Put the Fed, FDIC, and OCC Back In Their Proper Places

The Federal Reserve System (‘Fed’) and its governing Board (‘FRB’) were never meant to regulate, and this still shows. The Federal Deposit Insurance Corporation (‘FDIC’), by contrast, was meant to regulate, and this still shows as well. It’s accordingly a source of frequent failure that we have, since 1999, muddied up the jurisdictional waters of these two agencies which, along with the Comptroller of the Currency (‘OCC’), constitute our principal bank overseers. And the time has come, I think, to give these agencies their functions back – their clear and unadulterated functions.

A bit of history will clarify both how we got to where we are now and why this was a mistake…

The OCC is the oldest of our nation’s bank overseers. Established with the National Bank Act of 1864, its role was to manage the public-private franchise that our banking system’s been since the Civil War era. Prior to this time, the US didn’t issue its own currency. That was left to private sector banks that only states could charter. Different states were differently successful across space and time in keeping these banks stable, however, with the upshot that the paper banknotes issued by the banks would tend to fluctuate in value in relation to each other and in relation to the goods and services they could command.

This ‘monetary Babel,’ as I’ve called it in my scholarship, proved intolerable during the Civil War. The Union effort was the largest undertaking in our nation’s history before the 20th century, and accordingly required massive public spending. That is why the Congress promulgated our first attempt at federal income taxation during this time, and is why the nation could not tolerate unstable paper currencies of changing values over time and across geographic space.

Congress therefore passed, and President Lincoln signed, the Currency Act, the Legal Tender Act, and the National Bank Act in rapid succession from 1862-64. These enactments brought the modern banking franchise we have now. A franchise, as anyone who teaches corporate law can tell you, is a quality control arrangement. The franchisor delegates dispensory privileges to franchisees to disseminate the franchisor’s product. These privileges are conditional, not matters of right, and are subject to rules designed to maintain quality.

The US banking franchise that commenced during the Civil War was a paradigmatic case of franchising thus understood. The franchisor is the United States of America, the franchisees are the nationally chartered banks made possible by the National Bank Act, and the franchised good is the dollar, a.k.a. the ‘Greenback’ – the monetized and spendable full faith and credit of the United States. This is both why banks require public charters – think of them as licenses – and why they’re subject to strict regulation – think of these rules as the contract terms with which banks must abide to ensure that the our nation’s currency is uniform throughout the realm and over time (worth more or less the same across all regions and through time).

The Civil War banking acts did much by way of stabilizing the quality of our currency, but they suffered one infirmity that grew intolerable within 50 years: The OCC which administered our dollar franchise could maintain spatial uniformity well enough, and could ensure that the Greenbacks issued by bank franchisees did not grow worthless due to bank mismanagement. But it could not modulate our money supply in sufficiently flexible a manner to prevent inflations and deflations in the face of sundry ‘shocks’ that struck us as the national economy began to grow at breaknet speed over the later 19th and early 20th century.

But what I call money modulation is what central banks are tasked with doing, and we had examples we could draw on once the need of central money modulation became unignorable by 1913. Happily, an immigrant with rich experience in German central banking – the most successful of the 19th century – moved to America in time to help design our central bank. I refer to Paul Warburg, who with Carter Glass (of subsequent Glass-Steagall renown) designed the first rendition of our Federal Reserve System.

The genius of the early Fed was that it tied the nation’s credit-money supply quite closely to production – as distinguished from mere speculation. The twelve regional Fed District Banks were sited to reflect our sprawling nation’s many distinct regional economies, and tasked with levering startup and small business credit by purchasing – ‘discounting’ – commercial paper issued by firms which could then sell the paper directly to Fed District Banks or to private sector banks that could in turn sell them on to the Fed. This lent the Fed something of the character of a network of regional development banks – exactly as within the Germany whose lessons Warburg brought to the US at a most Providential time.

The early Fed’s discounting practice made the task of money modulation rather easy. By limiting new money issuance (via purchases of firm-issued paper) to productive lending, the Fed effectively ensured that all new money issued would be absorbed by new production, thereby averting inflation – ‘too much money chasing too few goods.’ This was prudently productive monetary policy, ensuring, Goldilocks style, that there would always be just enough money and no more to finance production.

As I’ve written at length in much of my scholarly and pamphleteering work, what caused all this to come acropper were the massive global money imbalances wrought by the First World War, which devastated the productive powers of all leading nations but the US. The resulting credit position of the US as the world’s creditor brought massive ‘exogenous shock’ in the form of payment inflows from our debtors, which duly swamped the Fed’s modulatory capacities – especially in owing to the monetary orthodoxy of the time, which viewed all money as endogenous and thus controllable, while in fact imbalances under conditions of unrestricted capital flow can periodically import ‘exogenous shocks’ as well.

Unaware that the ‘Real Bills Doctrine’ on pursuant to which it had operated since its start was half true and half false, the Fed accordingly watched helplessly as real estate, then stock price bubbles overwhelmed our money system. It accordingly drew the wrong lessons after the crash, not realizing that the Fed would have to pump money into the system to avoid slump once the money it had unwittingly let in to the system abruptly evaporated. The ensuing debt deflation – a.k.a. the ‘Great Depression’ – acted on bank balance sheets much as Jay Powell’s rate hikes now are doing, save ‘on steroids.’ Bank runs ensued, and spread so rapidly that Congress had to found another banking agency by 1933 – the FDIC.

Establishment of the FDIC completed the trifecta of the banking agencies we’ve had unto this day. Designed to forestall self-fulfilling prophecy-style bank runs of the kind that devastated US banking in the early 1930s, it maintained a large insurance pool from which to make depositors in failed banks whole. The hope – largely afterwards fulfilled – was that insurance’s existence would make insurance’s use unnecessary. (A bit like nuclear deterrents, that.) And this largely worked till bank accounts grew large enough to exceed FDIC coverage caps. That of course is what has happened to Silicon Valley Bank this month and several other institutions since.

Because the current coverage caps are obsolete and even dangerous, I have drafted legislation now in Congressional offices to lift them or remove them. With any luck we’ll see this legislated soon. But either way the time has come to recognize that the FDIC has been, since its inception, the best situated of our three banking agencies to regulate our banks for safety and soundness, and that it should accordingly have primacy again.

Why do I say this?

Well, first because it is best situated, and second because we’ve shoved it to the background over the past 25 years. Let’s start with the first point, then turn to the second, which will take us back to where we started in this column.

The FDIC is the best situate regulator for two reasons. First, as trustee of the Deposit Insurance Fund (‘DIF), the Corporation is incented to manage that fund prudently and minimize the likelihood that it will be spent down. This is probably why we have given it what is by far the most potent tool in the bank-regulator ‘toolkit’ – our regimes of leverage- and risk-based capital regulation.

Second, because every bank requires deposit insurance to stay in business, the ‘strings’ the Corporation attaches to coverage are all but unavoidable by banks. This includes, crucially, the nation’s state-chartered banks that are not subject to our OCC. All of our most potent bank rules and enforcement powers are, then, found in the 1800s of the US Banking Code – Title 12 of the US Code. This is surely why our most esteemed bank regulators in recent decades – e.g., Sheila Bair – have been FDIC Chairs, not Comptrollers or Fed Board Governors.

But then, in what sense is it true that we have shoved the Corporation to the background in the realm of banking regulation in the past few decades? Well, this is a longish story that I’ve told in other columns and in scholarship. But the short-playing version is revealing enough …

In a word, since the 1990s we have abandoned our nation’s longstanding tradition of suspicion of large aggregations of financial capital, and accordingly have allowed banks to branch across state line, combine with other species of financial instituion to form large conglomerates, and thus become more concentrated and ‘financialized’ – attending more to speculative opportunities in global capital, secondary financial, and tertiary derivatives markets than to ‘patient capital’ lending opportunities in the productive sectors.

This in turn has led to ever-growing primacy of the Fed where financial regulation is concerned, for only the Fed, prior to the 1990s, took cognizance of the financial system as a whole, rather than to any single silo like the OCC and FDIC, the SEC, the CFTC, the state insurance regulators, and so on. In other words, financialization and conglomeratization after the mid-1990s led oversight responsibility simply to devolve upon the Fed, not to its being carefully and deliberately vested with the Fed.

This ambiguity is why we’re facing volatility in our financial sectors – including now the banking sectors – once again. The Fed is simply too distracted in its many multitasking roles, and too devoid of any real history as a regulator, to do the regulating job with any real alacrity. The OCC, in turn, as noted earlier does not have jurisdiction over our state banks – the kind of bank, not accidentally, that SVB
was. The only way to get our banking regulation right again, then – or at any rate, the simplest way – is just to bite the proverbial bullet and vest the role back with the Corporation.

As noted both above and in a slough of columns that I put out last week, removing caps on FDI will help to bring about this salutary outcome. For the Corporation will have to assess far more premia from banks than it does now once coverage caps are removed. And with the ensuing growth of the DIF will come a heightening of the stakes of its role as the trustee of that Fund.

Let the Fed return to money modulation, then – which will require, as I have written at length elsewhere, a return to (principled, productive and not speculative) money allocation – and let the Corporation do the real regulating. The OCC in turn can upgrade its portfolio-regulatory regime to complement the Fed’s restored concern with productive rather than speculative credit allocation, and work with the Corporation as it does today in finding banks insolvent and in need of resolution.

Do these things, and all of us will know again what our distinct financial regulators are for. And, perhaps more importantly, those regulators themselves will know again what they’re to do.

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