What’s a Central Bank to Do?
Remembering the Lessons of Organization Theory in Rethinking the Fed

Karen Shaw Petrou
Managing Partner
Federal Financial Analytics, Inc.

A critical financial-reform decision is, of course, to determine the new role of the Federal Reserve. This involves not only reckoning with the changes in its monetary-policy responsibilities forced by all the new credit facilities, but also suggestions that the central bank should be converted into a systemic-risk regulator. As usual with discussion about the Fed, much of this debate is driven by economists. But, there is an important lesson from organization theory that should also be carefully considered as the Fed is reconstructed in the wake of the financial crisis: bigger almost always isn’t better. In fact, the best way to institute effective systemic-risk regulation isn’t to give it over to the Fed. Instead, it would be better to reform the existing regulatory structure and create a new set of checks and balances to ensure reformed regulators do not return to their old, complacent ways.

Organization theory is at its heart the study of how groups of people work together — or don’t — to achieve goals often far afield from the personal ones that drive each individual within the larger association. In organization theory, combining several problematic organizations into a new, big one is called “synoptic” decision-making. It’s the opposite of incremental, test-it, fix-it, action plans which rely on remedying known problems in measurable, reversible ways. A good deal of incremental decision-making is based on the hard lessons from engineering – think about why planes have more than one big engine to understand the value of multiple, competing organizations charged with the same task. In contrast, synoptic actions almost always combine numerous failing parts into a bigger machine – with the Department of Homeland Security, not to mention some of the nation’s largest financial-services firms, as unfortunate examples of “reform” and “efficiency.”

As this cursory overview of one critical lesson of organization theory demonstrates, there are significant risks to making the already giant Federal Reserve still bigger. The important Group of Thirty report on financial reform has recognized the major control and risk challenges that result from giant, diversified financial-services firms, but fails to draw from this lesson the problems that will result should the FRB take on the role the G-30 recommends as a systemic-risk regulator.

The Fed’s jobs now encompass an already complex array of critical tasks. Monetary policy is no mean feat, but it’s not the only essential one with which the FRB is charged. The others include managing the nation’s payment system and ensuring its safety — an often-overlooked Fed responsibility that is at the heart of a sound financial system and growing economy, not to mention an area in which many improvements are overdue. Then, the Board is also the regulator of all of the nation’s financial holding companies or FHCs. FHCs are the biggest, most complex and most diverse banking organizations, and the Fed’s work here hasn’t been all that stellar as Citi, BofA and other recent casualties make painfully clear. The FRB is also the regulator of bank holding companies and state member banks, a role that puts it in direct contact with hundreds of banks around the country. It’s charged with surveying the condition of the nation’s economy through the twelve Federal Reserve Banks, which themselves present numerous managerial challenges. Finally, the Fed is the nation’s back-stop consumer regulator, responsible for essential rules aimed at ensuring appropriate disclosures and consumer protection in products ranging from mortgage loans to credit cards to all sorts of emerging electronic-payments instruments.

Getting all that right isn’t easy, as the Fed’s recent lapses show. Adding to this an even more challenging task – supervising all of the nation’s biggest firms to prevent any from posing systemic risk – would, thus, pose formidable challenges. At the least, this additional, high-risk and high-profile charge would challenge the political independence that lies at the heart of successful monetary policy. The Board’s other responsibilities already contradict that independence; adding another task outside central banking could doom the Fed’s essential separation from day-to-day politics.

Even worse, though, adding systemic-risk to the Fed’s responsibilities could doom this essential element of financial-industry reform. The Board might just lard another layer of regulation atop all those in place and soon to be added for systemic-risk firms. In fact, naming the Fed as systemic-risk regulator could mask a fundamental challenge here: identifying which regulated and non-regulated entities in fact pose systemic risk. This tableau will by necessity be an evolving one – place one set of firms (e.g., hedge funds) into the systemic-risk framework and another will quickly pop up around it to evade the new standards. Some firms will start small – think Long-Term Capital Management – but grow or become so intertwined with others that they too pose systemic risk even if not now named in the new systemic-risk line-up.

So, let’s go back to organization theory and the lessons it learns from engineering. We know we need to build a better control system for financial-services firms, based on the missed calls of all of the current financial regulators (the Fed included). In stark terms, we have two choices: put a master switch atop all the other regulatory systems even as we fiddle with the sub-systems or improve all of the smaller control systems in transparent, measurable ways and install a new, top-level, high-decibel warning bell when sub-systems fail.

The latter choice makes the most sense to me. It ensures redundancy – multiple, competing smaller systems will still monitor each of the individual components as a whole. This isn’t to say the OCC, OTS, SEC and so on should be left as is – far from it. They need significant improvement but this could be overlooked or left half-done if we focus too much on the Fed. Rebuilding the current framework to ensure accountability, transparency and prompt corrective action would result in quick, measurable reform. Should any of the smaller control systems falter, then others at or near the same level must be triggered to intervene. Should this then fail, a system independent of the sub-systems – Treasury? – must be charged with the responsibility to overrides the sub-systems and the power to takes the rudder.