The Federal Reserve Takes the Lead in the Financial Reform
Business + Economy

The Federal Reserve Takes the Lead in the Financial Reform

Iva Hruzikova/The Fiscal Times
As Congress continues its standoff on financial reform legislation, the Federal Reserve has quietly taken steps to significantly tighten its oversight of the nation’s biggest banks. According to people familiar with Fed operations, these changes include a beefed up supervisory staff that compares how large banks’ management of complex risk stacks up against the performance of other comparably sized banks. At the same time, a new committee of senior Fed economists has been set up in Washington to analyze the new flow of information from the banks and suggest added questions bank supervisors should be asking.

This new focus is intended to give bank supervisors a broader perspective of the market pressures being felt by banks. To generate the new data required for this heightened scrutiny, banks are now required to conduct regular stress tests — a sort of what-if exercise to estimate the losses an institution would incur if the economy abruptly slowed or financial markets soured.  

Senate Democrats are trying this week to overcome Republican opposition to moving ahead with a financial overhaul bill that would create a consumer protection authority within the Fed, raise bank capital and liquidity standards, and create a new council of regulators to watch for risks to the financial system. The financial reform bill would also provide new authority to liquidate failed financial firms in order to avoid bailouts of banks regarded as too big to fail, increase regulation of derivatives, streamline bank supervision, give stockholders a nonbinding vote on executive compensation, and add new rules for credit rating agencies. The House passed a different version of the legislation last December, and the two chambers would have to reconcile differences.

Fed officials believe the changes in bank supervision they have made in recent months will be consistent with requirements of the new legislation, although Congress might alter some of the Fed’s jurisdiction over the banking system. The behind-the-scenes tightening of supervision came in the wake of stress tests the 19 largest institutions were required to undergo a year ago to help both their executives and federal supervisors better understand what kind of shape the banks really were in after more than a year and a half of financial crisis and severe recession. The banks had to estimate what would happen to revenues and losses if economic growth, unemployment and house prices declined more than had been forecast for two years. 

Both the executives and the supervisors learned a lot, including how much additional capital — $75 billion — ten of the banks needed to raise to be able to survive if financial conditions worsened again. Executives found their institutions had far more problems than they realized, and supervisors found their normal examination procedures weren’t coming close to uncovering them. Only one company, GMAC Financial Services, required government assistance in raising the required capital. Equally important, the big banks have been forced to deal with other deficiencies, such as poor risk management plans and inadequate information.

Federal examiners working exclusively in one large institution gained new insights from other banks in the group which helped them deliver a better evaluation. It also turned out that the information systems in some institutions performed far better than others. Fed Gov. Daniel K. Tarullo said in a speech in March that “many of the banks were unable to quickly and consistently consolidate risk exposures across products, business lines, legal entities and geographies. It does little good to run a stress test, even one using a sophisticated quantitative model, if it does not effectively capture all relevant exposures because the bank’s information systems are poorly managed or integrated.”

The Fed’s newly established committee in Washington is monitoring the findings of bank examiners. By putting senior economists in charge instead of bank supervisors, the Fed is getting more useful recommendations and sharper perspectives than before.

Now the big banks are running stress tests on their own, generally on a quarterly basis, with examiners looking over their shoulders. Top management is regularly involved and in some cases helps decide what bad turn of events should be used in the tests. As a result, executives are much more familiar with the risks their banks are incurring.

In another speech earlier this month, Tarullo, who heads the Fed’s committee on bank supervision, proposed regularizing the banks’ stress tests and making the results public. First, he said, “releasing such information could assist investors in the difficult task of valuing loan portfolios that at present are not very transparent. Second, releasing details about assumptions, methods, and conclusions would expose our supervisory approach to greater outside scrutiny and discussion.” Tarullo would like to expose both the banks and bank supervisors to greater market discipline.

However, some officials are concerned that under some circumstances this could undermine confidence in a particular institution. For that reason, making the information public is not yet part of the new strategy.

Whatever financial reform emerges from Congress and gets signed by President Obama, some of the new rules are not likely to be fully implemented for years to come. Fortunately, most of the big U.S. banks are in much better shape than they were a year ago, partly because the U.S. economy is growing again.

John M. Berry covered the Federal Reserve and the U.S. economy for The Washington Post for 25 years.