T?he US Treasury has just taken the historic step of proposing a new regulatory regime in which the Federal Reserve would become a systemic regulator. The plan raises three questions. Do we need a systemic regulator? Should the Fed be the systemic regulator? Are there dangers from this proposal for the Fed and its core mission of conducting monetary policy to control inflation and promote maximum sustainable employment? The answer to all three is yes.

Do we need a systemic regulator?

Before the current crisis, financial regulation in almost all countries was designed to ensure the soundness of individual institutions, principally commercial banks, against the risk of loss on their assets. This focus ignores critical interactions, when attempts by individual financial institutions to remain solvent in a crisis can undermine the stability of the system as a whole. As we have seen in this crisis, the failure of one financial institution can inflict severe losses that threaten the viability of many others. In addition, the focus on individual institutions can also cause regulators to overlook important changes in the overall financial system. For example, although the markets for securitised assets and the shadow banking system of lightly regulated financial institutions grew dramatically in the years before the current crisis, the existing regulatory structures did not evolve with them.