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!