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.

Since 2008, the five largest independent Wall Street investment banks — Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns — have gained banking powers, been merged with other banks, or were purged by the market.  (Goldman’s latest quarterly earnings of more than $3 billion in profit, most from risky trading, stunned the Street.)  Over the last decade there also has been a rapid movement towards “universal” banking.  Examples include Citigroup, Bank of America, Barclay, HSBC, and Deutsche Bank that provide a full array of risk-taking products from commercial loans to derivatives trading.  And, increasingly, large insurance companies are acting and feeling like banks.

Concentrated power in our regulators can come at too high of a cost because this new breed of risk takers need to be regulated and examined differently.  Establishing an independent oversight board outside of the Fed also sends an important message to the market that regulators will no longer be rewarded for a job poorly done.

Not until we established more of a performance-based regulatory system and increase accountability at the agencies entrusted to protect us (e.g., the Fed, FDIC, OCC, and SEC) will our regulatory system begin to operate effectively.   If the Fed thinks it can do a better job, it will have the opportunity to earn back the trust of the market and, if successful, the task force oversight board could eventually be phased out.

More eyes viewing banking activities can only assist in better risk identification, monitoring and mitigation, before excessive risk taking is allowed to occur again.  The market, the economy, and the American people have suffered from lax regulatory oversight.  A new, independent Systematic Risk Oversight Board is a step in the right direction.

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.”

Fundamentally, banks attempt to make money only three ways — interest loans, fee-based products and services, and proprietary trading.  Each has a varying degree of risk.  What makes one bank willing to take more risk than another is driven by management risk appetite, the perception of risk being taken, and the amount of capital to support such risk taking.  A bank with lower capital is a boat that needs to stay close to shore.  Banks with higher capital have greater ability to go out to sea, take risks, and weather a financial storm.

As expected, some bankers see an inherent conflict with large capital reserves as this can reduce their perceived returns.  While bankers have no control over the economy, they have absolute control over the level of risk that they take and the capital levels they deem as adequate.  Ideally, bankers should take these factors into account as they continue to recalibrate their risk-taking activities to match the level of capital needed.

Fourth, the government’s very public stress-testing blitzkrieg elevated general awareness of the benefits of using such risk-management tools in evaluating and planning around possible adverse financial outcomes.  And while stress testing has been used for decades by banks and regulators, the fact that banks overdosed on risk over time and not overnight suggests that such tools were infrequently used or ignored in the pursuit of seeking excessive profits. Also, more aggressive model assumptions can and should be applied. Going forward, with elevated awareness of stress testing, bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.

Some banks have a greater propensity to overdose on risk, regardless of the initial size of their boats.  Many, such as BofA, Citigroup, Wells Fargo, and Capital One, are out to sea in a financial typhoon and now must be brought (or towed) back to safe harbor.  Stronger capital requirements, better regulatory risk oversight, and bankers with a stronger handle on fundamental risk-management principles should help reduce the chance of another banking meltdown.

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.

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.

Instead, the SEC must develop a stronger risk filter that will quickly flag investment advisers which exhibit higher risk characteristics. Such red flags should center on corporate governance issues such as level of independence and checks and balances. For example, does the investment adviser clear its own trades or do they use an independent third-party? Who is this third-party? Are they well known and do they have a good reputation? Who is the accountant for the investment adviser and what is their reputation and size?

Other warning indicators can come in the form of formal as well as informal complaints. What is the nature and frequency of such complaints and is a particular firm being consistently implicated?

Importantly, the SEC needs to develop a better “whistleblower” framework so it can quickly identify and respond to such complaints. If managed properly, the thousands of e-mails the SEC gets annually can be a powerful risk management tool to identify and respond to potential risk.

The SEC maintains a website to collect complaints and tips. However, the fact that whistleblower tips about Mr. Madoff’s firm were received as far back as 1999 and yet they were never fully vetted speaks to the weakness in the SEC’s risk filtering and response system. The SEC must be able to quickly sort through creditable allegations. Once such allegations have been identified, they must be prioritized, investigated and resolution reached in a timely manner.

Internally, the SEC should revise policy and include a clear action plan, process, and timeframe to address whistleblower complaints and tips. This would establish immediate accountability. To further encourage SEC investigators to comply with new response policy, standards must be directly linked to annual employee performance reviews.

In 1920, long before the SEC was established, Charles Ponzi was able to keep his scam running and undetected for only eight months. Fortunately, this fraud quickly unraveled when local media began to raise and followed up on some basic risk-related questions. The Madoff case and the failure of early detections is a further indication that the SEC should move to a more risk-focused approach.

Doing so, when coupled with timely follow up and consistent risk-based examination practices will help restore market confidence that the SEC can and will protect us against investment fraud.

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.

Regardless of who else might be investing with a potential money management firm (relatives, acquaintances, movie stars, or billionaires) don’t neglect your duty of completing your own thorough due diligence.  It’s dangerous to blindly assume that those that have a lot of money can also pick the most honest money managers.

3.      If you can’t do your own due diligence, hire a qualified agent to do it.

There are consultants and hedge funds with the expertise to conduct thorough due diligence.  But delegating this duty does not mean you can consider your work finished.  There must be constant monitoring, reporting, and ongoing dialogue between the investor, the agent, and the investment management firm.

4.      Remember that risk and return always goes together.

Investment returns mirror the level of risk taken, a fundamental investment management principle.  If investment returns are steady, regardless of an up or down market, it would suggest that there is a deviation from this principle.  Returns never lie and are a great “red flag” monitoring tool.

5.      Money management firms are not charities; they are commission driven.

Many good money managers who are not good marketers hire salespersons to talk up their services.  Be aware that the person selling you on an investment manager might be motivated more by their commission than any commitment to help you.  Ask to have all sales commissions put in writing.

6.      Money manager diversification is your best friend.

Large investors should consider diversifying, using more than one investment manager.  Doing so will avoid putting all your eggs in the hands of one firm and will reduce the financial consequences of fraud.

7.      Asking questions is great but getting clear answers is even better.

Investment related questions must be asked frequently with responses monitored and documented.  If questions are not being fully addressed, not provided in writing, or if the story changes over time, it might be a warning sign that it is time to take your money and run.  Examples of basic questions include:

a.      How is the money being invested?

b.      Where are the returns coming from?

c.      What are the portfolio performance benchmarks?

d.      How is the portfolio performing relative to these stated benchmarks?

e.      What is the level of portfolio risk being taken relative to expected return?

8.      Conduct on-going monitoring of the relationship.

Once money managers have been chosen, on-going monitoring is needed to insure that the firm(s) continues to act, walk, and talk as they have represented themselves.  Like fruit, people can rot over time.  You need to know when the fruit flies start appearing.

9.      Good returns do not mean due diligence can be stopped.

With all investment returns come a level of risk.  Make sure your money is not exposed to excessive risk taking.  Be suspicious of consistent returns that do not track with market fluctuations.

10.     Money managers that are highly regulated tend to have reduced levels of fraud.

Fraud can persist anywhere, but banks with investment management divisions are highly regulated at the federal and state level.  For investment clients, these extra layers of oversight can be a safety net against fraud losses.  Banks also tend to be very concerned about reputational risk events and are focused on developing tighter internal controls to minimize fraud.  As added protection, if fraud occurs, banks tend to have more assets to go after when filing legal action.  They also tend to be motivated to settle legitimate fraud based lawsuits to avoid the negative publicity.

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.

What would happen to this market if corporate defaults by larger CDS protection sellers (such as Citigroup, Bank of America or Morgan Stanley) defaulted? The fact that this critical question cannot be answered with absolute certainty suggests that we need to exercise caution and require more, not less, reporting and regulatory oversight. A centralized CDS clearinghouse would also help to alleviate credit fears by spreading risk among a broader participant group.

While still standing, the CDS market is wobbly. Investor confidence is waning and many participants, including hedge funds, have been forced to unwind and deleverage their holdings. Although individual credit events haven’t knocked out the CDS market yet, there is much credit uncertainty as the economy continues to deteriorate. As a safeguard, putting in place smart regulation and a clearinghouse will help backstop credit concerns and restore investor confidence. Without such needed changes, as more investors flee this market, CDS will be the next domino to fall.