Is the Fed up to examining your trillion dollar bet?

By Mark Williams
January 30, 2009

Mark_Williams_Debate– Mark T. Williams, a professor in the Boston University School of Management’s Finance & Economics Department, was a former Federal Reserve bank examiner in San Francisco and Boston. The views expressed are his own. –

Washington is doling out more than $1 trillion to banks, a hefty capital commitment putting taxpayer money at risk. Meantime, Congress is moving to expand financial sector oversight and the Federal Reserve Bank is likely to take on this additional duty.

As the government’s financial involvement increases, the Fed must be ready for this expanded role. Unfortunately, the current fleet of Fed examiners is in way over their heads. I should know: I used to be one.

The root cause of the financial crisis has been bank driven. Under the Fed’s watch, Wall Street wizards were allowed to concoct, sell and speculate on risky credit-related products. In addition to monetary policy, the Fed has an important duty to maintain a safe and sound banking system. Although this supervisory role is well understood, banks still overdosed on risk — not overnight but over time. This significant risk trend was missed by the Fed and its examination force.

In maintaining safety and soundness, bank examiners are the first line of defense. They are the foot soldiers, the Fed’s eyes and ears. The examination process includes physical sampling, on-site visits, and executive interviews, culminating in a formalized bank rating and written report. These ratings are an important risk measurement and provide a bank’s financial health scorecard. The Fed does not make these ratings public but uses these to assemble lists of the weaker banks that need further attention and oversight.

Data from bank examination reports are also used to evaluate longer-term risk trends on a local, regional, and national basis. As the Fed conducted on-site examinations, it is difficult to imagine how they missed this growing credit storm. The Fed could have quickly put the brakes on risky lending practices, reduced the number of bank failures and better protected the financial strength of this vital industry.

The Fed missed spotting the risk because many of its field examiners lacked the needed sophistication, training and measurement tools. While the bets being placed by regulated banks grew in size and complexity, Fed examiners were ill-equipped to adequately measure, monitor and report on these risks.

This growing gap in examiner knowledge and skills provided greater opportunity for banks, armed with generous bonus plans and sophisticated models, to overindulge in risk.

The banking industry continues to consolidate. In the last 25 years, the number of U.S. commercial banks has declined from over 14,000 to approximately 7,300. This significant trend has caused greater concentration of risk as more assets are being controlled by fewer banks. One botched Fed examination at a major bank can have much more far reaching implications than just 20 years ago. In addition, recent strategic miss-steps by major banks, such as Citigroup and Bank of America, have obliged more day-to-day surveillance and stressed an already wobbly examination force.

The on-going financial crisis has also forced investment banks, such as Goldman Sachs and Morgan Stanley, to adopt commercial banking status. As a result, the Fed now has a new type of “risk-taking” animal to tame and put under regulatory oversight. Unlike commercial banking, investment banks historically have taken more risk and used more leverage in seeking profits. The Fed must quickly and thoughtfully retool its examiner force so it can better carry out the critical role of maintaining a safe and sound banking system.

With significant taxpayer money on the line and more slated to be released, Fed examiners in today’s marketplace must better protect our investment as well as keep banks from inflicting financial harm to themselves and to the broader economy.

To upgrade Fed examiner capabilities, there are four critical areas which needs fixing:

1. The Fed must immediately hire more specialized bank examiners to provide better risk training and establish adequate incentives so the best will be encouraged to stay.

Fed examiners need to show a strong aptitude and understanding of the risk-taking activities which now drive bank earnings. The Fed should hire from the very institutions it regulates. In the last decade, the flow of hiring has been primarily from the Fed to such banks, which has further eroded the strength of the national examination force. In addition, adequate incentive systems need to be put in place to minimize the brain drain and insure that the best examiners have financial incentives to stay.

2. The Fed must tighten regulation and leverage-ratio requirements of investment bank-related activities.

Recent financial losses, including such high profile bankruptcies as Lehman Brothers, the shot-gun marriage of Bear Stearns to J.P. Morgan, and the continued financial harm inflicted by Bank of America’s ill-conceived acquisition of Merrill Lynch division, reinforce the danger of using excessive leverage. The Fed needs to re-examine its position on what is acceptable leverage and provide clear policy.

3. Compensation schemes at commercial and stand-alone investment banks must be re-evaluated with tighter oversight and linkage to overall ratings.

Bank-derived compensation systems can reinforce good as well as destructive behavior. The Fed should take a more active role in better identifying when incentive systems are positively aligned or when they encourage excessive risk taking.

4. The Fed must provide tighter regulation oversight on bank prime-broker operations.

Many commercial banks offer prime-brokerage lending services to unregulated, high-risk hedge funds. Up until recently, this business segment has grown substantially. There are more than 6,500 hedge funds in the U.S. that control more than $1.2 trillion. A bank can only be as strong as its customers. Given that the hedge-fund industry is looking shakier every day, the Fed must strengthen its expertise in regulating and tightening up lending standards in the prime-brokerage areas of its member banks.

By focusing on these four areas, stronger Fed examination staff and oversight will strengthen our banking system and go a long way toward protecting your $1 trillion bet.

29 comments

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1)”Economics is the dismal science”
2)Government exists for those who work for it, not so much for those it is meant to serve. Fed examiners? Whatever.
3)I’m sure glad the SEC put Martha Stewart in jail.

Posted by JRaymond | Report as abusive

While I applaud the author’s detailed inside account of the inadequacy of the regulatory process, it does not get to the heart of the matter. This melt-down was precipitated by a criminal hands-off policy that was publicly stated and demonstrated by the executive branch and the the Fed directors. If the leadership is cheerleading for looting and plundering, why would anyone expect the lowly regulators to spoil the party?

Until criminal charges are brought against the very top leadership, this debacle will continue. Since that is unlikely to happen by the complicit Democrats, hold onto your seat, we are in for a very bumpy ride.

The only solution to this fiasco is what John Stewart, the news comedian suggested. Give the bailout money directly to the household debtors for use in paying of their debt. Turn the debt over to a “Debt Resolution Corporation”. Allow the debtors to pay off with reduced payments over a longer period of time with an additional premium tacked on for the privilege.

Sad commentary when the most intelligent solutions come from the comedians!!

Posted by Jonathan Cole | Report as abusive

Interesting insider’s perspective.
Having spent a lot of time on governance and regulatory issues, I thought the discussion and proposed solutions skipped some key points. In particular:
- How clear are the instructions to banks and to examiners, with what oversight and what reporting streams?
- What exactly are the incentives on the examiners?

Unless there are clear instructions, reporting, oversight and good incentives, any examination system will tend to suffer from client capture and turn mushy over time. The privacy of the system doesn’t help – it becomes a club. I understand that publically identifying weaker banks will make it more difficult for them to recover, but there are other techniques to bring a little fresh air into the room.

I think this fraud is at a much higher level than most people would want to believe or even think about. How could our Fed not have seen what was going on, unless there were other agendas behind this financial meltdown, but I am accusing no one of anything directly, merely voicing my opinion. One of the reasons I left the mortgage industry to go back to school was because of the amount of fraud and forgery that was happening at a broker level; it was almost a daily occurrence and it was looked upon by managers and other brokers I have worked for in numerous offices as “this is how it’s done”. I never took part, I never sold an option ARM because I knew the general public wouldn’t know what to do with this financial weapon and would not put their savings elsewhere but spend it and keep paying a min payment or interest only thinking their house would keep going up in value, which people wont listen…they hear 10% increase per year in house value but don’t look to the future when the bubble collapses. I have closed several NINA, no doc loans but only to small business owners who had a valid business and income but had written off most of their paper revenue on personal returns and wouldn’t qualify without bringing in business tax returns and the rate was close to the same. However, I stayed away from those loans as much as I could, while they were being pushed by fellow brokers to ordinary people who could not qualify for a home loan based on income but had the credit qualifications. I stuck with fixed rate refinances, mostly sub-prime to A paper once they were able to qualify for A-paper. I saw this coming 4 or so years ago and have been waiting for it to actually happen not in a good way but because I knew eventually it would all come undone. I think the Federal Reserve shouldn’t be private either and I also think nationalising the banks wouldn’t be such a bad idea until we can sort this situation out and sell them back to the public after the financial sector has been reformed. People need to be held accountable, including mortgage brokers and originators that were fraudulent in their activity and investors as well. I say we go after them all and teach them a lesson, Wall Street included.

Posted by Damian Palmares | Report as abusive

Two comments :
1) Fed examiners go after setting up fences for loan/debt portfolios. We also need investigators to go after the thieves. There is too much of an assumption that everyone was acting above board.

2) Neither the lender nor the borrower should escape from carrying the burden of the bad debts. Both sides were feeding the frenzy of these loans. In addition, there are 3rd parties, other than the banks, who have not only benefited in the high volume of transactions, but have also increased the SERVICES FEES beyond what was used to be OK. They were as complicit in the scheme as the banks. Real Estate agent fee of 6% on a $300K transaction at fair value vs 6% on an overvalued $500K property.

Posted by Jay Jones | Report as abusive

I knew some honest brokers and still do that still have their offices open but it seemed to me, in that business, there were more dishonest brokers then there were honest ones. World Savings, I believe was their name, used to push the option ARM loans like crazy, if it’s the same one I’m thinking about and Wachovia may have purchased them after they went bankrupt…I’m pretty sure they went bankrupt because that was one of their largest portfolios.

Posted by Damian Palmares | Report as abusive

Let them fall…here’s more proof of the hoarding going on…. http://www.forbes.com/2009/02/03/banking -federal-reserve-business-wall-street-02 03_loans.html

What do you expect from that industry? It’s time to let them fail and move on.

Posted by Damian Palmares | Report as abusive

Oops, wrong debate…sorry.

Posted by Damian Palmares | Report as abusive

After 911 I was under the impression that financial markets would be closely monitored for unusual transactions and trading activities through the use of data mining and algorithmic models. My basic argument is that oversight should be systematic and computerized. Without even knowing any specifics about account holders, aggregated data would have indicated problems. Instead we have a lot of old technological illiterates around a table discussing obscure, academic and largely unproven notions of economic stability. It has been my great pleasure to take their cash.

Posted by Don | Report as abusive