04/18/2010 05:12 am ET Updated May 25, 2011

Fed President: Great Depression Possible If Federal Reserve Stripped Of Bank Oversight

The U.S. risks falling into another "Great Depression" if the Federal Reserve is stripped of its bank oversight powers, a top Fed official warned Tuesday.

In his first public speech since becoming the newest regional Fed chief, Minneapolis Fed President Narayana R. Kocherlakota took aim at calls for the nation's central bank to relinquish its bank supervision authority.

Acknowledging that the Fed made "significant mistakes" as a bank regulator, Kocherlakota nonetheless said the central bank's actions in preventing the financial panic of 2007-08 from mushrooming into another Great Depression -- including an expanded cheap lending program for financial institutions and last year's publicly-released bank "stress tests" -- was a "success" enabled because of its role as a bank supervisor.

"Would we have had Depression 2.0 without the Federal Reserve's using this range of policies? We will never know for sure," the 46-year-old, the youngest of the 12 regional Fed presidents, said in his prepared remarks. "However, it is clear to me that these policies worked as intended...These policies eliminated the possibility of Depression 2.0." [Emphasis in original]

But, if Senate Banking Committee Chairman Christopher Dodd's proposal to strip the Fed entirely of its bank supervision authority were to be implemented, it "would needlessly put a Great Depression on the menu of possibilities for our country," Kocherlakota told a gathering of the Minnesota Bankers Association in Saint Paul.

Kocherlakota's public comments -- his first since becoming Minneapolis Fed President in October -- are among the most forceful uttered by a top Fed official since the secretive institution has come under fire for the taxpayer bailouts it conceived and oversaw for Wall Street firms, and its widely-panned lackadaisical approach to bank supervision.

Kocherlakota was unsparing in his defense of the Fed. Specifically mentioning Dodd and his proposal, he asked rhetorically how the Fed's cheap lending program for financial institutions would have worked had the central bank not already been a bank supervisor. After all, the Fed would want to know the condition of the institution it's lending to before agreeing to fork over the cash.

He answered his own question by pointing to "two distinct problems." One, the bank regulator the Fed would presumably have relied on would have been too busy to respond.

"During a crisis like 2007-09, this other regulator would necessarily face huge resource demands in terms of obtaining and sharing information about a financial institution's quality," Kocherlakota said. "Getting a phone answered in a timely fashion about a given financial institution might well be extremely challenging."

The second, bigger problem has to do with incentives, he said. Specifically, when the Fed agrees to make a loan to a financial firm it does so knowing that if it sours, the loss ends up on the Fed's balance sheet. "It has every incentive to do a good job in assessing the borrower quality," Kocherlakota said.

But if the Fed had to rely on another agency, that agency's incentives would not necessarily be aligned with the Fed's.

"What exactly are this other agency's incentives to provide the Federal Reserve with the best possible information? This other agency is not going to suffer a loss for making a bad loan -- the Federal Reserve is," Kocherlakota said. "Indeed, one can readily imagine that in the politically charged circumstances of a financial panic, this other agency's objective might be to keep as many banks alive as possible.

"In these circumstances, the Federal Reserve would have no way to obtain reliable information from this other regulatory body and would have no way to make appropriately targeted loans," he said.

In other words, this other agency may not have the taxpayer's interests at heart.

Bloomberg reported Tuesday that "Robert E. Lucas Jr., 1995 winner of the Nobel Prize for economics, called Kocherlakota 'the best abstract theorist ever to head a Federal Reserve bank.'" Next year he'll play a role in setting interest rates as a voting member of the Fed's top policy-making body, the Federal Open Market Committee.

Kocherlakota also pointed to the stress tests federal bank regulators conducted last spring on the nation's 19 biggest bank holding companies, the results of which were made public and have been acknowledged as having calmed the markets and boosting confidence in the banking system.

If the Fed did not supervise banks, he argued, the stress tests "would never have taken place" because none of the other regulators were up to the task.

In fact, so great is the Fed's powers that if it had the kind of authority over the nation's entire financial system that the House of Representatives recently authorized, Kocherlakota said the stress tests could have taken place in October or November of 2008 -- a point near the height of the crisis and roughly five months before the stress tests officially began. That would have been "enormously helpful," he said.

"I hope that I have convinced you that these interventions would have been significantly more difficult, if not actually impossible, in a world in which the Federal Reserve did not have a supervisory role," Kocherlakota told the group of bankers.

He ended his remarks with the following warning:

"Right now, our regulatory system has the ability to prevent those [financial] crises from generating 30 percent falls in output and unemployment rates of 25 percent [like the Great Depression]. When changing the system, we have to make sure that it doesn't lose that ability. Stripping the Federal Reserve of its role in supervision is a step in the wrong direction."

READ his full speech below:

Kocherlakota speech -