Is the Fed up to examining your trillion dollar bet?
— 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.