Rosengren stresses Fed’s role as bank watchdog

In addition to managing the economy, primarily by raising and lowering interest rates, the Federal Reserve also has regulatory authority over banks. Some financial reform proposals in Congress would strip the Fed of its bank supervision powers and roll them, along with oversight authority held by other financial regulators, into a single agency.

Rosengren, however, said that keeping supervisory and policy-making functions under the Fed would provide benefits. In a paper presented at the Boston Fed’s annual conference here, Rosengren said information gathered by regulators about the health of banks could improve forecasts that the Federal Reserve uses to determine economic policies.

Conversely, the economic forecasts could be used by regulators to determine whether banks are in the position to weather economic shifts.

For example, a bank with a large share of commercial real estate loans would seem healthy when the economy is growing, businesses are expanding into more office space, and rents are rising. But the bank could be at risk of failure when the economy turns, businesses cut back, leasing income falls, and borrowers cannot pay back the loans.

In such a case, regulators might require the bank to add reserves to cover potential loan losses if forecasts indicate an economic downturn in the future.

“Forward-looking assessments of bank health are particularly valuable if macroeconomic conditions, or even local economic conditions in the case of smaller banks, are likely to change,’’ Rosengren and his coauthors wrote in the paper. “Bank ratings could be improved if they incorporated the likely future path of the economy when evaluating bank health, serving as an improved early warning system.’’

Rosengren presented the paper with his coauthors, Joe Peek, a University of Kentucky economics professor, and Geoffrey Tootell, deputy director of research at the Boston Fed. It was one of a series of papers presented as conference attendees examined ways to prevent a repeat of the financial crisis that pushed the US and global economies to the brink of a second Great Depression.

The relationship between banks, regulation, and economic policy is a topic Rosengren explored as a researcher at the Boston Fed. Peek and Tootell are longtime collaborators.

The Federal Reserve System was founded in large part to insure financial stability, Rosengren said. Policy makers need to consider the health of banks in their outlooks and actions.

For example, Rosengren said, the Fed might not have cut interest rates aggressively early in the financial crisis if it had just relied on traditional indicators inflation and unemployment. Unemployment was still low and inflation pressures were building at the time. But banks were struggling and tightening credit, creating a drag on the economy.

Unfortunately, Rosengren said, many economic models do not incorporate much data about the financial system. Many forecasts failed to see the extent of the economic downturn. Including information that regulators collect from banks could help.

“If macroeconomic forecasts can be improved using supervisory data, the central bank will have an advantage in estimating the future path of the economy,’’ Rosengren said in his paper. “It is clear that the economic outcome would have been much worse had the central bank not had the access to the knowledge about, and the hands on experience with financial institutions.’’

Robert Gavin can be reached at rgavin@globe.com.