Separate but equal.

Photographer: Andrew Burton/Getty Images

The Democrats' Misguided Plan to Reform the Fed System

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Bloomberg View. Follow him on Twitter at @smihm.
Read More.
a | A

The platform of the Democratic Party, approved in advance of this week’s convention, has plenty of sane, sober policy ideas. But there’s one particular proposal that might need some serious tweaking.

The sentiment is laudable:

We will protect and defend the Federal Reserve’s independence to carry out the dual mandate assigned to it by Congress—for both full employment and low inflation—against threats from new legislation. We will also reform the Federal Reserve to make it more representative of America as a whole.

But the platform goes on to say:

We will fight to enhance its independence by ensuring that executives of financial institutions are not allowed to serve on the boards of regional Federal Reserve banks or to select members of those boards.

Doing so would effectively overturn more than 100 years of sober precedent. The architects of the Fed went to great lengths to create a system of checks and balances that apportioned representation in the district banks in a fair, broad-based fashion. This system is not broken, and this proposal for “reform” fundamentally misunderstands the functions and historical evolution of the district banks.

QuickTake The Fed Lifts Off, Barely

A little history. In 1913, President Woodrow Wilson signed the bill creating the Federal Reserve System. The following year, a provisional committee -- consisting of the secretary of the Treasury, secretary of agriculture, and the comptroller of the currency -- decided where the district reserve banks would be based.

This was a tricky business: The new institution had to appear to cover the nation, not just Wall Street. So while New York City got a district bank, so did Minneapolis, Atlanta, Dallas, Richmond, and other cities. Bankers in New York weren’t happy about this: the sheer size of the financial industry in that city dwarfed the others, but it only got one piece of the pie.

Each of the district banks was a central bank unto itself, capable of formulating policy and intervening in its region. The newly created Fed was less a central bank than 12 semi-autonomous institutions that vied with one another and with a Federal Reserve Board in Washington that sought, with mixed success, to coordinate policy across the system.

Under the original legislation, the president got to appoint people to the Federal Reserve Board. But the district banks were different. Two-thirds of their boards were to be elected by the members of each district bank. This wasn’t like membership in a country club; rather, most of the members consisted of national banks that had to join as a condition of doing business. Membership, then, was something that related to the Fed’s power to regulate the banks under its supervision. (State-chartered banks could join, too, but only if they submitted to Fed oversight.)

The people who designed the Fed went to additional lengths to ensure that no single bank or group of banks could dominate district affairs. When it came time to elect representatives to the district bank boards, the members in each area were divided into three sizes -- large, medium, and small – depending on their capitalization. Every bank was given a single vote, regardless of its size relative to other members of its class.

Then there were restrictions on who could serve. Each of the three groups had to elect two members. Those picked for the first group, “Class A,” had to be bankers. Those in “Class B” had to be active representatives of “commerce, agriculture or some other industrial pursuit” -- but could not be a banker. Thus, three groups of bankers -- representing large, medium and small banks -- were allowed to elect six people total to the board from Class A and Class B.

In the spirit of checks and balances, the Federal Reserve Board in Washington got to appoint three more members from “Class C,” which was identical to “Class B,” but with the added restriction that its members could not own any bank stock.

In practice, this meant that the nine-member boards governing each district bank had only three bankers, with the rest representing other interests. These boards are responsible for supervising the district banks and for appointing a president and vice president to manage day-to-day operations.

Eventually, Congress amended the definition of the Class B and C directors. In 1977, membership in B and C were redefined as “due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor, and consumers.” Members of both classes still could not come from the banks or the financial-services industry, and members of Class C could still not own stock in banks or bank holding companies.

Even though bankers are a minority on these boards, the Democratic Party wants them off entirely. This is bizarre: the regional Feds are banks, after all. Special banks, yes, but the idea that they should be run only by people with no direct experience in banking makes little sense.

Stranger still is the idea that there’s something problematic about bankers electing these board members in the first place. Why shouldn’t the member banks have at least some say in who oversees their affairs? After all, the vast majority of these banks are not big players on Wall Street; they’re mostly conventional national and state-chartered institutions. If anything, they’re probably among the most responsible and well-regulated banks in the country.

But the most perplexing part of the platform proposal is its ignorance of the role and function of the district banks. These had some power in the earliest years of the Federal Reserve System, but in the 1930s, Congress centralized power in a newly powerful Federal Reserve Board of Governors. The regional banks have been on a tight leash ever since.

The only area where the district banks have a say in national policy is via membership in the Federal Open Markets Committee. But the board members don’t sit on the FOMC; rather, the presidents of the district banks fill this role on a rotating basis, with the exception of the president of the Federal Reserve Bank of New York, who maintains a permanent seat.

Perhaps that’s the subtext for this proposal: The New York Fed has been criticized for being lax in exercising its regulatory powers, and its current president, William Dudley, once was a Goldman Sachs executive. 

If that’s the motivation for the proposed change, the Democrats would be better off focusing directly on the workings of the New York Fed, or even the Federal Reserve Board in Washington. But they should leave the other district banks alone: they’re working just fine.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Stephen Mihm at smihm1@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net