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In a recent interview on CNN en Español I discussed the evolving role of the U.S. Federal Reserve Board and its implications for developing countries. People in Latin America are following this issue closely. That’s because the global crisis has reminded everybody that an unstable financial sector in the industrial countries has powerful ripple effects not only on the financial sector of developing countries but also on the real economy, with serious consequences for poverty and inequality.

The visibility of the Fed in financial markets has increased dramatically during the crisis. Essentially, Ben Bernanke redefined what it means for the central bank to be “lender of last resort.” Besides reducing interest rates to zero, the Fed created new facilities and largely broadened the scope of existing instruments, such as using repurchase agreements to absorb securities it had never before accepted. Some expressed concern that this new “activist” Fed could expose taxpayers to losses if these securities proved to be worth less than expected. Also, the broad provision of liquidity to a large number of diverse financial institutions without regard for the soundness of these institutions raised moral hazard concerns (i.e. worries that financial institutions might be more likely to take on excessive risk if they perceive that the Fed will bail them out in a crisis).

More recently, the proposed regulatory and supervisory authorities for the Fed are causing unease as well. Under the Obama administration’s proposal for financial regulatory reform, the Fed’s responsibilities would expand to include supervising all systemically important financial institutions, even if they are not banks (like AIG, for example). And, in addition to monitoring individual institutions, the Fed would monitor the risk to the financial system posed by their interconnections.

As I explained in the CNN en Español interview, I believe that the Fed’s proposed expanded regulatory and supervisory authority has merit for two important reasons: crisis management and crisis prevention. Regarding crisis management, it is important to recognize that in every major banking crisis around the world, the central bank is always called upon to inject liquidity to the financial system. But deciding how much to provide requires knowledge of both the quality of the financial institution needing the liquidity and the interconnections of that institution with the rest of the financial system.

As for crisis prevention, in my view, the current crisis could have been largely avoided—or at least greatly ameliorated—if the Fed understood the complex links between Lehman Brothers and other systemically important institutions (again, AIG is one such example). A central bank can only deal with a crisis effectively when it has sufficient knowledge of the entities involved and their interrelationships.

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But this does not mean that the Obama administration’s proposed “super-regulator” role for the Fed is not without risk. The independence of monetary policy, for example, could be questioned. The Obama Proposal would create a council of regulators chaired by the Treasury Secretary to “advise the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability.” While communication among regulators is important, I fear this council could ultimately invite interference in monetary policy by giving the Treasury Secretary a lever into the workings of the Fed. Extreme care needs to be taken in the passing of a law to avoid such an undesirable outcome. In this same line of thought, the proposed Federal Reserve Transparency Act of 2009 is completely unacceptable. The bill would allow the Comptroller General of the Congress to audit the Fed’s discussions on monetary policy. This would severely curtail the Fed’s ability to pursue independent policy decisions. Protecting the autonomy of the Fed needs to be a central objective in new regulatory and supervisory legislation.

Getting the right division of supervisory responsibilities will be crucial to ensure the stability of the financial system in the United States and elsewhere. In my view, however, this will still not be enough to prevent global financial disruptions of the kind the world is now experiencing. In a globalized world, financial interconnectivity goes well beyond geographical borders, and so must financial supervision. This will ultimately require extremely close coordination among financial supervisors around the world or—in my view, even better—a global financial supervisor.

Disclaimer

CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.