The Fed’s regulatory errors

By Felix Salmon
December 21, 2009
Binyamin Appelbaum and David Cho have a very clear-eyed summary of where the Fed screwed up in terms of bank regulation over the past few years. Two things are clear: that the Fed had the power to prevent the excesses that banks got involved in over the course of the Great Moderation; and that it didn't even come close to beginning to wield that power until after the Great Moderation had become the Great Recession and it was far too late.


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Binyamin Appelbaum and David Cho have a very clear-eyed summary of where the Fed screwed up in terms of bank regulation over the past few years. Two things are clear: that the Fed had the power to prevent the excesses that banks got involved in over the course of the Great Moderation; and that it didn’t even come close to beginning to wield that power until after the Great Moderation had become the Great Recession and it was far too late.

The list of reasons why the Fed was so lax is a long one. But just running down the article, we can find:

  1. Simple analytical failure: Even after the subprime bust started, the Fed was convinced that it would have minimal repercussions on banks.
  2. A belief that the Great Moderation was a sign of lower systemic risk, as opposed to being a sign that enormous amounts of risk were being pushed into tails.
  3. A touching belief in securitization and triple-A credit ratings, which allowed Citigroup and others to build loan pools of 20 times the size of the underlying capital, up from a former cap of 10x leverage. The result was that Citi increased its total assets by 68% while increasing the size of its capital reserves by only 36%.
  4. A feeling that banks had to be able to compete with non-bank lenders which were outside the Fed’s jurisdiction, such as GE and GMAC.
  5. Failure to notice contingent liabilities at banks, especially with regard to SIVs.
  6. Failure to notice deteriorating asset quality, especially with regard to subprime loans.
  7. Overreliance on other regulators, especially the OCC and OTS, which were busy competing with each other for banks to regulate, giving both of them a strong incentive to be very bank-friendly.
  8. Overreliance on internal bank risk officers, and the concept that so long as the regulator keeps a relatively close eye on the risk-management function at a bank, it doesn’t need to spend much time looking at the actual risks themselves.
  9. An unworried belief that banking had become so complicated that regulators couldn’t possibly stay on top of the risks involved.
  10. Failure to pay attention to warnings from economists both inside and outside banks that things were looking very ugly.
  11. Failure to rein in a huge wave of bank mergers: The Fed approved 5,670 of them over the past decade, an approval rate of well over 90%. No one seemed to be remotely worried about the problem of too big to fail banks.
  12. Trust in, and a desire to move towards, Basel II.

I’m sure there are more, but we may as well stop at a round dozen. The question is whether, given all these failures, it’s remotely realistic to hope or believe that the Fed can change its spots and become a smart and strong regulator with teeth. Fed governor Daniel Tarullo, who has been appointed by President Obama to overhaul the Fed’s approach to regulation, thinks it can:

“Supervision of the largest institutions is something that’s going to be very hard to do and to do well,” Tarullo said, “and the Fed is the one part of government that has the resources and the capacity and the expertise to fill this role.”  

My feeling is that he’s more right than wrong. Yes, the Fed screwed up big time over the course of the past couple of decades, essentially giving up most of its important regulatory oversight role. But at the same time it seems improbable, to say the least, that anybody else could do a better job than the Fed.

To put it another way, the Fed’s our best hope here. Its chances of becoming an effective regulator might be slim, but they’re higher than the chances of getting an effective regulator if you give the job to a different agency entirely. Either way, the most likely outcome is probably that banks will continue to act with reckless impunity. But we ought at least to try our best to stop them from doing that. And the Fed’s the only agency which has a chance in hell of succeeding.

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