Nov. 16 (Bloomberg) -- Members of Congress are plumping their feathers, holding press conferences and congratulating themselves for a job well done.

Not that they need an excuse. This time, though, they’re celebrating the completion of a draft bill to overhaul the financial regulatory system.

The proposed legislation from the House Financial Services Committee, under the leadership of Massachusetts Democrat Barney Frank, would create a council to monitor systemic risks.

Council member 1: “Say, what do systemic risks look like?”

Council member 2: “Dunno. We’ll know it when we see it.”

The council would identify firms that are too big to fail and subject them to enhanced oversight. The legislation would establish a process to wind down troubled non-bank financial institutions in such a way as to minimize the burden on taxpayers.

Over on the Senate side, Chris Dodd’s Banking Committee unveiled 1,136 pages of draft regulations, including a proposal to strip the Federal Reserve and Federal Deposit Insurance Corp. of their regulatory authority and create a single supervisory agency, appointed by the president and a board.

What’s missing from the discussion of creating a “new architecture” for financial regulation is this: Regulators are human. It matters very little whether you place them in Cell Block 1 or Cell Block 9, call them a council or an agency, or provide them with specific rules or general guidelines.

People Are People

Regulators aren’t robots. They are subject to the same emotions as the rest of us, including envy and greed. Over time, they come to identify with those they are regulating -- a phenomenon known as “regulatory capture.”

Like all humans, regulators are fallible. When it comes to the next big crisis, “a large number of well meaning and well- paid regulators will miss it by a country mile,” says Bob Barbera, chief economist at ITG Hoenig, a New York brokerage.

All the focus on regulation, or re-regulation, is entirely misplaced, Barbera says. “What we need is a broader definition of monetary policy.”

During his years on Wall Street, Barbera has watched the gauge used to assess the stance of Fed policy evolve from the nominal fed funds rate to M1 to M2 to real M2 to the real fed funds rate. The back-to-back bubbles in the late ‘90s and early aughts should be a clear sign that policy is missing the boat -- and sinking the ship.

And yet, there has been almost no discussion of the role of policy in inflating asset bubbles or any change in it to prevent a recurrence.

Clipping Fed’s Wings

For its part, Congress is determined to minimize or eliminate the Fed’s supervisory role by rearranging the deck chairs and installing a different set of regulators in a new regulatory agency.

Lest anyone forget, FDICIA, or the Federal Deposit Insurance Corporation Improvement Act, was a tough new piece of banking legislation enacted in 1991 following the savings and loan crisis. Yet 17 years later the banking system was on the ropes.

“Regulation doesn’t work,” says Peter Wallison, co- director of financial policy studies at the American Enterprise Institute in Washington. “And now they’re proposing regulation that doesn’t work for the entire financial industry,” which will sustain large institutions and harm smaller ones.

Both the House and Senate draft bills would curtail the Fed’s lender-of-last-resort function, the purpose for which the central bank was created in 1913, well before it was handed a dual mandate of maximum sustainable growth and stable prices. The White House said Friday that the Fed needs to be involved in regulating systemically important institutions.

Independence Challenged

In a further challenge to the Fed’s independence, the directors at the 12 Federal Reserve district banks would be chosen by the Fed governors in Washington, with the board chairman subject to Senate approval. Currently six of the nine directors are chosen by private-sector banks, a process with conflicts of its own.

Making Fed bank boards political appointees would increase Congress’s leverage when it comes time to raise interest rates. Fed Chairman Ben Bernanke is going to have to withdraw the excess stimulus well before the unemployment rate is at politically acceptable levels. And not in 25 basis-point increments this time.

You have to hand it to the ethically challenged Dodd, he of the sweetheart mortgages from Countrywide. He possesses a unique ability to overlook the role he played, turning a blind eye to problems at Fannie Mae and Freddie Mac, two former government- sponsored enterprises that were placed in conservatorship last year.

Dodd or Bernanke?

Fannie and Freddie have cost the taxpayer $112 billion so far to keep them afloat, with more to come as the government assumes losses from homeowners and lenders.

Yet Dodd faced the cameras last week and said the Fed had been an “abysmal failure” at consumer protection and regulation.

Yes, it was. So was Congress, which entrusted the GSEs to a weak regulator and made sure little was done about size and quality control.

While bank regulation has been pared back over the last two decades, banking is still a highly regulated industry. It was regulators, not regulations, that failed. Now our bought-and- paid-for Congress, which oversees the regulators, is going to fashion a regulator in its own image and no doubt for its own purposes.

The next crisis will be managed by committee, with Congress looking over its shoulder, not by the Fed. Won’t you sleep better knowing that?

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

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To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: November 15, 2009 21:00 EST