Center for Financial Innovation and Stability

Notes from the Vault
Larry D. Wall
July 2017

Most U.S. federal government agencies are funded by an annual congressional appropriation from general federal revenues. This process gives the Congress, serving as the voters' elected representatives, the ability to control the level of agency spending and to somewhat control its allocation across different agency priorities.

By contrast, the federal bank regulatory agencies are not funded through the appropriations process. Instead, these three agencies (the Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and Federal Reserve (Fed), have independent funding sources and are allowed to determine their own annual budgets.

This Notes from the Vault post reviews the issues in funding prudential supervision outside the normal congressional budgeting process. The post begins with a brief review of congressional oversight of federal agencies in general. It then discusses the budgetary independence of the banking agencies and some reasons for that independence. The post then provides two examples of congressional involvement in prudential regulation. The first focuses on when Congress used its budget control to weaken the Office of Housing Enterprise Oversight's (OFHEO) conduct of prudential supervision of Fannie Mae and Freddie Mac. The second involves special circumstances prior to the financial crisis that led Congress to support higher capital requirements than would have been required under Basel II.

Congressional oversight of federal agencies
Legislative oversight of government agencies is an important part of representative democracies. An earlier Notes from the Vault post explained that passing new regulatory legislation in the United States is difficult, and that revising existing legislation can be even more difficult. As a result, congressional legislation often gives government agencies a general set of goals and some specific tools for accomplishing those goals. The agencies are then left to translate the goals into specific actions using their available tools. Invariably, however, the agencies interpret some parts of their mandate and use some of their authority in ways different from what most members of the current Congress want.¹ Nevertheless, Congress may find it difficult to statutorily change the agency's mission or powers as those who approve of the agency's actions need only block the new legislation. However, a majority in Congress must ordinarily approve the agency's budget if it is to continue to function, which gives the majority an alternative way to exert influence over the agency.

In carrying out its legislative oversight, the relevant congressional committee(s) can conduct detailed reviews of individual agencies and programs. However, political scientists have long observed that such oversight often occurs on an ad hoc basis as individual Congress members respond to complaints from their constituents (individually and as a part of lobbying groups). University of Texas at Austin professors Mathew D. McCubbins and Thomas Schwartz (1984) provide a rationale for this approach to congressional oversight. They observe that relying on constituents can be more efficient because reviews of individual agencies may waste time on areas that are working well and miss problem areas. In contrast, most major problems are likely to adversely affect some constituents, who can then take these concerns to their Congress member.

Federal banking agencies' independent funding
Congress purposely shielded the federal banking agencies from the appropriations process. An OCC booklet on the agency's history observes that, although congressional appropriation funded the OCC's headquarters operations, individual examiners were paid directly by the banks "to insulate examiners from the pressures of the federal budgeting and appropriations process."²

Chapter 3 of the FDIC's booklet The First Fifty Years: A History of the FDIC 1933–1983 discusses the early years of the FDIC. The Banking Act of 1933 created a temporary FDIC that was initially funded by the U.S. Treasury and the Federal Reserve to provide insurance coverage to a deeply distressed banking system. The Banking Act of 1935 made the FDIC permanent and gave it authority to impose an annual assessment on bank deposits to finance both the agency's operations and the fund it maintains to resolve failed banks.

The 12 Federal Reserve Banks, which principally earn income from the spread between what they earn on their assets and what they pay for their liabilities, have always paid for the Fed's supervisory activities.³ In fact, the Fed has typically had earnings in excess of operational costs that it has paid to the Treasury.

While Congress has forgone control over the budgets of the federal banking agencies, this does not imply that the agencies are free to ignore congressional intent. Even though it may be difficult, Congress could pass legislation that eliminates an agency's budget freedom and could even terminate its existence at any time. Thus, the agencies seek to show that they are carefully managing their budgets.⁴

Advantages of independent funding
That Congress has historically forgone control over the federal banking agencies' budgets suggests that there must be some reasons for doing so. One possible reason is noted by McCubbins and Schwartz (1984), who observe that reliance on constituents to raise concerns also makes oversight "particularistic" in that it focuses on the interests of certain individuals and lobbying groups over the public at large. Thus, particularistic oversight can lead to especially one-sided oversight given the confidential nature of bank examinations.

A second reason for the budgetary independence of federal banking agencies is that, while funds spent on prudential supervision have short-run consequences for the federal budget, failing to spend adequate amounts can have potentially large long-run consequences for the budget. Holding government revenues constant, the short-run consequences of money spent on bank supervision is that this money is unavailable for Congress to allocate to tax reduction, other spending, or deficit reduction. However, underfunding a regulatory authority may lead to weaknesses and failures in the banking system due to inadequate supervision. This may adversely affect future budgets both directly from the increased spending to resolve failed banks and indirectly through the failures' negative spillover to economic activity, which can result in lower tax revenues and increased spending.⁵

OFHEO: A supervisor reliant on congressional appropriations
The risks of appropriation funding for a prudential supervisor are illustrated by the experience of the Office of Federal Housing Enterprise Oversight, which supervised Fannie Mae and Freddie Mac between 1992 and 2008. Fannie Mae and Freddie Mac play a central role in the U.S. housing finance system through mortgage securitization and investment. While the U.S. government does not explicitly insure the obligations of these two institutions, their congressional charters and past government actions have long led to the widespread (and ultimately correct) impression that they were implicitly federally insured.⁶

While the stated intention for creating OFHEO was to give Fannie Mae and Freddie Mac more effective prudential supervision, the two institutions engaged in intense lobbying to limit OFHEO's effectiveness.⁷ As a result, the legislation that created OFHEO, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, did not imbue the new agency with legal powers comparable to those of federal banking agencies in areas such as enforcement, capital requirements, and receivership.

Furthermore, while OFHEO was funded from fees levied on the two regulated entities, the supervisors' expenditures were subject to congressional appropriation. Thereafter, "Fannie Mae's lobbyists worked to insure that the agency was poorly funded and its budget remained subject to approval in the annual appropriations process," according to OFHEO's 2006 Report of the Special Examination of Fannie Mae. Those lobbying efforts persisted into the early 2000s, with Common Cause reporting that the two government-sponsored entities (GSEs) gave campaign contributions of more than $180 million from the election cycles of 2000–08.

The GSEs' influence over OFHEO's funding was felt in a variety of ways. Hagerty (2012, p. 91) notes that Armando Falcon, one-time head of OFHEO, said if the agency had been funded like bank regulators, he would have had 60 examiners rather than the 10 to 15 he actually employed. Further, Congressional Research Service specialist N. Eric Weiss notes that OFHEO said its reliance on congressional funding limited its ability to respond quickly to new regulatory concerns. Indeed, in 2004, Washington Post reporter David S. Hilzenrath reported on a proposal to withhold part of OFHEO's funding until its director resigned.

The GSEs' success in weakening their prudential regulation is highlighted by the finding of the Financial Crisis Inquiry Commission that the two GSEs held or guaranteed more than $2 trillion in mortgages but had only $35.7 billion in capital. However, that success in weakening capital regulation resulted in the GSEs having a buffer too small to absorb increased losses they suffered from their guarantees and holdings of residential mortgages and mortgage-backed securities. The two GSEs were put into conservatorship in September 2008 and, in confirmation of expectations of an implicit guarantee, they signed an agreement to sell Treasury an amount of equity sufficient to keep their accounting capital from becoming negative. The Federal Housing Finance Agency (FHFA) reports that the Treasury ultimately purchased more than $187 billion in the GSEs' senior preferred stock.

OFHEO's replacement, FHFA, was created in the summer of 2008 before the GSEs were put into conservatorship. Among the differences between the two agencies is that FHFA's annual budget does not require congressional approval.

A counterexample from recent banking experience?
Although the OFHEO experience highlights the potential dangers with congressional involvement in weakening prudential supervision, Congress has also used its influence to encourage tougher prudential regulations, especially in the case of the Basel II capital accords.

The Basel Committee on Banking Supervision agreed to the Basel II capital accords in 2004. Supervisory authorities in many jurisdictions promptly moved to implement these changes, but the U.S. implementation was delayed. The Federal Reserve and OCC viewed Basel II favorably and sought its implementation for the large banks. However, the FDIC and many in Congress were concerned that Basel II would significantly reduce large bank capital requirements. Because of the delayed implementation, U.S. banks had relatively stronger capital positions than many of their foreign competitors going into the financial crisis.

The full story of congressional opposition to the implementation of Basel II is more nuanced than merely Congress seeking stricter regulation. Although the large banks would have benefited from lower capital requirements under Basel II, smaller banks lacked the resources to engage in the complex quantitative modeling needed to obtain the capital reduction benefits of Basel II. As a result, the U.S. adoption of Basel II could have put the vast majority of U.S. banks at a competitive disadvantage in domestic lending markets, and community banking organizations strongly objected to its adoption. Those objections were often echoed in congressional statements about the merits of adopting the regulation.⁸

This counterexample highlights that Congress can be a force for stricter regulation. However, what sets this example apart from Congress's involvement with OFHEO is that the two GSEs operated in a similar manner and had nearly identical interests related to prudential regulation. By contrast, there are material differences in interest within the banking industry. These intra-industry differences can result in congressional pressure for tougher regulation if doing so benefits those who would be relatively disadvantaged. Such concerted intervention on behalf of stricter prudential regulation seems far less likely if there is no politically powerful constituency that would be disadvantaged by weaker regulation.

Conclusion
Congress ordinarily uses its control over government agencies' budgets to control the level of their spending and influence their priorities. However, Congress has historically delegated this authority with respect to the federal prudential supervisors of banks. Recent experience suggests that forgoing such control is likely to lead to stricter supervision.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Scott Frame for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

References

Hagerty, James R., The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall. Mt. Pleasant, SC: Arcadia Publishing, 2012.

McCubbins, Mathew D., and Thomas Schwartz. "Congressional Oversight Overlooked: Police Patrols versus Fire Alarms." American Journal of Political Science (1984): 165—79.

White, Eugene N. (2011). "To Establish a More Effective Supervision of Banking": How the Birth of the Fed Altered Bank Supervision" (No. w16825). National Bureau of Economic Research working paper 16825.

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¹ Such differences in interpretation may arise both because the agency’s leaders exploit ambiguity in the legislative language to use their powers differently than was originally intended by Congress and because congressional views about the appropriate use of those powers may change over time.

² In contrast to the examiners, the OCC’s headquarters relied on congressional appropriations until 1948. However, as Rutgers University professor Eugene White (2011) explains, the OCC relied more on market discipline in the form of double liability for bank owners than supervisory penalties until 1933.

³ The Fed’s largest holding of interest-bearing assets in its early days was discount loans, but in more recent times the largest holdings have generally been Treasury securities. The Fed was not legally authorized to pay interest on its principal liability, bank reserves, until 2008, but it has been paying interest on reserves since then.

⁴ For example, although the presidential hiring freeze announced in January 2017 was not legally binding on the federal banking agencies, all three agreed to comply with the spirit of the memo, according to Wayne Abernathy and Shaun Kern from the American Bankers Association (2017).

⁵ None of this discussion is intended to suggest that budget independence is a sufficient condition for effective prudential supervision. Rather, adequate funding of prudential supervision is a necessary condition for effective prudential supervision, especially in circumstances where market discipline is being muted by explicit and implicit government guarantees.

⁶ See my paper with my Atlanta Fed colleague Scott Frame.

⁷ The Financial Crisis Inquiry Commission says, "The GSEs had shown their immense political power during the drafting of the 1992 law." For a more detailed discussion of the process, see Wall Street Journal reporter James R. Hagerty (2012, p. 85—91).

⁸ For example, see the House hearing "Basel II: Capital Changes in the U.S. Banking System and the Results of the Impact Study."