Feb. 9, 2015

Recent statements by senior Federal Reserve officials show that the agency is stepping up efforts to investigate and ultimately regulate what they call the “shadow-banking system.” As the regulators define that term, it is nothing less than capital and securities markets—the industries principally responsible for the growth of the U.S. economy over the past 40 years.

In December, Stanley Fischer , the Fed’s vice chairman and head of its internal systemic-risk committee, told an asset-management group that the New York Fed is “mapping” the relationships between and among financial institutions with a view to determining the scope of the shadow-banking system. The Fed, he said, is considering whether it has sufficient authority to regulate shadow banks. If it doesn’t, he said, the Fed will turn the matter over to the Financial Stability Oversight Council—created by the Dodd-Frank law and made up of the heads of all federal financial regulators, with the Treasury secretary as chairman—for appropriate action.

And on Jan. 30, Daniel Tarullo, a Fed governor, told a conference of financial regulators that the agency was working to corral financial activities that “migrate outside the regulated perimeter”—that is, financial activities that are not regulated like banks. The Fed, he said, wants to “serve the macroprudential aim of moderating the build-up of leverage” in shadow banks.

Most people probably imagine that the term shadow banking refers to large nonbank financial institutions that do what regulated banks do—borrow short-term funds like deposits and turn them into long-term assets like loans. Maturity transformation, as it is called, can be risky, because a firm that has lent out funds it has borrowed short-term may be pressed for cash if its short-term creditors want their funds returned immediately. The fear is that large firms facing this difficulty could fail, creating a “systemic” event.

For this reason, Dodd-Frank is based on the idea that all large nonbank financial institutions, including investment banks, finance companies and insurers, should be subject to designation by the FSOC as systemically important financial institutions, or SIFIs. Once designated, SIFIs are turned over to the Fed for stringent regulation.

The regulators apparently want to cast an even wider net. A 2012 report by the international Financial Stability Board—made up of central bankers and bank regulators of which the U.S. Treasury and the Fed are members—stated that systemic risks are created in the shadow-banking system through “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”

What is a “chain of transactions”? As former Fed Chairman Ben Bernanke explained that year, a finance company might create a pool of auto loans for securitization. Afterward, “an investment bank might sell tranches of the securitization to investors. The lower-risk tranches could be purchased by an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing commercial paper that is purchased by money market funds.” In other words, a “chain of transactions” involving many different firms can create the same systemic risks as a single large firm.

These are normal transactions in the securities and capital markets. So when Fed officials say that they are investigating and hope to regulate shadow banking, what they mean is that they want to regulate what kind of transactions occur in the securities and capital markets. What is necessary, Mr. Tarullo noted, is a “significant building out of a regulatory regime” for shadow banks, “and so I think that’s where attention is going to be paid.”

One big, threshold question: Where do the Fed and FSOC imagine that they obtained the grant of such power? It can’t be from Dodd-Frank. As capacious as this legislation is, it doesn’t provide authority to regulate financial firms that by themselves are not systemic but become systemic because they participate in a “complex chain of transactions.”

The most likely possibility is the Financial Stability Board, an entity little known outside the financial industry. This group was deputized by the G-20 leaders in 2009 to reform the international financial system, and since then—with the explicit approval of the G-20—has made the regulation of the shadow-banking system a major objective. Perhaps the FSOC and the Fed see the decisions of the G-20—of which President Obama is a member—as authority for their actions in the U.S.

While this might be true in other countries, the U.S. Constitution provides for a separation of powers in which Congress makes the laws and the president carries them out. The fact that a president has agreed with other G-20 leaders to take international action of some kind would not give federal agencies the authority to act in the absence of explicit legislation.

And yet if Congress fails to insist on a recognition of its authority, the Federal Reserve and the Financial Stability Oversight Council will be free to take control of and regulate sectors of the economy that even the drafters of the far-reaching Dodd-Frank law saw fit not to include.

Mr. Wallison is a senior fellow at the American Enterprise Institute. His most recent book is “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” (Encounter, 2015).