Senator Chris Dodd's latest bash at reforming financial regulation hands wide prudential authority to the Federal Reserve, with input from a council of regulators. With appropriate teeth, such a mix stands a decent chance of improving systemic oversight.

It is broadly logical to expand the central bank's role to include bubble-prevention. It is already a hands-on bank regulator and the lender of last resort should have something to say about systemic risk.

Yet while the Fed's efforts as a regulator have arguably been better — or at least no worse — than other watchdogs', it hasn't dealt with, say, hedge funds. Critics also argue that it didn't crack down on systemic risk with much enthusiasm in the past, even when it could have.

That's where the other piece of Dodd's puzzle, the Financial Stability Oversight Council (FSOC), comes in. This body would recommend increasingly tough rules for the Fed to set on capital and other measures for financial institutions as they grow bigger, so that firms get less risky as they get larger.

The Council would also be able to require Fed regulation for non-bank financial companies — insurers, hedge funds or whatever else financial whiz-kids dream up — deemed systemically risky. And to help avoid bailouts of too big to fail institutions, the Fed would be able to propose forcible break-ups, subject to the council's approval.

While this two-way street has its advantages, there could be traffic jams. Six of nine FSOC members — not a group known for a consistency of views in the past — would need to agree, and there might be hot spots which neither the FSOC nor the Fed noticed.

Dodd's plan would also add yet more to the Fed's bailiwick — oversight of a new Consumer Financial Protection Bureau. Properly funded and resourced, all this might be feasible. But the new tasks could distract the central bank from its monetary policy mandate and attract political interference.

The biggest risk to the new plan, however, may not be in the devilish details or even the broad thrust, but in the feel-good factor that credit bubbles inspire in regulators as well as markets. But it's hard to legislate against groupthink.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.