Don’t give the Fed a new job
– Mark T. Williams, a former Federal Reserve Bank examiner, teaches finance at Boston University’s School of Management and is writing a book on the rise and fall of Lehman Brothers. The views expressed are his own. —
In the real world, outside the Washington Beltway, when someone does a bad job they do not get more work. The Council of Institutional Investors and the CFA Institute Center for Financial Market Integrity task force report agrees with this fundamental point: Don’t give the Fed the new job. As an ex-Fed examiner, I applaud this conclusion.
Creating an independent Systematic Risk Oversight Board (SROB) to monitor firms that pose significant risk to the market would inject new honesty to regulatory supervision. This sound proposal comes at a time when Treasury Secretary Geithner would like to give his former employer, the Fed, additional regulatory duties even if they have failed to earn this right. The report also is critical of previous light-touch regulation. The SROB would provide a firmer approach, not repeating the mistake made by the Fed of coming with a knife to a gunfight.
A new oversight board would provide a fresh approach to preventing banks and other financial firms like insurance companies from engaging in risky and financially harmful practices. Importantly, the task force report recommends restricting risk-taking activities, forcing banks to refocus on their core competencies – taking in deposits and making loans. Although banks can get into trouble making loans, such activities are more transparent and easier to monitor than the trading of derivatives that, in a flick of a finger, can blow up a firm. The report also advocates strengthening capital adequacy standards, important for a cushion against losses and insolvency.
Traditionally, banks have made money only three ways — loan interest, fees for services, and trading. It would be extreme to say that all banks should be restricted from trading. But there are many that lack the expertise, capital, trained staff, or sophisticated monitoring systems needed to adequately measure, monitor and control risk.
In a capitalistic system it is important to allow market forces to work so that risk taking is adequately rewarded and excessive risk taking is penalized. However it is equally important to make sure that risky practices of banks do not come at the expense of broader market disruption, economic decline, lost jobs, and financial hardship.
The banking industry is at a fundamental inflection point. To say, “It’s business as usual, let the Fed do the heavy lifting,” does not address the underlying problem. How much risk taking should be allowed and how much concentrated financial power should be permitted in the hands of a few banks and non-bank financial firms is a paramount policy issue.
Stress tests: The results are in, now what?
– Mark T. Williams, who teaches finance at Boston University’s School of Management, is a former Federal Reserve bank examiner. The views expressed are his own. –
The market has anxiously waited over two months. With the stress test results in, we now have our work cut out for us. Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One. They were problem banks before the tests and they continue to be. But this painfully drawn-out process has spawned four tangible benefits worth discussing.
First, the stress test results raise an important policy question: Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry. In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.
Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards. Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.
It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities. Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.
Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table. Doing so will help to separate higher risk-taking banks from lower risk-taking banks.
Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking. Not long ago, the term “stodgy” was used to describe a bank or banker. Today it’s more accurate to use “risky.”
Just one thing more should happen after your points.
Banker’s income should be decoupled from share value and company’s profits. The remodelling of their income not fully connetced to equity stakes and involved interests, should/could help, in addition to your 4 point remarks, to refocus on recalibrated risk-taking.
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.
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.
Why did the SEC fail to spot the Madoff case?
– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The views expressed are his own. –
With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.
The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.
The SEC is responsible for overseeing registered broker-dealers, transfer agents, clearing agencies, investment companies and investment advisers, yet there is not a consistent risk approach used in all of these examinations. For example, in 2003, after widespread unlawful trading practices surfaced in the mutual fund industry, the SEC took steps to take a more risk-based approach.
Yet these higher examination standards were not viewed important enough to be applied to investment advisers such as Bernard Madoff. The weakness in the SEC’s existing examination approach can be best highlighted by the fact that, in the last 16 years, while Madoff’s firm was investigated 8 times, no fraudulent activities were ever uncovered.
As part of their broad regulatory mandate, the SEC is responsible for overseeing over 10,000 investment advisers. This agency needs to adopt a “where there is smoke there is fire” approach. The SEC must become risk focused in the scope and frequency of its monitoring and surveillance operations. Given the significant number of investment advisers, even if we assume that 99 percent are low risk, that still leaves 100 that need to be closely monitored and scrutinized.
The SEC should keep a detailed list of the top risky investment advisers and use it to prioritize and set review frequency. Currently, there is no clear indication that the SEC links review frequency or scope of exam with level of perceived riskiness. Former SEC Chairman Arthur Levitt recently indicated that only 10 percent of investment advisers are examined every three years. A wealth of new fraud can be dreamed up, hatched, and perpetrated at such firms in the interim.
Good work Mark. The SEC should never have let it get this far, if we had adopted a “where there’s smoke there’s fire” approach they might have been able to stop this from happening. I mean, if you are obviously making a substantial return that is significantly higher than everyone else supposedly in the same market as you, have done it consistently year after year, then something doesn’t add up. Don’t they have a team or teams risk management auditors that should have been able to pick this up? Also, what about the institutions and people that actually contributed millions of dollars through his feeder funds or directly, don’t they have a responsibility in researching where their money is going? I know, I myself, if I was investing 5 million to Madoff who supposedly told me he could earn a 12% return on my money, would want to know exactly how he was doing it, not that I could take my money and do it myself to avoid his fees but it just should have smelled fishy from the start. Hopefully we are on the right track now too safeguard these types of losses and schemes that these unethical businessmen are causing.
Minimizing exposure to investment management fraud
– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The opinions expressed are his own. —
It looks like the oldest trick in the book was used to allegedly bilk wealthy investors, banks, charities, endowments, and hedge funds out of their money. How could sophisticated investors have been duped by what could potentially be the largest Ponzi scheme in U.S. history? The answer may center on their due diligence prior to signing up with the investment firm run by Bernard Madoff, accused of masterminding the massive fraud.
Due diligence is the rigorous process undertaken to evaluate the controls, credibility, and capabilities of an investment firm prior to putting money at risk. This process doesn’t stop once a money manager is chosen, but continues over the life of the relationship. The $50 billion in reported losses and the fact that this scheme went undetected for so long are stark reminders that there is no substitute for solid investor due diligence and ongoing monitoring. Unfortunately, it has taken a down market to expose such fraud.
The following are 10 steps to help to reduce the chance of fraud. (Note: Until a human fraud meter is perfected, such risk can never be completely eliminated.)
1. Find a great money manager not a great friend.
Make sure the candidate pool is based on professional reputation, capabilities, investment track record, size of audit firm, and level of overall risk controls. Deciding on the right money manager should be a pure business decision. Confusing this business relationship with friendship or a person’s golfing handicap can cloud sound judgment.
2. Conduct your own independent due diligence.
All good points, but what do you do if you’ve been LIED to ?
You know the old saying : there are no honest fortunes, and the people investing your money are rich, so you do the math !
CDS market: contributor, not cause
– Mark T. Williams is a finance professor at Boston University’s School of Management. The opinions expressed are his own. –
The Credit Default Swap market shares some blame, but it isn’t justified to make it the Beltway’s latest scapegoat responsible for the economic meltdown.
There is, however, a need for its regulation and a strong CDS clearinghouse as a direct response to a real and growing danger. One or two more defaults from CDS protection sellers could roil this already fragile market.
The fact that the CDS market continues to function is not proof alone that it is healthy and doesn’t need fixing. Unfortunately, today’s financial crisis can trace its roots back to elevated risk-taking fueled by CDS. The real question is, Would banks have still lost over $1 trillion in the current credit debacle if the CDS market had not existed?
In less than 10 years, this market has grown from a tiny, strictly inter-bank market for hedging credit risk to a highly speculative market with a multitude of counterparties. This growth is understandable, as CDS created a cheaper form of betting on company defaults without requiring sizable cash outlays. Since 1997, this market has grown from under $1 trillion to $60 trillion. Although the way the market uses these products today has changed dramatically, the same unregulated OTC trading structure has remained.
While it is true that the net CDS payouts of over $6 billion, triggered by the Lehman Brothers bankruptcy, was relatively smooth, it is important to realize that this represented only one credit shock. Would the CDS market have continued to function if AIG, Freddie Mac, and Bear Stearns had not been rescued?
The weakness of the existing CDS market is that a few players dominated the field, and as long as their credit stayed strong, the market also was strong. Once creditworthiness declined, investor confidence quickly eroded.
Hello Mark,
I like your statement:
MTW: “In a capitalistic system it is important to allow market forces to work so that risk taking is adequately rewarded and excessive risk taking is penalized.”
Between us big CAPITALISTS, who was penalized for “excessive risk taking” in case of Lehman brothers or AIG?
Executives? Yep, they suffered. With economy goes south they lost jobs and now have to count every million on their private accounts.
Lehman? Yep, as a bank it paid ultimate price, but after all it was a legal entity not a live creature that suffers pain of death.
Shareholders? They suffered most. Te whole investment was wiped out. But with broken corporate governance all across US they had very little control over events. In every big corporation executives are shielded by hand picked boards.
Tax payers. Why they have to suffer and pay 168 BIL to bail out AIG and etc? It sound like communism to me – everybody gets as much as he/she needs.
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Banks and even insurers became vehicles to extract profit at any cost without thoughts beyond next bonus.
Capitalism failed there. Society cannot allowed bad guys to fall.
In your abbreviation SROB the key letter ‘I’ stays for ‘independent’ and it is absent.
Don’t forget every bank including Lehman had/has Risk controllers. They all failed badly. So the body must be independent.
FED doesn’t have infrastructure and expertise in measuring risk. But the truth is that nobody has.