Regulatory failure datapoint of the day, Citigroup edition

By Felix Salmon
November 30, 2011
book on the financial crisis; I'll have a full review of it soon, but for the time being let's just say that for my money it's the best crisis book so far.

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

I can highly recommend Nick Dunbar’s new book on the financial crisis; I’ll have a full review of it soon, but for the time being let’s just say that for my money it’s the best crisis book so far. Fair, detailed, unsparing, and — most importantly — written by someone who was reporting on the structured-products market all the way through the boom, instead of just looking back after the bust and asking what happened.

There’s a lot of reporting in this book, too, and today Reuters has an excerpt of how the Federal Reserve in general, and the New York Fed in particular, failed in its job of overseeing Citigroup. When DC-based examiners started asking tough questions, they were met with stonewalling from the New York Fed, which behaved exactly as you would expect from an institution captured by its big-bank shareholders.

The market and liquidity risk team and others in the Federal Reserve Board supervision division had grown concerned that as large banks built up their trading businesses and accounting rules gravitated to fair value measurement, bank balance sheets were increasingly subject to short-term market moves that could lead to rapid falls in regulatory capital. A memo produced by the team pointed out the issues and risks involved in increased use of fair value and warned that a sudden freeze in certain markets might imperil bank solvency. But when the market and liquidity risk team tried to interest Dahlgren in their findings, she retorted, “I think our banks know how to manage to fair value,” ending the discussion.

In 2006, the market and liquidity risk team attended a Citigroup risk assessment presentation to a committee of Fed examiners. When asked for the rationale supporting the designated satisfactory rating for interest rate risk, the New York Fed team could not provide any information. At another Citi meeting the market and liquidity risk team attended, the New York Fed examiners had been asked to come up with a list of supervisory priorities for the bank. They identified approximately twenty items and patiently explained why each one was important. Near the end, Peters interrupted and told his staff to cut the number of priorities to five or six because twenty was “too many.” The Washington, D.C., team was stunned—twenty was too many things to check regarding the largest and most complex bank in the United States?

This is a perennial problem — and the only reason we know how bad things were is because one small group of examiners, in Washington, was marginally less bad at regulating banks than another group in New York. Most of the time, there’s only one group of bank examiners, and they never blow the whistle on themselves.

At the end of the passage, Dunbar reveals that even if the full list of 20 priorities had been implemented in full, Citi would still have blown up, since no examiners had a clue that Citi was hiding $43 billion of CDO exposure off its balance sheet and outside its value-at-risk calculations.

Dunbar reports one particularly vivid conversation, in the wake of a carbon-trading desk blowing up:

One person on the market and liquidity risk team vividly remembers a New York Fed bank examiner shrugging off the emission trading losses, arguing, “Don’t worry about that. We just have to respond to these things when they happen. We can’t get ahead of these problems. We don’t have enough people, and the bankers have a lot of smart people.”

The sad thing is that the New York Fed examiner is probably right. They couldn’t get ahead of these things. And they still can’t.

An ounce of prevention, we’re all taught at an early age, is worth a pound of cure. But central banks are really bad at the prevention side of things. Which is why they have to put so much effort into their attempted cures.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

Linked to get book title and discovered that I have a copy right now – it’s on loan from the library.

It’s been moved to the top of the is list.

Posted by MarkWolfinger | Report as abusive

We can blame the regulators
We can blame the ratings agencies
We can blame the banks
We can blame the MSM
We can blame busted economic theories and models.

I have read Devils Derivatives and let me tell you that the one thing people are missing is the actions of people like Nick Dunbar and the industry that he represents. This guy worked at Risk Magazine. Did anyone at Risk ever make the point that these derivatives (CDS, CPDO, CPPI, etc) were devious? No they did not. They are every bit responsible for creating this culture.

Posted by JayTrader | Report as abusive

Police departments have learned you cannot fight sophisticated, heavily armed criminals with beat cops and career detectives. In response, they have created SWAT teams.

The military has learned that you cannot attack and defeat sophisticated, highly mobile enemies with conventional ground and air forces. In response, they have created special forces.

I continue to be mystified why there is so little interest and/or so much resistance to the idea of creating regulatory SWAT teams of highly-trained ex-bankers and lawyers–properly compensated, controlled, and overseen to minimize cognitive and direct regulatory capture–and embedding them within the trading and lending operations of systemically important financial institutions. There is literally no other way we will be able to catch and prevent similar blowups in the future.

Posted by EpicureanDeal | Report as abusive

I think EpicureanDeal’s viewpoint is flawed – he wants policing instead of prevention. I would much rather have beat cops and career detectives walking the streets and understanding the neighborhood and building a relationship with the community than, as is currently the case, heavily armed cops sitting in patrol cars waiting for another call to bang heads together. SWAT teams are useful and all when the crap hits the fan, but why not just prevent crime in the first place? Why let banks still engage in all these complex transactions, when odds are they will still slip through the cracks of these highly-paid regulators?

Posted by KingCanute | Report as abusive

Who do you think funds the regulators? CONGRESS.
Who do you think is captured by the Banking Industry? CONGRESS.

What we have seen over the last 10 years is that the SEC and other regulatory bodies have gotten their budgets cut by Congress. These guys don’t regulate when they had a bloated budget.

What EpicureanDeal says on the surface is correct. We do need a smarter, more nimble, tough regulatory body to crack heads but that will never happen as the bought and paid for Congress won’t allow it. I can see it now. Congress funds regulatory black opps squad to regulate Wall Street. You actually think Congress would ever allow a government agency to do such a thing?

Posted by JayTrader | Report as abusive

Gee. Felix, when Ron Suskind points out that the s4b who ran the NY Fed in 2006 and turned a blind eye to The Big C’s mismanagement moved to a certain position in the Current Administration and continued shielding them from any real action, you (and Brad DeLong and several others Who Should Know Better) defend him.

Want to mark that belief to market now?

Posted by klhoughton | Report as abusive

@KingCanute — I was not clear. Prevention is my goal, not clean up. But to do that, you need to embed skilled, knowledgeable regulators deep within banks’ trading and lending operations for realtime oversight. Banks won’t like it, but one benefit they will get is access to regulators who have a much better view of *aggregate* market behavior and trends, which will be extremely valuable to their own risk control.

@JayTrader — You are correct. Until we sever or tightly control the access of money to politics, such an idea will go nowhere. What you did not mention is the fact that Americans (everyone?) tend to be rightly scared and suspicious of smart, capable regulators. We prefer them dumb. That is a whole other issue.

Posted by EpicureanDeal | Report as abusive

@epicureanDeal, you seem relatively reasonable, candid, and open to opposing viewpoints. You are a longtime insider, and clearly senior. Your blog seems to be relatively respected in an industry that garners little of that commodity.

Let me suggest that you shed your anonymity and speak out in favor of the financial industry that you envision. It will almost certainly be better than the one we have now.

Posted by Curmudgeon | Report as abusive

@epicureanDeal – You are correct. I did not mention that Americans are suspicious of regulators and policymakers in general. Unfortunetely, this is self evident.
Where we diverge is that Americans don’t necessarily feel that regulators are incompetent are plain dumb, but that they are all captured by the industry that they are supposed to oversee. Of course we all want smart, nimble, and well paid regulators just like we want our women all to look like Heidi Klum. This is not in the cards under the current structure.

Posted by JayTrader | Report as abusive

@Curmudgeon — Thank you for the kind words, but I am neither senior nor wealthy enough yet to commit career suicide as you suggest. I will continue to comment pseudonymously from deep within the belly of the Beast.

Posted by EpicureanDeal | Report as abusive

@EpicurianDealmaker: thank you for clearing up your point: that strong, knowledgeable and independent regulators are necessary and net_beneficial for the banking sector.

For I was going to remark that you seem to equate bankers with criminals and military opponents, both of which are net negatives to society, and if of sufficient size, are classified as potential destabilizing forces that threaten the state and its citizens.

But other than that, I won’t comment on your Kinsley gaffe.

Posted by SteveHamlin | Report as abusive

DEVIL’S DERIVATIVES really is a great book – not just insightful and sharp-eyed, but beautifully written. I wish more financial journalism was done so well; the only other author I can think of who writes so clearly is John Lanchester (albeit aimed much more at general readers). Anyway, regulatory capture is the least of it: Dunbar’s explanations of how and WHY the instruments were structured are consistently fascinating.

Posted by MikeCooper | Report as abusive

+1. Fantastic book. His other book, inventing money was also fantastic, shows what a journalist can write when he bothers to learn the basics and fact check.

Posted by Danny_Black | Report as abusive