The centerpiece of Senate Banking Committee Chairman Chris Dodd's financial reform proposal is a new Financial Institutions Regulatory Administration to regulate all banks and thrifts and their holding companies.
Though crucial flaws exist in Senator Dodd's FIRA proposal, it has promise.
The proposal would consolidate into a one agency the regulatory functions of the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of Thrift Supervision. FIRA would be headed by a presidentially appointed chairman and have representatives of the FDIC and Fed on its board.
The proposal would create a strong, independent agency and unify bank and bank holding company supervision. It has never made sense to me to separate supervision of a bank from its parent company. Moreover, I have always been uncomfortable with the comptroller of the currency being part of the Treasury Department rather than independent.
Though some may view the proposal as a slap at the Fed, I do not. I wrote in 2006 that conversion of the largest banks to national charters, coupled with the growth in size and power of these institutions and the declining importance of the bank holding company structure, seriously eroded the Fed's authority over the largest banks.
A stronger, more objective Fed might have checked some of banks' excessive growth leading up to the crisis. The Dodd proposal would shift relative power back to the government by moving the comptroller into an independent agency with the Fed.
A major flaw in the Dodd plan is that it would substantially weaken the FDIC. This agency cannot perform its crucial watchdog role without examination and enforcement powers. If the FDIC should lose those powers, systemic risks would grow significantly.
We must never forget that the S&L regulator, leading up to the S&L crisis, had absolute authority, including control over the deposit insurer. The nation paid dearly for this lack of checks and balances.
Another problem with the Dodd proposal is that it would destroy the "dual" or state/federal bank regulatory system by placing state banks under the supervision of FIRA. This flaw could easily be remedied by directing the FDIC to oversee state banks and thrifts and their holding companies.
Two actions are needed to strengthen the FDIC and contain systemic risks. The first is to reduce the FDIC board from five members to three, as it was until 1989, with all three being appointed.
The agency now has three appointed members plus the comptroller and the head of the OTS as ex officio members. Whenever there is one vacancy or more among the appointed members, the current structure puts the comptroller and OTS in position to control the FDIC.
This is not hypothetical.
Due to continual vacancies on the FDIC board, the comptroller and OTS chief were able to curtail FDIC examinations of national banks and thrifts in 1993, and the FDIC board could not reverse this action until 2004. The FDIC as watchdog was neutered during the heyday of growth preceding the current crisis.
We should also restore the FDIC's ability to determine that "severe financial conditions" exist, so that it can use its emergency authority. This authority was instrumental in letting the FDIC and Fed guide us through some 3,000 bank and thrift failures during the 1980s, including many of the largest in the country, without causing panic.
Congress, after the S&L crisis, removed the FDIC's authority to declare an emergency unless it were requested by the secretary of the Treasury in consultation with the president. This politicized the crisis management system and subordinated the FDIC and Federal Reserve to the Treasury.
The results — including the ill-conceived Troubled Asset Relief Program and public stress tests for 19 of the largest banks — were extraordinarily harmful to the economy and the financial system.
Just as generals, not politicians, should determine how to fight wars, financial crisis management should be left to professionals at the central bank and the deposit insurer.
The Fed also has emergency lending authorities. Perhaps the FDIC and Fed should each have a seat on the other's board to give each a much better window on systemic risks. And perhaps a two-thirds vote of each board should be required to approve of the use of emergency authorities by either agency. This would establish control of the process without politicizing it.
My hat is off to Senator Dodd for opening the debate on serious regulatory reform. The issues are complicated and the stakes are very high. We should not rush to judgment on the issues; we need to get it right this time.