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Report | June 2, 2021

Working Paper: New Federal Reserve Governors Must Deploy All of the Institution’s Tools to Advance the Public Interest

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Working Paper: New Federal Reserve Governors Must Deploy All of the Institution’s Tools to Advance the Public Interest

Over the course of the next eight months, Biden will have the opportunity to reshape the Federal Reserve Board of Governors with nominations for up to four of its seven seats, including the positions of Vice Chair of Supervision, Vice Chair, and Chair (listed in the order they will become vacant). In choosing nominees for these posts, it will be essential that Biden consider the full weight of the Federal Reserve’s immense power and select individuals who are ready and willing to deploy every ounce of it to advance the public interest. 

The Federal Reserve’s power to set monetary policy is by far its most widely appreciated. It’s little wonder why. The Fed’s decisions on interest rates have enormous short- and long-term consequences for the U.S. and global economies. And, in recent decades, the board’s excessive focus on one half of its dual mandate —to keep inflation low — at the expense of the other — to target full employment — has had devastating impacts for our country’s most vulnerable communities. It is only within the last decade that that harmful consensus in favor of overly tight monetary policy appears to finally have broken, and the Fed has yet to articulate a clear policy to achieve full employment. Biden must choose four nominees who will defend that progress in the face of inevitable inflation scaremongering and seek out new ways for the Fed to advance its full employment mandate. 

That is not, however, the only metric by which he must assess potential candidates. Although less discussed, the Federal Reserve has many important powers beyond its control of the money supply. How, or if, the Fed uses these powers — which include the ability to supervise individual banks, safeguard financial stability, lend in times of crisis, and set the research agenda for the economics profession as a whole — will also weigh on or buoy the U.S. and global economies in the near- and long-term. If Biden is serious about tackling the country’s most pressing crises, from the pandemic and associated economic downturn to climate change and racial inequality, he will have to choose Fed nominees who are eager to deploy these additional powers creatively and aggressively to serve the public interest. 

REGULATOR:

The United States’ banking regulatory system is famously complex, made up of a host of overlapping regulators. The Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency all have responsibility for supervising and regulating banks. The fact that the Fed’s bank regulatory power is shared can lead to a mistaken impression that it is unimportant. The Fed’s failure to adequately fulfill its responsibilities in this regard only aggravates the misconception that they can be safely ignored. Nothing could be further from the truth. 

While it is true that the Federal Reserve is one among several bank regulators, it stands above the other institutions in several respects. As this graphic from the Federal Reserve’s own report on its “Purposes and Functions” illustrates, the Board has responsibility for a wider variety of financial institutions than other bank regulators. Further, where regulatory and supervisory authority is shared, it is the Federal Reserve that has the highest-level, most comprehensive view of the institution’s risk. This is important as it is most often Fed-regulated bank holding companies’ nonbanking subsidiaries that are the greatest source of destabilizing risk. 

The Federal Reserve also has the sole power to administer many of Dodd-Frank’s most important financial stability-related reforms. The Fed is responsible for implementing the law’s more stringent standards for the country’s largest financial institutions, including enhanced regulation for those institutions that the Financial Stability Oversight Council designates “systemically important.” It has significant leeway to decide how strong those rules are and to which institutions they will apply. It can also go even further to simplify or break up banks (if it concludes their resolution in a crisis would be impossible) and force divestment from risky subsidiaries, powers that if fully employed could force Glass Steagall-like separation without the need to pass legislation. Without a Board willing to use them, however, these key planks of Dodd-Frank are rendered useless. 

The Fed’s outsized power makes the deregulatory regime that this Board ushered in, under the direction of Vice Chair of Supervision Randall Quarles and Chair Jerome Powell, all the more dangerous. Biden must nominate a new majority that is ready to reverse those changes for the financial institutions under its supervision, including to the Volcker Rule, capital requirements, stress tests, living wills, and bank ownership rules. 

They shouldn’t, however, stop there. To address economic and racial inequality and climate disaster, the next Fed board must both make better use of familiar tools and look to untapped regulatory powers. Below are a few possibilities: 

Community Reinvestment Act: The next Fed board can work to strengthen the Community Reinvestment Act (CRA), a civil rights-era law designed to combat redlining by requiring banks to work to meet the credit needs of low- and moderate-income neighborhoods. The CRA came under threat in the Trump era, thanks to Comptroller of the Currency Joseph Otting’s personal vendetta against the measures. The Fed, in a rare and welcome move, ultimately declined to participate in Otting’s destructive effort, largely thanks to pressure from Board member Lael Brainard. But there are very real problems with the law’s implementation that do need to be addressed: namely, it is too weak. The next Fed board should advance as strong a standard as possible to ensure that the banks under its supervision live up to the law’s goals of remedying racial inequity in credit access.  Without any new legislation, the Fed and its fellow bank regulators have enormous power to expand and strengthen the CRA, including its ability to tackle problems that were not top of mind when the original law was enacted, like the racially disparate effects of climate change

Mergers: The Federal Reserve’s role in bank mergers is among its most consistently overlooked. Given that the Fed has not rejected a merger in approximately twenty years, that shouldn’t come as a surprise. It is important, however, that the institution’s failures on this front not be used as an excuse for them to continue. That is especially true at a moment when most analysts agree the country is facing a wave of new bank mergers. This could cause serious damage. In a letter to Department of Justice regarding its bank merger rules, the American Economic Liberties Project, Open Markets Institute, and Washington Center for Equitable Growth explained that “the harms witnessed in communities impacted by bank consolidation include reduced small business formation and access to credit, greater income inequality, increased reliance on predatory financial products due to the reduced availability of traditional banking services, increased crime and evictions, and decreased economic growth.” The current Board of Governors has continued the tradition of failing to challenge this consolidation, even as members of the public make clear that they oppose it. In one of the more egregious examples, the Board approved the merger of BB&T and SunTrust — the largest bank merger since the financial crisis — despite calls from the National Black Farmers Association and others to block it. Worse still, the Fed is currently taking steps to make its merger review standards even more lenient. 

The time is ripe for a break with this dangerous consensus. Biden must nominate governors with the resolve to challenge decades of non-enforcement, both through individual merger cases and stronger regulation. 

Climate Finance: The Federal Reserve’s regulatory powers are most notable and necessary in the climate finance arena, where the timeline for action is short and the stakes existential. As it stands, the financial system is a major contributor to climate disaster and is simultaneously under significant threat from its effects. Avoiding the catastrophic financial instability that could result from climate-fueled natural disasters and a transition away from carbon energy is solidly within the Fed’s responsibility, as laid out in Dodd-Frank. That law also gives the board numerous tools to drive climate action and ensure stability, all of which are being un- or under-used. The Federal Reserve board can mandate (not merely suggest) that climate risk factor into banks’ stress tests. It can also, alongside other bank regulators, “consider climate-related risks in the supervisory and examination processes.” Most significantly, for systemically important financial institutions, the Fed can mandate divestment from destabilizing and risky carbon assets. That power is unique to the Fed and absolutely critical to achieving a rapid and orderly transition.  

EMERGENCY POWERS

With each new economic crisis, we see ominous headlines about the Federal Reserve’s power almost magically growing. It is more accurate to say that with each successive crisis, a greater share of its legal authority is realized. Following the financial crisis in 2007 and 2008, the Fed took the unprecedented step of purchasing securities directly. In response to the pandemic-induced downturn, the Board went much further. Even before Congress had passed the CARES Act, the Fed had established facilities to lend directly to large corporations. With additional appropriations from the Treasury from Congress to serve as a backstop, the Fed opened additional facilities for main street businesses, municipalities, and nonprofits. 

These steps were an important part of containing the crisis but they also gave the Fed even greater power to shape market outcomes in the immediate- and long-term. For instance, Wall Street benefitted handsomely from the facilities the Fed designed for its use. The oil and gas sector, which was struggling prior to the downturn for reasons unrelated to the pandemic, also benefited from the Fed’s largesse. An analysis by the organization InfluenceMap found that the Fed’s Secondary Market Corporate Credit Facility was significantly overweight on oil and gas assets despite the low quality of these investments. Many fossil fuel companies also benefited from the Main Street Lending program after a successful push by the industry lobby and congressional Republicans to get the Board to change the terms of participation. Meanwhile, many small and medium-sized companies struggling as a result of the pandemic were unable to take advantage of easy credit from the Fed.

Similarly, the Fed’s Municipal Liquidity Facility, under the direction of former and future EY advisor Kent Hiteshew, offered such unattractive loan terms (far less favorable than those extended to corporations) that only two used the program. This was not for a lack of need: local governments across the country had the second highest rate of net job losses among sectors, shedding just shy of a million jobs between February 2020 and April 2021. That is behind only accommodation and food services. State governments across the country lost over 300 thousand jobs. It is clear from the differences between these programs that the Fed continues to reserve its most aggressive and creative problem-solving for Wall Street, not the public. The consequences in this case will continue to be felt well into the future, whether in one of a variety of asset bubbles, small business closures, or the delay of inevitable fossil fuel industry bankruptcies.

We cannot know when the next economic downturn will come, but it seems safe to say that when it does, the Federal Reserve will play an important role in the response. Biden should choose nominees with this in mind, elevating those who will not be afraid to stand up to industry lobbyists and their paid-for lawmakers when they come looking for undue favors. Board members should be prepared to place common-sense conditions on loans to the country’s largest corporations and work hard to ensure the Fed’s power serves the public interest directly and indirectly.

Of course, “common sense” might mean different things to former private equity titans than, say, a Democratic economist.

NEW PROGRAMS

Crisis or no, it is highly unlikely that the Federal Reserve’s power will remain unchanged over the course of the next decade plus. Many legislative proposals currently under discussion, from postal banking to the Green New Deal, envision an increased role for the Federal Reserve. Moreover, inevitable technological evolution will necessitate that the Fed take on new focus areas and do some of what it already does differently. For example, it already has a pilot underway for a new, instant interbank payment system, FedNow. With many salient questions of design and implementation remaining, it will fall to the next Board to ensure that the system is public, equitable and successfully implemented. According to Federal Reserve Governor Lael Brainard, the board is also “stepping up its research and public engagement on a digital version of the U.S. dollar.” It seems likely that the Board will decide if and how to take action on that question within the next few years. 

We cannot predict everything that the Federal Reserve will take on in the coming decade, but Biden can and should choose nominees who can be trusted to tackle new problems with the public interest top of mind. 

SETTING THE RESEARCH AGENDA AND SHAPING THE ECONOMICS FIELD 

Another significant source of Fed power derives from its central position in the economics profession. The Federal Reserve is a major producer of economic data on which researchers throughout the field rely. As a result, Fed economists’ decisions about what data to collect and how reverberate out into research agendas across the country. In other words, relatively small shifts within the institution could deliver big returns. With that in mind, many have advocated that the Fed make greater use of this power by developing datasets that would facilitate research into racial inequity and by undertaking greater consultation with experts and researchers outside of the institution about the types of data that would be most useful to them. Research undertaken as a result of these changes could have a direct impact on policy at all levels. Consider, for example, how a paper from the Minnesota Fed in the early 2000s helped to spur a wave of research demonstrating the large returns on investments in early childhood education. 

The Fed also has an important role to play in diversifying the top tiers of the economics profession. As a recent Roosevelt Institute working paper explains, “Fed hiring, directly and indirectly, plays an important role in certifying and building the network of economists who shape debates about the economy—not just here but globally.” As it stands, Fed hiring appears to be aggravating, rather than rectifying, the economics profession’s lack of diversity. 

A New York Times analysis found that “Black people are less represented within the Fed than in the field as a whole.” While “3 to 4 percent of the U.S. citizens and permanent residents who graduate as Ph.D. economists each year” are Black (already a troublingly low share) only 0.5 percent of those on the Fed’s staff in Washington are. This striking lack of diversity undoubtedly weighs on the Fed’s priorities and decision-making. As we are seeing now, the Federal Reserve can also serve as a pipeline into political positions elsewhere in the executive branch, making these deficiencies all the more consequential. If Biden is serious about addressing racial inequity, he will nominate Fed leaders who are committed to diversifying the institution.  

Conclusion

Between its monetary policy, regulatory, and agenda-setting tools, the next Federal Reserve Board will have immense power to help regular people, directly and indirectly. It could also be responsible for great harm through both action (e.g. further deregulation) and inaction (on climate change). To ensure his Federal Reserve achieves the former, Biden must select governors who will apply the full suite of the institution’s power aggressively and creatively to advance the public interest.

Header Image: “Federal Reserve Building in Washington D.C. – Illustration” by DonkeyHotey is licensed under CC BY 2.0

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