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It is a small miracle that on February 1, Janet Yellen will become chair of the Federal Reserve. She is not just the first woman to head America's central bank but the first labor economist. While the Fed is ordinarily obsessed with inflation, Yellen has given equal or greater emphasis to unemployment. Yellen represents a break with the Wall Street–friendly senior Obama economic officials who promoted their former colleague Larry Summers for chair. Had Summers gotten the post, the Fed and Treasury would both have been in the hands of the same old boys' club that coddled the big banks before and after the financial collapse of 2008. That the job went instead to Yellen means the Fed will be an independent power center, and somewhat to the left of the administration. With a four-year term as chair, Yellen will serve at least two years into the next presidency as well.
The transformation of the Fed since the economic collapse of 2008, however, is far broader than the person of Janet Yellen. The Fed is not only more radical than at any time in its history; as an engine of recovery, it is the only game in town. In the past, the Fed's autonomy produced an institution protective of Wall Street. Never before in the Fed's hundred-year history has its independence resulted in a central bank more committed to strict financial regulation and expansive monetary policy than the executive branch. Ironically, progressives who have long railed against the Fed's insulation from politics are now cherishing it.
Despite fierce partisan battling over such particulars as the sequester and the government shutdown, the White House and the GOP have both embraced several trillion dollars in budget cuts over a decade as necessary medicine. The result is agonizingly slow growth and persistently high unemployment. Against this consensus, the Fed is the surprising dissenter, playing against type. In contrast to the previous chair, Alan Greenspan, both Yellen and the current chair, Ben Bernanke, have fairly begged the White House and Congress to pursue more budgetary expansion. "Fiscal policy, at both the federal and state and local levels, has become an important headwind [reducing] the pace of economic growth," Bernanke warned in his speech at the Fed's 2012 annual conference in Jackson Hole, Wyoming. "Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve." Yellen has been even more outspoken. "Instead of contributing to growth [after the initial 2009 stimulus]," she said in a February 2013 speech at the AFL-CIO, "discretionary fiscal policy this time has actually acted to restrain the recovery."
Despite Bernanke's repeated plea that a central bank cannot make up for fiscal contraction, the Fed has devised radically unorthodox monetary strategies to generate economic stimulus. After the crisis hit, the Fed used its usual tools of buying and selling Treasury bills to keep short-term interest rates close to zero. The problem, however, is that rates can't turn negative. So the Fed, under the euphemism "quantitative easing," has been purchasing massive quantities of long-term bonds. The result has been the lowest long-term interest rates since the tightly controlled command economy of World War II. Facing criticism that these policies could court both financial bubbles and inflationary pressures as well as premature optimism about declining nominal unemployment rates, Yellen made clear at her confirmation hearing that she will continue monetary expansion until a durable recovery takes hold.
At its monthly meeting December 18, the Federal Reserve's policy-setting committee, with Yellen's support, began the long-awaited process of very gradually reducing its bond purchase program, from $85 billion a month to $75 billion. The financial markets responded with a huge rally. Apparently, there is broad confidence that the Fed, under its new leadership, can get this balancing act right. That bodes well for Yellen, whose first test will be to continue adjusting the quantative easing program just enough to wean money markets from government help, but without causing interest rates to rise at the risk of slowing growth or triggering a new recession. Yellen has left herself plenty of room to dial the program up or down as economic conditions warrant.
The arduous process of reforming America's banking system, meanwhile, has only begun. The Federal Reserve was given new authority under the Dodd-Frank Act of 2010, including the mandate to monitor all large, "systemically significant" financial institutions, but it's not yet clear how the Yellen Fed will use it. Scandal after scandal continues to reveal Wall Street as a private club where conflicts of interests fatten executive bonus pools and pass the risk on to the public. The government has more powers to contain a future collapse, but the business model of the banks that crashed the economy in 2008 is essentially unchanged. The biggest five banks now have more market share than before the crash. So the task of returning the financial system to the role of servant of the economy rather than master lies ahead. Though the economy is slowly on the mend, Yellen's work will be every bit as challenging as that of her predecessor.
Yellen's tenure as Fed chair will build on the improbable odyssey of Ben Bernanke. During his years at Princeton, Bernanke was known as a close student of the Great Depression and an admirer of Milton Friedman, the laissez-faire eminence who counseled the Fed to run monetary policy by formula and trust the theory of self-correcting markets. The crisis was Bernanke's jarring lesson in the reality of catastrophic market failures and the need for bold intervention.
President George W. Bush first named Bernanke to a seat on the Fed in 2002. He moved to the Council of Economic Advisers in 2005 so that the Bush team could get a closer look at him as a possible successor to Greenspan. With Greenspan's blessing, he was appointed Fed chair in February 2006. Until the collapse, Bernanke, like Greenspan, showed little interest in the financial house of cards that banks had become. But once the crisis hit, Bernanke used all of the Fed's legal powers, and then some, to avoid a repeat of the Depression. The collapse made him into an activist.
In the first phase of the crisis, however, Bernanke worked closely with the Bush team and then with the Obama Treasury to prop up rather than clean out the largest failed banks. Bernanke has testified that all but one of these banks was technically insolvent. The road not taken would have fired executives and shut down bankrupt institutions, with shareholders and bondholders taking the loss. Instead, the Fed advanced massive sums to Wall Street, making up program names and legal rationales as it went along. The team of Bernanke, Summers, and Tim Geithner crossed swords with critics such as FDIC Chair Sheila Bair and Elizabeth Warren, then the chair of the Congressional Oversight Panel, on whether the biggest banks should instead be broken up. When a fragile stability returned to Wall Street in 2010, Bernanke became a moderately tough regulator. He assigned the day-to-day franchise of banking reform to Fed Governor Daniel Tarullo, President Barack Obama's first appointee to the central bank and one of the Fed's few regulatory hawks.
On monetary policy, Bernanke and Yellen have been ingenious and politically courageous. Under the quantitative-easing program, now in its third round of purchases ("QE3"), the Fed since September 2012 has had a pre-announced goal of buying $85 billion worth of Treasury bonds and mortgage-backed securities every month. Supporting these financial markets on a massive scale has resulted in rock-bottom interest rates. Low-interest mortgages, in turn, broke the fall in housing prices and put more money in the pockets of consumers by allowing refinancing on better terms. Cheap new car loans stimulated auto purchases. These interest rates also levitated the stock market by making stocks more attractive than bonds.
Besides keeping the financial collapse from becoming a full-blown depression and inventing new tools of monetary policy, Bernanke's other legacies are institutional.
Unlike previous chairs, who arrogated most of the power to themselves, Bernanke's style has been collegial. He ran the Fed more in the manner of a university department, delegating authority to other governors, listening as much as talking. The other governors have no professional staff; all of the staff traditionally report to the chair only. Under Bernanke, other governors have been given responsibility for particular policy areas, including in Tarullo's case power to redeploy and supervise some staffers. Bernanke has also supported increased disclosure of the Fed's internal deliberations, a cause promoted even more emphatically by Yellen.
What Bernanke has not supported, however, is a drastic transformation of the financial system. That will fall to Yellen. "You can think of Bernanke as the firefighter who managed to put the fire out," says Dennis Kelleher, who heads the reform group Better Markets, "and Yellen as the building engineer who needs to redesign the structure so that it never happens again." In some ways, the harder job will be Yellen's, because of the mistaken perception that the crisis is over.
Yellen's career can be read as preparation for her post of Fed chair. After graduating summa cum laude in 1967 from Brown University, she pursued a doctorate at Yale, studying with James Tobin, the great Keynesian economist and later Nobel laureate. Another Yale mentor was Joseph Stiglitz, who termed her "one of the best students I have had in 47 years of teaching." Yellen taught first at Harvard and then mostly at Berkeley. In 1994, President Bill Clinton named Yellen to her first term on the Federal Reserve along with Princeton economist Alan Blinder as counterweights to then-Chair Greenspan.
In 1993, Greenspan made an unprecedented deal with Clinton explicitly offering lower interest rates in exchange for cuts in the federal deficit. Subsequently, Greenspan began wondering how fast the economy might be allowed to grow without triggering inflation. He decided to stage a hawk-dove debate for his colleagues and asked Yellen to make the case for lower interest rates. "He turned to Janet," Blinder says, "because she was well prepared, smart, and could make arguments without getting the others angry." Yellen's research helped to persuade Greenspan that the Fed could lighten up and allow higher growth without courting inflation.
Yellen was tapped to chair Clinton's Council of Economic Advisers in 1997. She became president of the San Francisco regional Fed Bank in 2004 and then returned to the Board of Governors as vice chair in 2010. Yellen is the exceptional Fed chair with a prior career mainly as a university-based economic scholar. The other two were Arthur Burns, who served as chair from 1970 to 1978, and Bernanke. The current Fed regime represents the rare primacy of the intellectuals over the financiers.
Yellen's professional passion has been researching labor markets and strategies for driving down the rate of unemployment. With her husband, George Akerlof, who won the Nobel (with Stiglitz) in 2001, she developed what became the efficiency wage hypothesis, which helps explain why free markets can't solve the problem of unemployment. Yellen and Akerlof stumbled on the insight at Berkeley in 1981 while advertising for a baby sitter in the university newspaper. They offered to pay above the going rate, reasoning that they'd get a more reliable pool of applicants. They later published scholarly papers demonstrating that employers often pay more than the wage that will fetch minimally qualified workers. Consequently, labor markets do not "clear" like product markets but leave some people with premium pay and others without jobs-thus requiring fiscal and monetary intervention to maintain full employment.
Because of her intellectual care as a researcher, disarming candor, and calm temperament, Yellen is skilled at winning over critics. Her campaign for greater Fed transparency has won her the esteem of many Republicans. At her confirmation hearing, several of the senators encouraging Yellen to crack down on Wall Street were Republicans such as Bob Corker (Tennessee) and David Vitter (Louisiana). Corker went out of his way to defend Yellen against the charge of being a knee-jerk inflationist, noting that during her tenure on the Fed she had voted for rate hikes 27 times. When her appointment was announced, Richard Fisher, president of the Reserve Bank of Dallas and a monetary hawk, declared, "She's wrong on policy, but she's a darn good, decent, wonderful person."
One of the trickiest issues facing Yellen will be how to "taper" the Fed's unprecedented program of bond purchases. As critics have pointed out, a weak economy facing fiscal contraction has grown dependent on these infusions of cheap money. When they cease, markets may bid up interest rates. Higher rates, in turn, would slow what is still a feeble recovery. As Senator Corker warned at Yellen's confirmation hearing, "It seemed to me that the Fed had become a prisoner to its own policy." Financial markets are addicted to the Fed purchases, critics argue. "To really try to step away from QE3," Corker added, could "shatter … the markets."
That view, however, is far from universal. Economist Adam Posen, a former member of the Bank of England's policy committee, points out that there is massive global demand for U.S. Treasury securities, and that the real economy is soft. People forget, Posen says, that the Fed retains all of the ordinary tools of monetary policy and that it will use those to keep short-term rates low. As long as the tapering is gradual, he adds, it should not cause an increase in rates. When the November jobs numbers were better than expected, financial markets momentarily flinched with apprehension that the Fed would pull back, but then the markets quickly rallied.
Critics of QE3 have also emphasized the risk that cheap money will create new bubbles. But the best anti-bubble medicine is strict regulation. Tough limits on speculation allow the Fed to create cheap money without fear that banks will abuse it-thus the connection between regulatory and monetary policy. By contrast, in the Greenspan years the Fed combined loose money and lax regulation, virtually inviting the housing bubble.
Yellen has made clear that she intends to delay ending the bond purchases until a much stronger durable recovery is on track. Yellen, however, is only one member of the Board of Governors. Ironically, the Yellen Fed could prove more orthodox than Bernanke's, because four and possibly six of the seven seats on the Board of Governors are or will soon be open. Since the same people who promoted Summers for chairman will be advising Obama on whom to name, it is unlikely that most new appointees will be as progressive as Yellen either on monetary or regulatory policy. Yellen will have to be an exceptional leader to be master in her own house.
Under Bernanke, the Fed had four governors who were advocates of both monetary easing and regulatory reform, though they differed on the degree-Bernanke, Yellen, Tarullo, and Sarah Bloom Raskin. A former banking commissioner of Maryland, Raskin emerged as the Fed's most pro-consumer board member. Besides these four, the three other board members were more conservative, but only one, Jeremy Stein, an economist on leave from Harvard (and a close colleague of Summers), actively opposed Bernanke's monetary policy.
When Yellen becomes chair, however, the board's composition will be drastically different. Raskin is moving to the Treasury as the new deputy secretary. The White House has signaled that Obama plans to appoint the more orthodox Lael Brainard, former Treasury undersecretary, to the seat and to reappoint one of the Fed's moderate conservatives, Jerome Powell.
In mid-December the White House leaked the name of the eminent MIT economist Stanley Fischer as a likely choice for Fed vice chair. Fischer, at different points in his career, has been orthodox on both monetary and regulatory policy, though since the collapse of 2008 he has favored tighter regulation and more relaxed monetary expansion. However, he has also been close to Summers and Robert Rubin, who in 1994 named Fischer to the No. 2 job at the International Monetary Fund, where he promoted deregulated global capital flows. Rubin then brought him to a senior job at Citigroup from 2003 to 2005. Rubin, who worked hard to get Summers installed as Fed chair, may yet get a senior friend at the Yellen Fed. Fischer recently stepped down as governor of the Bank of Israel. At the Fed, he would be a force in his own right. Yellen is reportedly supportive of Fischer as vice chair.
Another of the Fed's incumbents, Elizabeth Duke, retired last summer and has yet to be replaced. A Republican ally of small community banks, Duke challenged the primacy of Wall Street. Among those prominently mentioned for her seat are Thomas Hoenig, a former president of the Kansas City Fed Bank and current vice chair of the FDIC. Hoenig is a heartland Republican skeptical of easy money policy-but even more skeptical of Wall Street. In a series of speeches going back a decade, he has been scathing on the subject of the big banks and supportive of breaking them up. Hoenig, as a Republican, might get appointed as part of a package deal with a progressive Democrat, such as Jared Bernstein, Vice President Joe Biden's former chief economist. The recent filibuster reform, letting confirmation proceed with 51 rather than 60 votes, allows President Obama to make more progressive Fed nominations if he chooses. As in the case of most past Fed chairs, the White House will run the names of potential nominees by Yellen and solicit her suggestions but will not give her a veto or allow her to dictate appointees.
Another complication involves the fraught relationship between Yellen and Daniel Tarullo. One of President Obama's earliest senior economic advisers, Tarullo in 2009 had hoped for a senior White House post, such as chair of the National Economic Council. But when that post went to Summers, he became the administration's key man at the Fed. He and Yellen are close ideological allies on financial regulation and monetary policy but have clashed personally. The bad feeling was amplified when word got back to Yellen that Tarullo had promoted Summers, an old friend, for Fed chair.
Tarullo, a formidable legal scholar with a large personality, had expected to have more influence under Summers. He let it be known that he would leave if the top job went to Yellen. At the same time, Tarullo is deeply committed to completing several financial reforms that he has begun, which will take well into 2014. Close observers expect Yellen to make peace with Tarullo, perhaps by naming him vice chair for supervision, a new post created by Dodd-Frank. "Both of them are grown-ups," says one former regulatory official. "They need each other. Both have a history winning some battles and losing others-and moving on." A former colleague says, "If Janet held a grudge for all the stupid things that have been said to her over the years, she'd be the most miserable woman in the world, but she is one of the most gracious."
The seat of Jeremy Stein, the critic of easy money, could also come open. A Fed statement last June implying the early end of the QE3 bond purchases was composed mainly to appease Stein. However, the statement spooked money markets and the Fed quickly reversed course and reaffirmed its plan to continue QE3 as long as the economy was soft. Harvard has a two-year limit on academic leaves, and Stein's expires this academic year.
A further element complicating Yellen's leadership on monetary policy is the rotation of seats on the Federal Open Market Committee. The committee is the Fed's official policy--setting body on interest rates. Its voting members include all seven Fed governors and a changing cast of five presidents of regional Fed banks. The presidents are a mixed lot. In 2014, the bank presidents coming onto the committee will be far more hawkish on money policy than those rotating off. One of them is Dallas Fed Bank President Richard Fisher, who warned in a recent speech of a "tipping point" where monetary policy becomes "an agent of financial recklessness. None of us really knows where that tipping point is. But with each dollar of Treasury and MBS [bond] purchases … we inch closer to it."
An important and still-unfolding Yellen relationship will be with Treasury Secretary Jack Lew. The Fed and the Treasury have overlapping jurisdiction in several areas, and an assertive Fed will require Treasury cooperation. Although Lew enjoyed a lucrative short-term job at Citigroup, courtesy of Rubin, before returning to government, he is not a career Wall Street man. His main expertise is budgetary. Lately, Lew has been talking like a born-again regulator.
Lew startled admirers of Fed Governor Sarah Bloom Raskin when he recommended that the president name her to the No. 2 job at Treasury. The greater surprise was that Raskin accepted the job. But allies of both maintain that Lew was serious about wanting to get someone expert in financial markets as his deputy to complement his own strengths and weaknesses. By naming a liberal like Raskin, Lew was also signaling a deepening commitment to financial reform. In a high-profile speech December 5 at the Pew Charitable Trusts, where he made sure to be introduced by regulatory ultra-hawk Sheila Bair, Lew went out of his way to call for tough regulatory reform including personal liability for bank CEOs.
Raskin, presumably, has gotten commitments about the scope of her authority. She is close to both Yellen and to progressives on the Senate Banking Committee, which gives her independent political leverage. Traditionally, the deputy secretary at the Treasury is primarily in charge of operations, not policy. If Lew wants to, says one close observer, "it will be easy to box her in." On the other hand, if Raskin's appointment does signal a pro-regulation shift at Treasury, it bodes well for Yellen. A Treasury allied with a reformist Fed, rather than one more allied with Wall Street (as under former Secretary Tim Geithner), would be a potent combination.
Yellen will need not only to build a working majority on the Fed's board and its Open Market Committee but to control a powerful Fed bureaucracy that is traditionally protective of banks. "Historically, the Fed has shrouded bank supervision in secrecy," Kelleher says. "They worried about bank runs, and the way to prevent runs is to keep the public in the dark while they fix things behind the scenes. That's what they've always done, that's how everybody got their job and got promoted. Now they have to shift from a closed-door supervisor who views banks as clients to a frontline regulator who views banks as potential threats. That is a cultural and bureaucratic change for which there is almost no precedent."
An emblematic challenge for Yellen will be how to handle the Fed's most influential senior staffer, general counsel Scott Alvarez, a career 32-year Fed veteran who manages to keep his name out of the press. He is well liked by the staff and respected and feared by Fed governors. Alvarez is also Wall Street–friendly and a back-channel ally of the big banks. In early 2013, Alvarez on behalf of the Fed signed off on a settlement of mortgage abuses widely considered by consumer groups to be a giveaway to the financial industry. He did not consult the Fed's board of governors but insisted he could do so on his own authority.
A well-worn aphorism holds that there are two kinds of lawyers-those who tell you what you can do and those who tell you what you can't do. At the Fed, if the chair asks the general counsel if a policy is legal and the counsel advises not, she is unlikely to go ahead, because of the risk that the legal staff will not back her up in litigation or congressional questioning. This gives Alvarez immense power, even more so in the post-collapse era, because the Dodd-Frank Act contains many ambiguities and many of the Fed's interventions will necessarily be judgment calls.
One of the most important Dodd-Frank regulations is the Volcker Rule, which partly re-establishes the old Glass-Steagall wall between commercial and investment banking. Yellen and Lew have both supported a strong Volcker Rule. But in his confidential testimony to the Financial Crisis Inquiry Commission in 2010, Alvarez was blasé when asked about the impact of scrapping Glass-Steagall on the practices that led to the 2008 financial collapse. "I don't think the repeal of Glass-Steagall was the cause of the crisis," Alvarez testified, "nor do I think repeal of the Glass-Steagall Act actually exacerbated the crisis."
This view puts him at odds with most regulators, most Fed governors, and with the mandate of the Dodd-Frank Act. Yellen supporters are divided on whether she should move to replace Alvarez with a general counsel more committed to reform, something she clearly has the power to do. Some say this would be an early test of her leadership. Others argue that Alvarez has so many allies and friends across the Fed senior bureaucracy that this is a fight she should not pick, certainly not at the outset of her term.
But the Alvarez case suggests just how astute and nimble Yellen will need to be if she is to transform the Fed. Alvarez is just one of a cadre of senior staff, both in Washington and at key regional Fed banks, that has historically been an appendage of the financial industry. When Tarullo, with Bernanke's consent, reassigned some staff to get more pro-regulation people into key positions, his critics were quick to say, "Dan doesn't get along with staff"-code for Tarullo is shaking the place up.
Despite passage of the Dodd-Frank Act in 2010, flagrant abuses keep unfolding. Banks are larger and more concentrated than ever. The large Wall Street banks still rely on investment banking and insider trading of securities for most of their profits. Derivatives markets are only partly reformed, and the eight largest banks now control 92 percent of derivatives trades. Trillion-dollar banks treat even multibillion-dollar fines as costs of doing business. There have been no criminal prosecutions of senior bank officials.
Newly revealed misdeeds have included the LIBOR (London Interbank Offered Rate) scandal, in which banks rigged markets on this key benchmark. LIBOR, the rate that underpins the $350 trillion derivatives market and other key bank rates, is supposed to be set by a free--market bidding process. It's now clear that major banks, including Barclays, UBS, JP-Morgan Chase, and Citi, ran LIBOR as if it were a price-fixing cartel for their own enrichment. Billions in fines have been paid, and criminal investigations are ongoing in several countries.
Then came the "London Whale" affair, in which JPMorgan Chase lost $6.2 billion in 2012 on a bet gone bad, putting at risk depositors' money guaranteed by the FDIC. Morgan chief executive Jamie Dimon initially dismissed the matter as a "tempest in a teapot." Morgan has since paid a billion dollars in fines in the U.S. and the U.K., and criminal investigations continue.
The Justice Department has an open investigation of trade rigging in the largest market of all, the $5-trillion-a-day foreign-exchange market, which is a source of huge profits for the biggest banks. There have also been revelations of conflicts of interest in commodities trades, in which large banks not only write derivatives contracts ostensibly to help clients hedge against price swings but buy and sell the underlying commodities (such as aluminum), creating opportunities to rig the banks' own derivatives trades.
What these and other practices have in common is that the big banks, privy to inside information, capture windfall gains at the expense of the investing public. The profits drop directly to the banks' bottom line. In the event that trading strategies go awry, the taxpayer is ultimately at risk. All this suggests that the banking system, five years after the crisis, is more about its own self-dealing than about efficiently allocating capital and credit to the real economy.
The Dodd-Frank Act doesn't explicitly cover many of these new maneuvers, and much of the work of carrying out the act remains unfinished. From the moment Dodd-Frank passed, lobbyists moved to weaken regulations, often outnumbering the officials charged with drafting the rules to carry out the law. Several hundred separate rulemaking actions, spread across six U.S. government agencies, with the Fed first among equals, are required to carry out Dodd-Frank. Of these actions, the most important are:
The Volcker Rule. This ambiguous provision is intended to be a partial restoration of the Glass-Steagall wall. In principle, it prohibits "proprietary trading" (trading for the bank's own account as opposed to executing orders for customers) by federally insured banks. The intent is to minimize speculative trading in credit derivatives and other securities by banks whose deposits are guaranteed by the government. But the banks have argued, disingenuously, that much of their trading is conducted for their customers or for legitimate hedging purposes. The final rule, issued December 10 after intense infighting, was stronger than its early drafts but depends on interpretation and enforcement by regulatory agencies. As Yellen noted at the meeting where the Fed governors formally voted to approve the rule, "Supervisors are going to bear a very important responsibility to make sure the rule really works as intended." To the extent that loopholes remain, the Fed can address abuses through its bank-supervisory powers, which give it broad authority to address threats to safety and soundness.
Capital Standards. The banks that nearly went under in 2008 turned out to be far too thinly capitalized. The international Basel III accords, recently completed, will raise capital mandates modestly. Yellen has said that she wants to raise capital standards beyond the Basel minimums, especially for the biggest banks and perhaps to require more capital to the extent that big banks rely on speculative investment banking. This doesn't go as far as many senators would like; several on both the left and right are pushing legislation for full restoration of Glass-Steagall as well as punitively high capital requirements for the largest banks. But Yellen could accomplish much of this reform through the Fed's residual powers. "The Fed," says one insider, "has the power to look closely at a bank's balance sheet and say, 'We don't like your mix of assets. Change it or reserve more capital against losses.'" Higher capital standards, argues Mike Konczal of the Roosevelt Institute, accomplish several goals. They make it much less likely that banks will fail; they make the end of "too big to fail" much more credible; simpler capital requirements move regulation away from "risk weighting" formulas that are too easy for banks to game; and they allow regulators to discriminate against the biggest banks to discourage concentration.
Too Big to Fail. The Dodd-Frank Act tries to prevent the need for future bailouts in two complementary ways. The Fed is given broad supervisory authority over bank holding companies, which include all of the largest banks, as well as over large non-banks deemed to present systemic risks if they should fail. The Fed is required to work with banks to devise "living will" plans in advance, so that a failing bank could be broken up without the need for taxpayer bailouts. This would be done through the normal bankruptcy process. As a fallback, the FDIC is given additional powers, to "resolve" (break up) failed banks under Dodd-Frank's Title II. Those regulations have been written and have been praised by reformers, though there is concern that another systemic crisis would not be limited to a single bank and might overwhelm the FDIC's resources. The Fed's living-will negotiations with the big banks are ongoing.
Derivatives Reform. The Dodd-Frank Act charged regulators with mandating that trades in derivatives be transparent and conducted either on exchanges or well-governed clearinghouses. Derivatives trading losses were heavily implicated in the 2008 collapse. The biggest banks have been on a massive lobbying campaign to water down as yet unfinalized derivatives rules. The point man for the government has been Gary Gensler, the chair of the Commodity Futures Trading Commission (CFTC).
Gensler, once a senior trader for Goldman Sachs and a subcabinet official at the Treasury under Rubin and Summers, has become a surprisingly tough regulator. He has resisted the industry campaign to weaken derivatives regulation to the point where the big banks successfully lobbied the Obama administration not to reappoint him. The Obama Treasury unhelpfully exempted the huge, opaque, and lucrative market in foreign-exchange derivatives from Dodd-Frank entirely. As an illustration of the kind of games the big banks play, Gensler recently intervened to frustrate a ploy in which the big banks nominally book a trade as partly existing in the U.S. and partly "offshore," even though both traders are physically in the U.S., to put the trade outside the regulatory framework. Gensler, in ruling that such a maneuver is a sham, declared, "A U.S. swap dealer on the 32nd floor of a New York building and a foreign-based swap dealer on the 31st floor of the same building, have to follow the same rules when arranging, negotiating, or executing a swap." It remains to be seen how aggressive the CFTC will be under Gensler's successor, Tim Massad, who once worked for Ralph Nader but who became a lawyer to bankers and helped run the bailout program at the Treasury.
A further source of tension in the Yellen era will be between a more assertive Fed and an SEC that has been notoriously lax at going after patterns of abuse. The two agencies overlap because the SEC has direct authority over broker-dealers, which are part of the bank conglomerates that the Fed regulates at the holding-company level. The Fed's broad jurisdiction over safety and soundness issues trumps the jurisdiction of the SEC, but the Fed has to be willing to invoke it.
Dozens of other major areas of reform are far from complete. Some of the major ones include adequate regulation and oversight of credit-rating companies such as Moody's and Standard & Poor's, whose conflicts of interest were central to assigning triple-A ratings to sketchy mortgage-backed bonds; addressing risks in the huge money-market mutual industry, whose incipient crash in the fall of 2008 was prevented only because the Fed stepped in to guarantee all money-market mutual funds; and the continued reliance of major segments of the financial industry on short-term ("repo") loans that can dry up in the event of a panic. Historically, regulators worried about runs by depositors. Federal deposit insurance solved that problem in 1933. But when the investment banks Bear Stearns and then Lehman Brothers collapsed in 2008, the reason was that short-term lenders, not depositors, suddenly aware of the high leverage and risk of failure of these firms, took their money and ran. No federal insurance can insure against that risk, nor should it. With most investment banking now the province of banking conglomerates that also do commercial banking, the only remedy is much closer supervision of their business strategies, capital reserves, and the quality of their assets-or a full Glass-Steagall wall.
Senator Elizabeth Warren has long warned that the system's regulatory premise has been that complex financial engineering is permitted unless expressly banned. Instead, she argues, products need to be prohibited unless explicitly permitted. This insight was behind the creation of the Consumer Financial Protection Bureau as well as another sleeper provision of the Dodd-Frank Act, which created the Office of Financial Research, to identify threats in the form of incipient toxic products. But the Fed is a long way from prohibiting categories of financial products before they are offered. That shift will require the aggressive use of explicit rules and also of the Fed's more elastic supervisory powers.
To review the challenges facing Janet Yellen as she assumes the chairmanship of the Federal Reserve is to appreciate that her job is second in importance and difficulty only to the presidency. Yellen's legacy will be judged on multiple dimensions. Did she succeed in stimulating a flattened economy without creating new bubbles, despite no help from the executive or legislative branches? Did she manage to taper bond purchases without aborting the recovery? Did she build a working majority on a balky Fed open-market committee and gain control of an entrenched career staff? Did she convert the Fed from a central bank whose main constituency was other bankers to one committed to a reformed banking system? Did she produce greater harmony and resolve among other regulatory agencies? Did she devise even more inventive and unorthodox policy successes than her predecessor Ben Bernanke?
At the far fringes of debate within the Fed are measures to pump money directly into the economy beyond the current bond purchases. Some critics have pointed out that the current cheap money, which goes initially to the banks, is not trickling out into productive lending but is underwriting mainly insider plays to increase bank profits. There have been discussions inside the Fed about more venturesome bond-purchase programs that would directly support small-business lending, student-loan refinancing, or public infrastructure. All of these would be even more heroic uses of the Fed's latent power to overcome a stagnant economy.
Janet Yellen's tenure may lack the high drama of the Bernanke years of acute crisis, when the financial system nearly collapsed. But with the economy far from healed, the challenges facing Yellen are no less urgent. A key challenge is preventive-to reshape a dysfunctional financial system into one that serves the economy and presents less risk to the system because it takes fewer risks onto itself. Though the Dodd-Frank Act gives the Fed new powers to rescue and restructure failed banks, the more important power is to assure that a new rescue on the scale of 2008 will never be necessary. The Yellen Fed, in many respects, is a more radical central bank than at any time in its hundred-year history. But to prevent the next collapse and to complete the work of repairing a warped financial system, it will need to become more radical still.
