in the United States

Centralized power has been viewed with skepticism from the beginning of the United States’

history. In 1790, Alexander Hamilton proposed that the Congress establish the young nation’s

first central bank under the name of the Bank of the United States. While this proposal was hotly

debated, with many arguing against the creation of an institution that mirrored the powerful Bank

of England (which helped finance the British war effort against American independence),

supporters of the idea eventually prevailed. Congress chartered the Bank of the United States for

20 years, and Hamilton’s vision of a central bank serving as an important complement to federal

financing operations and the core of a national banking system that would promote interstate

commerce was given life. Hamilton recognized that this first central bank needed to be protected

against short-term political influence, but also needed adequate oversight if it was to retain its

power in the young republic. Thus, the government would take a 20 percent stake in the

ostensibly private bank and would require the bank to report on its condition regularly to

Treasury. Although the bank was largely successful – it served as an effective fiscal agent for the

Treasury, improved efficiency of the payments system in what was then a very fragmented

banking system, and even operated as a lender-of-last resort for state banks with temporary

reserve deficiencies – Congress declined to renew the bank’s charter in 1811.4

4 Cooley et al, pp. 53-54

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Without a central bank to help finance federal spending in the War of 1812, the federal

government struggled to meet its obligations while state banks, with the exception of banks in

New England, suspended convertibility of their bank notes to base money. In effect, this meant

that money held in one state could not be easily used to buy or sell goods in a different state at

face value of the bank note. The result led to a rapid expansion in base money, and ultimately led

to a period of high inflation.5 With this experience fresh in their minds, lawmakers in 1816

quickly chartered what became known as the Second Bank of the United States. This bank was

modeled after the first bank, with the government again taking a 20 percent stake. However, the

government increased oversight by appointing a fifth of the bank’s directors. The second

incarnation of an American central bank proved equally successful, as the bank helped restore

convertibility of the currency, and presided over a period of rapid, noninflationary economic

growth. Yet this bank, too, did not survive long. Although Congress renewed its 20 year charter

in 1832, President Andrew Jackson vetoed the bill, ushering in the volatile era of free banking.6

In the 19th

century the young nation’s economy continued to expand, but periods of financial

turmoil were not uncommon. Although various alternatives to a central bank were established,7

none succeeded as well as the two incarnations of the Bank of the United States in promoting

financial stability. Over the combined forty years the Bank of the United States existed, the

country experienced just two banking crises, in 1792 and 1819. In the period that followed,

banking crises occurred roughly every ten years, in 1837, 1839-1842, 1857, 1873, 1884, 1893,

and 1907. Despite the instability, political will to re-establish a central bank was never great

5 Ibid, p.54

6 For a detailed explanation for how the banking system functioned in the Free Banking Era, see Gary Gorton,

“Creating the Quiet Period” in Misunderstanding Financial Crises, New York, N.Y.: Oxford University Press 2012. 7 Functions of the defunct central bank were performed by the Treasury, by clearinghouses of banks in major cities,

and—after the 1863 establishment of the National Banking System during the Civil War—by large national banks in

leading cities, such as the reserve city of New York. For details, see Cooley et al, p. 55

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enough to overcome entrenched distrust of centralized control of banking and monetary policy.

The Panic of 1907, which pushed the United States to the edge of economic collapse and

required a sizable bailout organized by the nation’s preeminent private banker, John Pierpont

Morgan, prompted Congress to reconsider its resistance to a central bank.8

In the context of the trust-busting interventions of the government under President Theodore

Roosevelt, perhaps the only thing Americans despised more than centralized government

authority was concentrated power and wealth in the private sector. In 1907, the federal

government had limited authority to address systemic economic pain, leaving the nation’s

economy beholden to the whims and abilities of private bankers to act in a coordinated manner to

avert economic catastrophe.9 Thus, the impetus for Congress to re-establish government control

over the nation’s banking system was born, although the ingrained distrust of centralized

authority characterized the form the country’s new central bank would take.

In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System to

operate as the nation’s central bank. At its creation, the Fed’s mandate was quite simple. It was

to furnish an elastic currency to stem regional fluctuations in reserve requirements and provide

liquidity to member banks.10

These fluctuations were often tied to agricultural seasons, as

demand for currency ebbed and flowed with the successes and failures of local crops. Banks in

need of short-term currency could now go to their regional Federal Reserve Bank for a loan,

pledging specific eligible assets as collateral.11

Although Congress recognized the need for a

central bank, it was wary of giving so much power to the federal government, and so built a

8 Cooley et al. pp. 55-56

9 Robert F. Bruner and Sean D. Carr, “The Panic of 1907: Lessons Learned from the Market’s Perfect Storm” in

Financial History Magazine, Fall 2007. 10

Norbert Michel, “Dodd-Frank’s Expansion of Fed Power: A Historical Perspective” Cato Journal, Vol. 34, No. 3. 11

Renee Haltom and Jeffrey Lacker, “Should the Fed Have a Financial Stability Mandate?” in Federal Reserve

Bank of Richmond 2013 Annual Report.

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system that revolved primarily around the twelve Reserve Banks, with a weak Board of

Governors mainly responsible for ensuring Congress had a line of communication to the Reserve

Banks.12

The decentralized central bank, however, proved unable to adequately deal with the

most damaging financial crisis in American history, the Great Depression. Instead of easing

money and credit, the Fed’s lack of coordination and commitment to the gold standard failed to

prevent bank runs from spreading across the country and doomed the nation to a protracted

depression. Not until 1935 under Marriner Eccles’ leadership did the Fed move to a more

centralized system, with the Board of Governors taking a more prominent role. However

wartime needs of the Treasury and the heavy involvement in monetary affairs of then-President

Franklin D. Roosevelt limited the Fed’s independence, which was restored as part of the

Treasury Accord of 1951.13

The Fed’s institutional design and governance structure reflects the competing desires of the

American public to limit the power of the federal government and ensure that bankers do not

have too much control over the nation’s financial system.14

As Cooley et al explain, “The

Federal Reserve System remains the pragmatic result of decades of evolution and haggling to

balance the public’s mistrust of bankers with its similar mistrust of politicians.”15

In many ways,

the structure of the Fed mirrors the structure of the federal government, with twelve reserve

banks responsible for monitoring banks in their districts and managing the payments system

overseen by a centralized board operating as the equivalent of the federal government’s

executive branch. The Federal Reserve Board of Governors (“the Board”) is comprised of seven

members, all appointed by the Executive Branch subject to approval from Congress. Governors

12

Michel, p.558. 13

Cooley et al. p. 56 14

For a detailed discussion of the historical development of the Federal Reserve’s governance structure, see Michel,

pp. 559-562 15

Cooley et al p. 64

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are appointed to 14-year terms to protect them from political influence once they are confirmed.

For similar reasons, members of the Board are not allowed to hold any office or employment in

any member bank while they are in office and for at least two years after their term expires.16

The Board also is responsible for the formulation of monetary policy, and does so through the

Federal Open Market Committee (FOMC), which is comprised of the seven Governors and five

of the twelve Federal Reserve Bank presidents.17

At the regional level, each Federal Reserve Bank is owned by its member banks, and is managed

by a nine-member board of directors divided into three classes: A, B, and C. Class A directors

are appointed by member banks in each district, and represent the interests of these banks. Class

B directors (appointed by member banks) and C directors (appointed by the Board of Governors)

represent the interests of the general public, and may not be affiliated with any banking

institution. Finally, the President of each Reserve Bank is appointed by its board of directors

subject to approval from the Board of Governors.18

The result is a relatively complex governance

structure that reflects the competing interests of the unique public-private organization

responsible for managing the nation’s payment system, providing banking services to depository

financial institutions and the Treasury, and supervising the nation’s banking system.

16

Smale, pp. 1-2. 17

The President of the Federal Reserve Bank of New York is a permanent member as the New York Fed is

responsible for implementing monetary policy decisions made by the board. The other four seats are assigned to the

remaining 11 Reserve banks on a rotating basis for one year terms. 18

Smale, p.4. Dodd-Frank has eliminated the ability of Class A directors to vote for the President of the Reserve

bank to reduce opportunities for regulatory capture.

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Dodd-Frank and its Implications for the Federal Reserve System

The financial crisis of 2007-2009 forced the Fed to take extraordinary measures to safeguard the

financial system.19

Some of these measures were controversial, and have informed the post-crisis

legislative changes to the Fed’s authority. Among the most controversial policy actions was the

Fed’s emergency lending to specific financial firms. In an effort to prevent what it believed

would be destabilizing bankruptcies, the Fed invoked its emergency lending authority under

Section 13(3) of the Federal Reserve Act to lend to non-bank institutions including Bear Stearns

and AIG.20

Lawmakers, unsettled by the notion of the Fed “picking winners” and providing

assistance on favorable terms to specific institutions rather than a market at large, have since

decided to restrict the Fed’s emergency lending authority. Section 1101 of the Wall Street

Reform and Consumer Protection Act (“Dodd-Frank”) provides that the Fed can no longer

legally lend to any individual, partnership, or corporation. Instead, if it wants to provide

emergency loans under its Section 13(3) authority it will have to do so through programs that

have “broad-based eligibility”, and it must receive approval from the Treasury secretary.21

The weakening of the Fed’s emergency lending authority is accompanied by a simultaneous

expansion of the Fed’s regulatory powers. In passing Dodd-Frank, Congress made the Fed the

primary regulator of the financial system. Prior to the new law, the Fed was responsible for

prudential supervision of bank holding companies and state-chartered banks that are part of the

Federal Reserve System. Dodd-Frank adds to these responsibilities, making the Fed the primary

regulator of thrift holding companies (previously under the jurisdiction of the Office of Thrift

19

For more information on the policy actions initiated by the Federal Reserve during the financial crisis, see Marc

Labonte, “Financial Turmoil: Federal Reserve Policy Responses”, CRS Report RL34427, July 15, 2010. 20

In total, the Fed provided loans to specific firms and groups of companies under at least 22 programs. (Michel,

p.563; GAO, “FEDERAL RESERVE SYSTEM: Opportunities Exist to Strengthen Policies and Processes for

Managing Emergency Assistance”, July 2011. 21

Michel, p.565.

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Supervision), and all systemically important financial institutions (“SIFIs”) identified by the

newly-formed Financial Stability Oversight Council (“FSOC”).22

Further, the Fed’s Chairman is

a voting member of FSOC, giving the Fed influence over which firms ultimately come under its

regulatory purview.

Dodd-Frank intentionally left much of the specific rulemaking to the regulatory authorities

tasked with implementing the reforms mandated by the new law.23

This has empowered the Fed

to impose stricter risk-based capital requirements, leverage ratios, liquidity and risk-management

standards, and exposure limits to individual counterparties. It also has led to the extensive use of

stress-testing as a regulatory tool aimed at improving risk monitoring at individual institutions.24

Finally, the Fed has the authority to require SIFIs to submit “living wills” that would be used to

resolve these firms in a way that minimizes systemic risk.25

The result of these changes is an

extension of the Fed’s regulatory turf, and increased flexibility in how the Fed can carry out its

responsibilities as a prudential supervisor.

Advantages and Disadvantages of Federal Reserve System’s New Legal Framework

The changes to the Fed’s legal authority carry both advantages and disadvantages. In this

analysis, the net result of Dodd-Frank is a decrease in flexibility in managing a potential future

financial crisis and an increase of power for the Fed in regulating the financial system. In

examining the alterations made to the Fed’s legal authority by Dodd-Frank, it becomes clear that

Congress has attempted to shift the focus of the Fed from crisis management to crisis-prevention.

22

Smale, p.6 23

Specifically, Section 604 gives the Fed the authority to “write rules for, impose reporting obligations on, examine

the activities and financial health of, and bring enforcement actions against subsidiaries, including entities regulated

by the SEC of CFTC and state-regulated entities.” Michel, p.564 24

Tim P. Clark and Lisa H. Ryu, “CCAR and Stress-Testing as Complementary Supervisory Tools”, December 20,

2013. 25

Marc Labonte, “The Dodd-Frank Wall Street Reform and Consumer Protection Act: Systemic Risk and the

Federal Reserve”, CRS Report R41384, August 27, 2010.

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The limitations on the Fed’s emergency lending authority outlined above reduces policy

flexibility and may inhibit the Fed’s ability to react quickly and decisively in the event of another

financial crisis. By constraining the types of lending the Fed can engage in under its section

13(3) authority, Congress has created a clear distinction between banks and non-banks. Dodd-

Frank does not prevent the Fed from directly lending to banks, but strongly curtails the Fed’s

ability to lend to non-banks that may pose an identical systemic threat. This distinction is at odds

with the Fed’s heightened responsibility for financial stability. As Cooley et al ask: “Why should

the lender of last resort fail to underpin the financial system because of the legal label borne by a

financial institution?”26

Indeed, doing so would seemingly run counter to Walter Bagehot’s

famous prescription for managing a crisis: “The holders of the cash reserve…must lend to

merchants, to minor bankers, to ‘this man and that man’ whenever the security is good.”27

Further, the requirement that the Fed seek approval from Treasury before using its emergency

lending authority threatens Fed independence and poses an additional bureaucratic delay that

may prove costly during a crisis. At the core of these changes is Congress’ desire to constrain

what they see as a direct threat to Congressional authority over appropriations. The provisions in

Dodd-Frank that reduce Fed power may lead to more accountability and transparency in Fed

policy actions during a crisis. However, these new constraints may also lead to less decisive and

timely action by imposing new bureaucratic hurdles and potentially politicizing the decision-

making process.

Despite new limitations on some of its authority, the Fed’s importance to the financial system

and the economy actually increased as a result of legislative changes in Dodd-Frank. While the

26

Cooley et al. p. 60 27

Walter Bagehot, Lombard Street, page 51, as cited in Cooley et al. p. 60

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Fed already had substantial authority to regulate bank holding companies and systemic risk,28

Dodd-Frank gave the Fed additional regulatory tools, granted it authority to enforce new

prudential rules on banking organizations, and expanded the types of institutions it could

regulate.29

The combination of these changes to the Fed’s legal authority has made the Fed’s role

as the nation’s systemic risk regulator more explicit,30

and increased its responsibilities for

prudential supervision of individual financial institutions.

Dodd-Frank’s emphasis on crisis prevention instead of crisis management is helpful. By giving

the Fed additional regulatory powers, it is more likely that the Fed will be able to contain

systemic risk before it spills over into the real economy. Further, by relying on the Fed for the

implementation of the majority of new regulations, Congress has reduced the likelihood that

political considerations will outweigh pragmatism in designing and enforcing these new rules.31

Although increasing the Fed’s power to intervene in the economy poses new challenges of public

accountability and transparency, pragmatic financial regulation that is designed to reduce

systemic risk, increase the resiliency of the financial system, and prevent regulatory arbitrage is a

desirable outcome, and one made more likely by the Fed’s new legal authorities under Dodd-

Frank.

28

For more information on the Fed’s regulatory powers before the crisis, see Marc Labonte, “The Dodd-Frank Wall

Street Reform and Consumer Protection Act: Systemic Risk and the Federal Reserve” CRS Report R41384, August

27, 2010. pp. 7-14. 29

Michel, pp.564-565. 30

The Fed has always had an implicit mandate for promoting financial stability given its “dual mandate” of

maximum unemployment and price stability. The Fed’s implicit mandate is discussed in a speech by Thomas

Baxter, “Financial Stability: The Role of the Federal Reserve” (Remarks at the Future of Banking Regulation and

Supervision in the EU Conference, Frankfurt, Germany). November 20, 2013. 31

As discussed by Evan Schnidman, “Why the Federal Reserve is Dodd-Frank’s Big Winner” in Harvard Business

Law Review Online, June 2011, the Fed is the only financial regulator that is entirely self-funded, meaning that it

does not rely on appropriations from Congress to implement regulatory reforms mandated by Dodd-Frank.

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References

1. Baxter, Thomas. “Financial Stability: The Role of the Federal Reserve” (Remarks at the

Future of Banking Regulation and Supervision in the EU Conference, Frankfurt,

Germany). November 20, 2013.

2. Bruner, Robert F., and Sean D. Carr. “The Panic of 1907: Lessons Learned from the

Market’s Perfect Storm” in Financial History Magazine, Fall 2007.

3. Clark, Tim P., and Lisa H. Ryu, “CCAR and Stress-Testing as Complementary

Supervisory Tools”, December 20, 2013.

4. Cooley, Thomas F., Kermit Schoenholtz, George David Smith, Richard Sylla, and Paul

Wachtel. “The Power of Central Banks and the Future of the Federal Reserve System” in

Regulation Wall Street: The Dodd-Frank Act and the New Architecture of Global

Finance. Hoboken, N.J.: Wiley, 2011.

5. GAO. “FEDERAL RESERVE SYSTEM: Opportunities Exist to Strengthen Policies and

Processes for Managing Emergency Assistance”, July 2011.

6. Gorton, Gary. “Creating the Quiet Period” in Misunderstanding Financial Crises, New

York, N.Y.: Oxford University Press 2012.

7. Haltom, Renee, and Jeffrey Lacker. “Should the Fed Have a Financial Stability

Mandate?” in Federal Reserve Bank of Richmond 2013 Annual Report

8. Labonte, Marc. “Financial Turmoil: Federal Reserve Policy Responses”, CRS Report

RL34427, July 15, 2010.

9. Labonte, Marc. “The Dodd-Frank Wall Street Reform and Consumer Protection Act:

Systemic Risk and the Federal Reserve”, CRS Report R41384, August 27, 2010.

10. Labonte, Marc. “The Dodd-Frank Wall Street Reform and Consumer Protection Act:

Systemic Risk and the Federal Reserve” CRS Report R41384, August 27, 2010.

11. Meltzer, Alan. ”US Policy in the Bretton Woods Era”, Speech at Washington University

in St. Louis, April 8, 1991.

12. Michel, Norbert. “Dodd-Frank’s Expansion of Fed Power: A Historical Perspective” Cato

Journal, Vol. 34, No. 3.

13. Schnidman, Evan. “Why the Federal Reserve is Dodd-Frank’s Big Winner” in Harvard

Business Law Review Online, June 2011.

14. Smale, Pauline. “Structure and Function of the Federal Reserve System” CRS Report

RS20826 November 10, 2010