Finance & economics | The Federal Reserve

The Tarullo show

The Fed’s broad but woolly powers give its senior officials vast discretion

The book of Daniel
|New York

IT IS the job of the Federal Reserve, according to the law that created it in 1913, to supervise banks and “to furnish an elastic currency”, among other things. Those tasks, it turns out, are quite elastic themselves. The Dodd-Frank act of 2010, which overhauled America’s financial regulations in the wake of the crisis, requires the Fed to write no fewer than 58 new regulations. It gives the Fed a say in everything, from how much collateral firms trading certain derivatives should provide their counterparties, to the “diversity policies” of financial institutions.

Dodd-Frank also creates a new position within the Fed, a vice-chairman responsible for regulation, to oversee many of those new rules. The president has never nominated anyone to fill that post, perhaps for fear of the awkward debate that would doubtless ensue during confirmation hearings in the Senate, about how appropriately the Fed was exercising its new powers. In fact, two of the seven seats on the Fed’s board are currently vacant. In the meantime, the administration of the Fed’s ever-expanding powers has fallen, more often than not, to Daniel Tarullo, a former law professor whom Barack Obama appointed to the board days after taking office in 2009.

Mr Tarullo sees Dodd-Frank as reversing three decades of deregulation. So far, the Fed and others, he says, have focused on the biggest problem created by this laissez-faire approach: the emergence of financial institutions that are too big to be allowed to fail and yet are far from failure-proof. But the regulators’ intention, he continues, is to tackle weaknesses throughout the financial system, not just at big banks.

At first glance, for all the Fed’s new powers, not much has changed. Big banks are bigger than ever. Officially, indeed, the number of too-big-to-fail entities has expanded in recent years, as the Fed has declared several insurers to be “systemically important”—its euphemism of choice.

Yet the Fed’s leverage over big banks, in particular, is enormously enhanced. It administers annual “stress tests” that not only examine the quality of loans and of management, but also determine what share of profits, if any, can be distributed to shareholders. Last year, for instance, the Fed blocked planned dividends and buy-backs at five big banks. Banks must also submit “living wills” to the Fed. These are intended to ensure that firms can be easily sold or closed if they fail, but, by extension, allow the Fed to dictate what businesses banks should be in. New rules on funding, in addition to those on capital, allow the Fed to influence how banks raise their money, as well as how they invest it.

The staff of the Fed’s supervision division in Washington, DC has expanded by almost two-thirds since 2007. The heart of the division is a new unit, supervised by Mr Tarullo, with a suitably vague and intimidating name, the Large Institution Supervision Coordinating Committee (LISCC), the mere mention of which sends a shudder down the spine of any bank executive. Meanwhile, the Fed’s regional branches, which played a central role in banking supervision prior to the crisis, now take a back seat.

This has widened the distance between regulators and the regulated, to both good and bad effect. The boards of the regional reserve banks are typically populated by bank executives, and so are often seen as insufficiently independent. But the new, Washington-based, system is often disparaged as reliant on intricate models that do not really grasp how banks serve their clients and the economy.

The Fed will continue to tweak the rules for banks, Mr Tarullo says, to encompass more economic scenarios, to bring about changes in the legal structures of banks and possibly even to make them more efficient. But the big changes that are still to come, Mr Tarullo says, are in “lacunas” in the regulatory system, where risk can fester unobserved. Using woolly phrases such as “prudential market regulation” and “systemic policy”, the Fed is claiming the right to interfere in any corner of finance, not just banks.

In particular, the Fed is now focusing on institutions which have leverage and funding sources susceptible to runs. Bond funds, which give investors the right to sell up instantly but which invest in illiquid securities, are a potential target of new regulation. This, though, is just the beginning. Markets are dynamic, Mr Tarullo says, and as a result regulators will have to revise and expand their rules constantly.

To many, this is the only way of ensuring a sound financial system. To others, it leads to a world in which a deluge of incomprehensible rules gives distant central bankers control over the allocation of capital. The sceptics are not just bankers, and not just opponents of regulation. David Skeel, a law professor at the University of Pennsylvania, is an enthusiastic supporter of the Fed’s efforts to rein in the big banks, but is critical of how opaque the new rules are. In his view, the Fed’s vague mandates and the enormous discretion they put in the hands of its officials undermine the rule of law. At the least, it is ironic that the system that the likes of Mr Tarullo are so carefully constructing could easily be undone by successors with a different view.

This article appeared in the Finance & economics section of the print edition under the headline "The Tarullo show"

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