Run for the Hills: Fed Plans to Build on Sham Stress Tests as Basis for Regulation

As readers may recall, we and just about anyone who understood anything about financial firm supervision saw the stress tests as a complete and utter farce. The authorities had tea and cookies with the 19 banks and then talked about model outputs. The talks sometimes got heated, so were were supposed to take this as serious exercise. No one did what one normally does in an real examination, which is go in an inspect at an operational level. For instance, in a bank exam, the procedure is to sample loan files to look for irregularities. In a trading operation, you’d need to look at how positions were valued (among other things). None of that happened, nada.

And now that bad process is about to be institutionalized, at least if the Fed is to emerge as planned as he One Regulator To Rule Them All.

A snippet in a Bloomberg story gives only a indication of what is in store.

The Fed is apparently trying to counter the well deserved image that it is neither good at nor terribly interested in supervision. As part of its effort to secure its hoped-for position as The One Regulator To Rule Them All, it is now trying to prove its chops as a regulator. Since it clearly has none, next best s to try to persuade outsiders that it could develop one.

So here is the pitch:

The Federal Reserve plans to strengthen its examinations of banks’ lending practices and financial health with new teams composed of experts in everything from law to economics and markets.

Fed Governor Daniel Tarullo outlined the step in testimony to a Senate Banking Committee hearing in Washington today. The overhaul, which would make reviews more uniform across the banking system, builds on the stress tests the central bank completed on the biggest 19 banks in May.

Oh boy, this sound bad. First, notice what is on and not on the list? I would not have economists as bank examiners or supervisors. This is the Fed’s culture writ large. Since the place is run by monetary economists, they assume that economists have insight into every conceivable problem. By contrast, if you look at a Wall Street firm, economists only do the sort of thing you’d expect that economists might have an advantage in doing….economic forecasts or in client facing roles where being a PhD economist might add cred. Notice the absence of folks like criminologists, accountants, and most important, former industry practioners. And the fact they want to build on the shambolic stress tests is truly alarming. That is telegraphiing that the Fed continues not to have its heart in being a regulator.

So let’s look at the actual Senate testimony to see if Bloomberg was being unfair or too cursory. Nope, it’s even worse, albeit coded, so you need to read the tea leaves. From Tarullo’s written testimony:

Applicable regulations must be well-designed to promote the safety and soundness of the institution. Less obvious, perhaps, but of considerable importance, is the usefulness of establishing regulatory requirements that make use of market discipline to help confine undue risk-taking in banking institutions

Yves here. What fantasy is this? “Market discipline?” The Fed has thrown a heavy duty safety net under the entire financial system, there was up to $23.7 billion that could have been deployed, and Tarullo has the temerity to invoke “market discipline?”

We have an official “No More Lehmans” policy. No one big or even not so big but well tied into the critical financial plumbing is permitted to fail. Tell me how you subject Citigroup, with $500 billion in foreign deposits, which for practical and political reasons the Fed would not want to backstop but if push came to shove probably would, is going to be subject to market discipline. Give me a convincing answer to that and maybe we have something we can talk about. Otherwise, this “market discipline” palaver is just code for “we’ll pretend the industry has good enough incentives to mind itself.” Greenspan took that line in 1996, if not earlier, that all regulations needed to do was mimic what the market would demand in the way of capital buffers. You can see where that line of thinking got us.

Back to Tarullo:

When a bank holding company is essentially a shell, with negligible activities or ownership stakes outside the bank itself, holding company regulation can be less intensive and more modest in scope. But when material activities or funding are conducted at the holding company level, or when the parent owns nonbank entities, the intensity of scrutiny must increase in order to protect the bank from both the direct and indirect risks of such activities or affiliations and to ensure that the holding company is able to serve as a source of strength to the bank on a continuing basis. The task of holding company supervision thus involves an examination of the relationships between the bank and its affiliates as well as an evaluation of risks associated with those nonbank affiliates.

Yves again, This is even worse. Recall that the proposed job description for the Fed is financial stability regulator, or :Lord and Master of the Massive Financial Backstops. The Fed could and should interpret that mandate broadly. But look at that language, This is legalistic. Basically, because the Fed is providing many of its lifelines via bank holding companies (think Morgan Stanley and Goldman) it is taking interest ONLY in the holding companies and defined the impact of the other operations ONLY with respect to their potential impact on the holding co. While technically correct, the wording here strongly suggests the other operation, where the risks really sit, will be treated as black boxes and only analyzed in a removed fashion. as to whether and how stuff like Goldman’s massive trading operations might affect the holding company. This viewpoint has the effect of making what ought to be the primary focus, a detailed inspection of the subsidiary operation, secondary.

Now a few pages later, Tarullo comes back and says something very different than what he said at the top:

Large organizations increasingly operate and manage their businesses on an integrated basis with little regard for the corporate boundaries that typically define the jurisdictions of individual functional supervisors. Indeed, the crisis has
highlighted the financial, managerial, operational, and reputational linkages among the bank, securities, commodity, and other units of financial firms.

Yves again. So you recognize the risks are integrated, yet you proposed a holding company vantage point. Which is it?

Now in fairness, he then spends some time talking about how (effectively) firms can all be making the same bets, so if you look in isolation rather than system wide, you can miss that, and he also makes noises about dealing with pro-cyclicality But next we get this:

Following up on that initiative, on June 30, 2009, the federal banking agencies requested public comment on new Interagency Guidance on Funding and Liquidity Risk Management, which is designed to incorporate the Basel Committee’s principles and clearly articulate consistent supervisory expectations on liquidity risk management. The guidance re-emphasizes the importance of cash flow forecasting, adequate buffers of contingent liquidity, rigorous stress testing, and robust contingent funding planning processes. It also highlights the need for institutions to better incorporate liquidity costs, benefits, and risks in their internal product pricing, performance measurement, and new product approval process for all material business lines, products, and activities.

Yves here. Mike Milken once said something like “Liquidity is an illusion. it’s there until you need it.” Bear effectively suffered a run on it. Counterparties started refusing to extend credit nine days before it went under. That wasn’t a market shock per se. And even though Lehman was on its way down. the fact that JP Morgan allegedly withhelld $17 billion in cash and collateral was the proximate cause of its demise. Put it another way, Bear and Lehman had risk management operations. I’ll bet they did stress tests too. Bear actually DID have contingent credit it didn’t use. In other words, it does not appear these proposed measures would have saved Bear or Lehman unless the a regulator was willing to examine and question both their methods and the true state of their balance sheets and contingent exposures in some detail.

Now we get the really scary bit. I have long been convinced that the Fed’s culture of seeing monetary economists as the alpha players would undermine any efforts to become an effective regulator, and this is borne out in spades:

Appropriate enhancements of both prudential and consolidated supervision will only increase the need for supervisors to be able to draw on a broad foundation of economic and financial knowledge and experience. That is why we are incorporating economists and other experts from non-supervisory divisions of the Federal Reserve more completely into the process of supervisory oversight. The insights gained from the macroeconomic analyses associated with the formulation of monetary policy and from the familiarity with financial markets derived from our open market operations and payments systems responsibilities can add enormous value to holding company supervision.

Yves here, Mind you, this is the FIRST mention of exactly who will be in the new enhanced regulatory apparatus, so clearly they see this as the lead measure. And we are supposed to believe that MACROECONOMISTS, should lead this exercise? Worse, these particular macroeconomists happened to miss the possibility that a crisis might happen, despite warnings for years from William White at the BIS and starting in 2005, from a broader range of sources, and then when the crisis started, insisted it would be contained. They are presumed to have a relevant perspective? They grossly underestimated risk! That should disqualify them from having to do ANYTHING with this exercise.

It gets worse. The Fed drank it own Kool-Aid,, big time, as far as the stress tests were concerned:

This unprecedented process involved, at its core, forward-looking, cross-firm, and aggregate analyses of the 19 largest bank holding companies, which together control a majority of the assets and loans within the financial system. Bank supervisors in the SCAP defined a uniform set of parameters to apply to each firm being evaluated, which allowed us to evaluate on a consistent basis the expected performance of the firms under both a baseline and more-adverse than- expected scenario, drawing on individual firm information and independently estimated outcomes using supervisory models.

Drawing on this experience, we are prioritizing and expanding our program of horizontal examinations to assess key operations, risks, and risk-management activities of large institutions. For the largest and most complex firms, we are creating an enhanced quantitative surveillance program that will use supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multi-disciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of on-site examination teams so as to provide an independent supervisory perspective as well as to complement the work of those teams.

Yves again, This is truly terrifying. They really think they did a good job on the stress test and want to use it as the template for future regulatory oversight! it was widely deemed to be a farce, but the markets bought it. So if it is good enough to fool the markets. that’s all that matters, right?

The bit that those vaunted economists provided was looking lousy even before the tests were completed. The adverse scenario was looking pretty middle of the road. But no, couldn’t change a high profile exercise mid-course and admit error could we, now? Oh, silly me, I keep assuming the purpose was to actually test the banks. The real purpose, clearly broadcast by Team Obama, was to restore confidence.

Saturday Night Live nailed it in this mock address by Geithner:

Earlier this week, I reported to you the results of the so-called stress tests my department ran on the nation’s 19 largest banks. This was an effort to determine each bank’s fiscal soundness…Tonight, I would like to reveal to you, the American people, the results to part 2 of the stress tests, the written exam taken by all 19 banks’ CEOs…. Initially, my department had planned to give each bank a numerical grade of one to 100, 100 being a perfect score. But then we decided that might unfairly stigmatize banks who scored low on the test because they followed reckless lending practices or were otherwise not good at banking. So we changed to a simple pass/fail system.

However, on reflection, a few of us felt that system was too rigid, so we changed it once again, to pass,/pass*. This seemed less judgmental and more inclusive. Eventually, at the banks’ suggestion, we dropped the asterisk and went with a pass/pass system. Tonight, I am proud to say that after the written tests were examined, every one of the 19 banks scored a “pass”. Congratulations, banks!

So now we are about to institutionalize sham regulation as the real thing. Simon Johnson, and more recently, Michael Lewis, are right. The bankers have captured the state.

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  1. GoodMonkey

    Another kick the can forward except the can is a 10 ton stone by now. If the financial markets make it to next year without something really bad happening this fall, it will be a miracle.

    The weakest point is the dollar. The FED is already printing huge sums of money, one way or another and that will eventually lead to dollar crash or worse.

    The worst scenario being (for Americans especially) the abandonment of dollar as reserve and PRICING currency. This might happen if major trading partners (EU and Asian countries) refuse to accept more dollars because the currency rate cannot be calculated due to forex market chaos.

  2. fajensen

    … if major trading partners (EU and Asian countries) refuse to accept more …

    They will never refuse, IMO.

    Nobody has yet any idea of how to act within the confines a different world economy than the present which they have gamed to perfection. However, there will come a time when they simply cannot absorb any more USD paper and still meet their own obligations.

    The FED and the political system (also here in Europe) are basically acting exactly like the compulsive gambler or the alcoholic in believing that More of precisely the same behavior that got them into the mess also will get them out of it – if only their luck would turn once, they find an edge e.t.c. (sic!).

    The world is running on delusions more than ever before and we are privileged that we are here to watch ;-)

  3. Kevin Smith

    Great piece Yves — in the spirit of Tanta!

    I'll bet your book will be a blast — gotta get it.


  4. Views By a

    "That is why we are incorporating economists and other experts from non-supervisory divisions of the Federal Reserve more completely into the process of supervisory oversight. The insights gained from the macroeconomic analyses associated with the formulation of monetary policy and from the familiarity with financial markets derived from our open market operations and payments systems responsibilities can add enormous value to holding company supervision."

    We are all doomed.

  5. rdd

    Great post.

    Unfortunately, the only good thing that I see in the system right now is that Congress will be in recess shortly. Sheila Bair et al have been giving testimony against some of the plans that Tiny Tim has for regulation. Hopefully, that will delay the legislators a while.

    I think the financial market millipede has some more shoes to fall. A delay in new regulations may give the opportunity for one or two more of those shoes to whack the legislators and Tiny Tim on the head so they can reduce their capturedness.

    Unfortunately, I think we are still in the middle innings. Probably something like 1973-1974 with another decade of the late 70s-early 80s in front of us as the US and world economy continue to digest deleveraging by the US consumer, among many others and the US and other developed countries crank up their leveraging.

    The Fed needs to focus on money supply and inflation/deflation. It largely failed at that over the past decade. We need a separate agency to regulate the internal business dealing of all significant financial institutions. We then need one more regulator to focus on the consumer end, including standard agreements with institutions like credit cards and mortgages.

  6. Eagle

    If you believe that no market discipline can be relied upon, why not state plainly the logical conclusion of that premise – that you believe we should shift to centrally-planned command economy, relying on those regulators that did such a fantastic job during this crisis.

    Also, if I remember correctly, there were banks who failed the stress test. Of course, I don't watch SNL as closely as you do.

  7. Grew

    My issue with all of this junk is that the government is so quick to try and create solutions in minutes when they need months to properly do so.

    Hey this person is bleeding from an artery. Lets Superglue the artery shut! YAY its working!

    They fail to realize they may have solved the short term problem but created far worse implications longer term (losing the leg)

    Now they are saying that they are going to institute the superglue fix as THE solution. Guys have some patience…. its truly frustrating

  8. Richard Kline

    *arrgghh* 'Market discipline' is simply a re-phrasing of 'self-regulation;' the two phrases describe the same concept. And that is telling. It indicates that the worldview operative inside the Fed is exactly the same now, used in formulating this approach, as it was in 2005, used in formulating this crisis. I mean, we knew that, but to see it from their own mouths is terrible. Strike that: odious. The Fed has learned _nothing_ from the crisis, other than that better visuals make for more stable market returns. "Those who do not learn from history . . ." and all that. —But then the Fed has no incentive to learn. It's brief is industry _promotion_. Which is exactly why charging them with 'regulation' of the industry they are designed to promote is a fool's exercise on a good day. All that will result is that one is, too, made a fool.

    Macroeconomists are the very last folks who should be tasked with regulatory supervision, I agree. The lack of industry participants envision in this outfit speaks volumes to the intent of its designers. No one in a position to understand the problems will be invited to consider the problems. Because, as you detail Yves, the goal isn't to actually _investigate_ problem centers but rather to talk with 'industry participants' how to better manage their visuals. Since the Fed will make them whole regardless. That is the REAL 'regulatory' framework: public dollars to private parties at all points of concern.

    This entire design is like a leaf rubbing of a tumor, or a cancer on the body politic. Regulation is too, too harsh. Just connect the financial big boys to public tax receipts at no charge to them, and let the good times roll. The only 'problem' is how to hide _that_ fact from the rubes amongst the sheeple. Which this the only real purpose of this entire sham scaffolding. Oh, they can blathter all they care to on 'counter cyclical' this and 'systemic concentration' that. When the rubber meets the road their plan is to steal public money and to lie about it, and to ensure that they are not caught TO CONDUCT *NO* CLOSE OVERSIGHT BEFOREHAND. That way, they can always say "It's a systemic event, we must act." No paper trail, and all that. This design is industry proposed _to prevent_ any actual regulation.

  9. Richard Kline

    Eagle: "If you believe that no market discipline can be relied upon, why not state plainly the logical conclusion of that premise – that you believe we should shift to centrally-planned command economy . . ." The second clause on 'centrally planned command economy,' does not logically follow from the first. There are both steps in between and other alternatives. Try posting again when you have a contention that holds water, my friend.

  10. Eagle

    Richard: Yves argues that no regulation should be relying on market discipline, calling it a fantasy. Care to explain how any market worth having functions with zero discipline?

  11. Eagle

    To be clear, if there's no discipline, no rational firm trades with a counterparty it can't trust to repay it. They either must be forced to trade by the government, or there is no market.

  12. Marcf

    Eve: what is wrong with monetary economists? After all this crisis is a monetary crisis (like most financial driven crisis) one coming from too much debt created by innovation and circumventing the regulated levels of debt money. The one criticism I would make of monetary economist research is that they believe that govt policy effectively sets inflation levels when it was actually set by the private sector. Monetary economists will know what to monitor to get at true monetary mass, including all the MBS, CDO and their residues on off balance sheet vehicles. Sometimes your cynicism gets the better of your analysis, criticism of everything goes only so far. Who is going to regulate this mess? practitioners? puhleaze.

  13. "DoctoRx"

    This post demonstrates Yves at her best. Nothing like finishing the writing of a book?!

    A quibble with the conclusion: perhaps as in the '30s the degree of capture of the state by the banks goes in cycles. I'm keeping the forlorn faith that righteousness and common sense will have their day.

    Perhaps when SNL parodies you and your actions, your time is drawing nigh.

  14. Siggy

    Very good post, very much on point. Wherever the phrase '19 banks' appears replace with 'primary dealer' banks. With that bit of clarification it becomes very clear that 'stress testing' is theater done to underwrite good feelings and maintain the ability of the Treasury to fund our profligate Congress!

    Our distress has been caused by: Greed, Hubris, Legislated Opportunity; and, critically the artificially low cost of renting loanable funds. As a society we cannot borrow our way to prosperity! We can, however, save our way to a propserity the cost of which is foregone current consumption. As the baby-boom generation ages it will become increasing clear that savings for future consumption will be critical. To some extent the body politic understands that reality and is now increasing its savings rate.

    So long as we adhere to a fractional reserve fiat currency we will have asset bubbles as the markets seek to maintain purchasing power. Recent experience suggests that asset acquisition that can be facilitated with borrowed funds are prime targets for the creation of a price bubble. For that reason the Fed should be focusing on the level of required reserves.

    As to regulation itself, before we run off and pass a lot of laws/regulations so that we can say that we did something, we should look at the laws that were not enforced. My peeve is AIG where there was a history of side letters and accounting improprieties regarding re-insurance. That adventure was followed by the sale of contingent contracts that the enterprise could not honor. Instead of bonuses, somebody at AIGFP needs to be the subject of a Justice Department Inquiry.

  15. Anonymous

    The Fed has learned _nothing_ from the crisis

    Why should anyone expect it to?

    The Fed was created for the sole purpose of increasing leverage for banks. It will NEVER waver from that.

    This is the reason having the Fed be the main regulator is a stupid idea. But you can't blame the Fed for not wanting to deny the essence of its existence. Ultimately, the is why having a Fed governor as Treasury Secretary is a ruinous idea. Obviously, federal government wants to be in on the leveraging game too – and IT will also never waver from that desire.

  16. asphaltjesus

    Eagle: you are attempting to draw out Yves on some ridiculously false premises.

    Care to explain how any market worth having functions with zero discipline?
    Economic history is full of examples of this. Your follow-on 'clarification' is naive and fatally flawed.

    At best, your economics thinking appears to be grounded in some kind of political double-speak that has no basis in economic history or economic discipline.

  17. Hugh

    This is Potemkin regulation. We have a financial system as corrupt and dysfunctional as ever. Having lost trillions in investors and homeowners' money, the same villainous actors, instead of being sent to jail and their operations liquidated, have been given new trillions in taxpayer backed funds to gamble away in similar fake and unproductive enterprises. It is no surprise then that the government is only interested in cosmetic "regulation", something meant to confuse and fool the rubes.

    I would not call this "capture" though. This isn't even a willing selling out of our elites to special interests. It is rather that Wall Street is part of our elites and our elites are part of Wall Street. Obama and the Congress, Democrats and Republicans, aren't mistaken or misinformed. They are doing precisely what they mean to do. Summers and Geithner are not subverting any agenda. They are the expression of the agenda.

    So it is that we have these two narratives. In one, there is non-stop talk of greenshoots, stepping away from the abyss, stabilization, a rallying stock market, a bottom to the housing market, recovery later this year, the stimulus is working, being past the worst of it, etc.

    On the other, is the recognition that none of the problems that underlie the bursting of the housing bubble and the financial meltdown have been fixed or even seriously looked at, leveraging, securitization, bubbles, distressed homeowners, massive and systemic fraud, job losses, falling housing prices, inflated oil prices, derivatives, even bigger TBTF institutions, fake or no regulation, trillions sunk into an unproductive financial sector, and the cooking of financial books and balance sheets.

    It is clear that the first narrative is currently dominant, despite its lack of substance (other than those trillions) but you have to wonder when the second reality based one will reassert itself, and what happens then.

  18. But What do I Know?

    Thanks, Yves, for that trenchant analysis–can't wait for the book. The central banks remind me of put sellers who have seen past sales rewarded and so think that they have the proper analysis and methods to deal with any crisis. If they start to lose they figure they can just create and throw more money at the problem. One day their theories are going to fail catastrophically and then they'll look around at each other and ask what went wrong. Just like every Martingale scheme. . .

    The "put selling" will probably work this time again–but it gets less and less rewarding every time they do it because the big money has realized that the game is ultimately unsupportable and are seeking wealth storage outside the currency system–gold, guns, and fuel. They know that the next time it goes down the Fed and its BIS partners might not be able to save it, IMHO, and the only prudent thing to do is hedge at least a little against disaster.

  19. skippy

    Well this is what happens when you put ATM's inside the casino and everyone draws equity out too become the next big dog on the street.

    The IB's loved the game whilst it was good, but blame the individuals making withdrawals, so why should they suffer, for with out the ATM's the game could not have ever been played.

    Regulate ha, any industry with perceived social license (TBTF) can bully or buy what ever they think they need and when it all goes horribly wrong, will stand with pins affixed to their chests decrying evil forces are at fault.

    I say give them all the rope they want, lets let them have every thing they want pronto, make or break deal. If it goes ka boom its their asses left out in the wind dangling for carving.

    Skippy…going out to kill as many feral camels as I can, then send the Blondie bimbo on CNBC an Aussie camel scrotum wine cooler, talk about green shoots, the green gift that keeps on giving. OOh don't kill the imported feral camel that destroys the enviroment skippy, its so romantic and cute, sheez.

    PS. If Blondie and Crammer ever mate, the human race is doomed, shudder.

  20. Anonymous

    Nice posting Yves.

    It really is sick to see western civilization so lacking in moral outrage over obvious class warfare. What are you going to tell the kids you did while the oligarchy raped and plundered the world economy.

    The dollar bubble has begun, actually it started last August. How long will it take to pop?

    Maybe we can all get jobs rewriting history to make the oligarchy look good.


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