WASHINGTON — Nearly a century after its creation, the Federal Reserve System faces growing questions over whether its structure is outdated and needs reworking.
"If we were to start over again and make a blueprint for the central bank of the United States, would we do what we did at the beginning of the 20th century?" asked Ralph Bryant, the Fed's former director of international finance who is now a senior fellow at the Brookings Institution. "Almost surely we wouldn't."
Potential changes run the gamut from stripping down the role of the 12 Fed regional banks, making them more akin to other regulators' field offices, to altering their corporate governance structure.
Even the 12 banks' location is under discussion. Missouri has two Fed banks, and a drive from Philadelphia to Boston passes three more, but the entire West Coast reports to the San Francisco Fed.
"The distribution of banking and economic activity, as well as population density, across the country was very different when the Fed was set up than it is now," said Robin Lumsdaine, a former associate director in the Fed's banking regulation and supervision department who is now a professor at American University. "The Federal Reserve Act already provides for possible readjustment or establishment of new districts, not to exceed a maximum of 12 districts."
Last month, the Senate approved an amendment to a nonbinding budget resolution calling for an evaluation of the number of Fed banks and their cost. The amendment, sponsored by Senate Banking Committee Chairman Chris Dodd and the panel's top Republican, Sen. Richard Shelby, was an effort to push the Fed toward greater transparency.
For decades, the regional Fed banks' primary business was processing checks, a function that is considerably less important now. In the past 18 months much attention has shifted to the banks' discount window role, a key source of financial institution liquidity.
But they operate in an awkward space between the private and public sectors.
The banks are privately owned by member banks but serve a significant public function as supervisors of bank holding companies.
"The Federal Reserve banks have always played an odd role," said Douglas Landy, a partner in Allen & Overy LLP and formerly a lawyer at the New York Fed. "They are owned by their members. However, they have supervision power. … It's this weird hybrid."
Central bank officials argue that the current system works.
Given the Fed's recent intervention in financial markets, "it is natural … for legislators to want to scrutinize what we do," Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, told reporters after an Atlanta Fed conference this week. "The structure of the system, with 12 Federal Reserve banks, has served our nation well. I think it has provided a measure of insulation for the monetary policy process from short-term, partisan political pressures."
Though major changes are not imminent, recent events have heightened scrutiny of the 12 banks. Stephen Friedman, the chairman of the Federal Reserve Bank of New York, resigned last week amid questions about potential conflicts of interest. He is a former top executive at Goldman Sachs & Co., which is now regulated by the New York Fed, and remained on the holding company's board of directors. Fed policy bars officers of banks from the type of board seat Friedman held, and the New York Fed sought a waiver for him. While the request was being considered, Friedman bought 37,300 shares of Goldman stock, raising conflict-of-interest questions.
As a result, House Financial Services Committee Chairman Barney Frank said last week that he wanted to examine conflict-of-interest issues at the Fed banks — but said a proper overview would have to wait until the financial crisis ends.
One possible reform would be a clarification of the role directors should play. Friedman was a Class C director at the New York Fed, which meant he was appointed by the Fed Board in Washington to represent the public's interest. He has been criticized for remaining in his post after Goldman became a bank holding company last year. But others say that, given his Goldman background, he should never have been a Class C director in the first place.
"It doesn't seem like his sitting on the New York Fed board was consistent with that classification of directors," said Cornelius Hurley, a former Fed lawyer who is now the director of the Morin Center for Banking and Financial Law at the Boston University School of Law. "He was hardly the type originally conceived of to sit in the Class C group."
Beyond Class C directors, members of the regional Fed banks appoint Class A directors to represent their own interests and Class B directors to make up another group representing the public interest. In addition to overseeing the operation of the regional Fed banks, these directors make suggestions on the rate for discount window borrowing.
Many corporate leaders hold seats that are dedicated to the public. At the New York Fed, the chief executives of PepsiCo Inc. and General Electric Co. are Class B directors. The chief executive of United Parcel Service and the chief financial officer of Home Depot are Class C directors at the Atlanta Fed, and the vice chairman of Chevron Corp. holds a Class C seat at the Federal Reserve Bank of San Francisco.
"It seems really, really awkward," said Kevin Jacques, the chairman of finance at Baldwin-Wallace College in Berea, Ohio. "It looks really, really clubby."
The real issue, some said, is confusion over what constitutes "public interest" at the Fed.
"Is it a macro public interest like, 'Don't crash the system?' " Landy asked. "Is it a public interest like, 'Don't lose taxpayer money?' … More direction on what these people should be doing makes sense."
But Susan Phillips, who was a Fed governor from 1991 through 1998 and is now the dean of George Washington University's School of Business, said the directors have no influence over banking policy.
"Those boards of directors don't deal with that kind of policy issue," she said. "They mostly focus on the running of the bank. Not the supervisory side but the running of the bank in terms of the processing of checks and money dispersion and the gathering and processing of economic information."
Still, at least some aspects of the relatively secretive regional Fed system could be opened up to more scrutiny by making the presidency of the New York Fed a position that would require Senate confirmation. "If you're looking at whether a public-private role is the right thing to do now, that's the one where you should really start looking," Landy said.
Advocates of this idea said it makes sense to single out the New York Fed president because he is vice chairman and the only regional Fed president who is a permanent member of the policymaking Federal Open Market Committee. Fed governors, who, together with Chairman Ben Bernanke, are the other permanent FOMC members, must win Senate approval to take their seats. "If you're going to be a permanent member of the FOMC, just like the members of the Fed are permanent members of the FOMC — and they have to be approved by the Senate — why shouldn't the head of the New York Fed be approved by the Senate?" Hurley asked.
The role of the New York Fed, which has always been the central bank's Wall Street watchdog, has also become increasingly important to the banking sector. It now runs several liquidity programs, including the Term Asset-Backed Securities Loan Facility, which is intended to jump-start consumer lending nationwide. The New York Fed also buys mortgage-backed securities from Fannie Mae and Freddie Mac, which has been credited with bringing down mortgage rates. "The head of the New York Fed … has significant power and, probably next to the chairman, is the most powerful person in the system," said Gil Schwartz, a former Fed lawyer now working in private practice.
Others, however, argue against filling the post through the confirmation process. They note that all the power residing at the New York Fed has been delegated to it from Washington, which could revoke it. That makes it inappropriate to hand over the New York Fed to political forces.
"I wouldn't be in favor of elevating it to the equivalent of the board," Lumsdaine said. "Currently under the Federal Reserve Act, the board supervises and regulates its operations, as well as those of the other 11 Reserve banks."
Another possibility would be converting the regional Fed banks into field offices like those of the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. This would effectively demote top Fed officials like William Dudley, the current New York Fed president, to a civil servant status. Such an approach would let the Fed sidestep the awkwardness of having supervised institutions that technically own their supervisor. Members of the Federal Reserve System are required to hold 3% of their capital as stock in their regional Fed bank. The stock is not traded publicly and does not fluctuate, paying a 6% annual dividend. This structure could be eliminated in a conversion.
"It is an odd-looking appearance to have the banks own their regulator," said Mark Flannery, banking chairman at the University of Florida. "If you're my regulator and I can vote for your board of directors and they might fire you in a way I don't like, that's a qualitative effect."
Moreover, a conversion to field office status would not change much about how Fed supervisors work on the ground. "The Federal Reserve has a role in bank supervisions and regulation, so you have examiners that run out of these regional Feds," said Jacques. "The FDIC and the OCC have exactly the same thing."
Still, Lumsdaine said a conversion would disrupt contributions the Fed banks make beyond supervision, particularly on the central bank's policymaking committee. Presidents from the regional Fed banks rotate one-year terms on the FOMC. "The districts have additional roles with respect to providing input into the conduct of monetary policy, as well as banking-related operations such as check processing," she said.
Phillips said the regional Fed banks play a crucial role in developing monetary policy — but that this role would be lost if the banks were downgraded to field offices.
"They bring all that information to the table," she said. "When we'd get together for FOMC meetings, the governors would tend to wait back and wait until the presidents spoke about their districts before they said anything themselves. They knew the presidents were bringing first-hand information."
A larger question looming over this debate — one that has dogged the central bank for years — is whether the Fed should be involved in day-to-day supervision at all, given its focus on monetary policy. "One of the basic questions is whether or not the Fed should be involved in banking supervision," said Bert Ely, an independent consultant in Alexandria, Va. "That debate is back on the table now."