Mark T. Williams

Don’t throw the keys to the Fed

By Mark T. Williams
July 2, 2009
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THE OBAMA administration’s plan to close the existing regulatory gap by using the Federal Reserve Bank as the main systemic-risk regulator is theoretically sound but a bad idea under existing Fed structure.

The Fed employs thousands of examiners stretching from Boston to San Francisco in an attempt to ensure a safe and sound banking system. They are the first line of defense in our banking system, ideally providing a financial firewall against excessive risk taking by physically inspecting banks and ensuring that adequate capital is available to support risk activities. Ratings provide a health scorecard and a comparison with peer institutions.

Although Fed examiners scored major banks such as Citigroup, Bank of America, and Wells Fargo, why didn’t they pick up on the bad banking behavior that President Obama characterized as “wild risk taking’’ on Wall Street? This trend should have been discovered, except that the Fed is adverse to change and its examiners are way behind the regulatory curve.

If the financial market was a gun fight, the Fed would be carrying pea shooters while the Wall Street structured-product gurus would be carrying AK-47s. The sophistication gap facing those charged with measuring and protecting our financial system is staggering.

Meantime, the corporate culture at the Fed has made examiners second-class citizens compared with the more glamorous monetary policy geeks and the economists who roam the marbled hallways. Of the 12 sitting Fed presidents, none came up through the ranks from examiner. Fed examiners continue to have a limited advancement track and salaries at least one-fifth less than those of the people who create the derivatives on Wall Street. How can the Fed attract the best and brightest this way?

The Obama plan would give more responsibility to the Fed at a time when it hasn’t earned it. The recent banking debacle makes clear the Fed has failed to demonstrate that it is capable of taking this added responsibility. Handing the Fed this new duty, given its recent track record, is the equivalent of giving your teenager a new car right after he wrecked the last one. This significant sophistication gap at the Fed, compared with market counterparts it is charged with regulating, is why the Fed didn’t detect the growing risk taking by the major banks. Examiners did not have the adequate training, skills, or tools needed to go head-to-head with the Wall Street rocket scientists.

Why, for example, didn’t the Fed examiners see the growing threat of derivatives? These financial products that got so many banks in trouble were first concocted in the financial laboratories of First Boston and Salomon Brothers back in 1983. The Fed should have had time to amass an understanding of how such derivatives worked, and what kind of financial damage they could cause if used in excess or for the wrong purpose.

But under its current charter, the Fed is not held accountable for a job poorly done. In response to the current banking debacle, there have been no penalties, demotions, firings, or even a public hearing on how and why the Fed dropped the ball. Moreover, when banks do fail (approximately 40 so far this year), it’s the FDIC, not the Fed, that must clean up the mess.

Before the Obama administration expands the Fed’s role and throws it the keys, it is important to fix the varsity-versus-jayvee vulnerability at the Fed. At minimum, this will require that more capital (human and financial) be committed to specialized hiring, training, and increased use of state-of-the-art risk-measurement tools (e.g., computer modeling). The goal is to improve the use of risk-focused exams and to create a skilled examination staff that can detect and halt wild risk taking before the company, market participants, and the economy are harmed.

In addition to the Fed being held more accountable, there must be implementation of performance-based incentives for a job well done. Equally, there needs to be clear consequences to the Fed for poor performance. Only after we plug this regulatory sophistication gap at the Fed can confidence in this agency be restored.

Mark T. Williams, a former Federal Reserve Bank examiner, teaches finance at the Boston University School of Management.

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