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A Fault in Reg Reform: Deciding Who's Accountable When Things Go Wrong

A Senate hearing in March 2009 about the debacle at American International Group Inc. dispelled two oft-repeated myths.

The first was that AIG's notorious derivatives operation had fallen between the regulatory cracks. An hour and 17 minutes into the testimony, the acting director of the Office of Thrift Supervision, Scott Polakoff, offered up that it was his agency, as the consolidated company's regulator, that was responsible for the financial products unit.

In doing so, he knocked down the second, arguably more pervasive myth: that no one in Washington would ever willingly accept accountability for anything. There followed a brief but unmistakable halt in the proceedings as the senators made sense of what they had just heard.

"It was a wonderful moment," said Lawrence Baxter, a Duke University law professor who studies bank regulation. "Our system is so broken up in terms of accountability that when someone finally accepted some, it was like the dog that caught the cat: now what do we do?"

Encourage more of it — that would be the obvious answer.

But aside from dissolving the widely criticized OTS, the financial reform legislation does little to ensure accountability among regulators.

"The microlevel question about which particular [regulatory] functions messed up and how come they didn't interact well — I can't think of hearing anyone having that conversation. I would hope that within the agencies they are," said Phillip Swagel, who was the Treasury Department's assistant secretary for economic policy from 2006 to 2009 and is now a visiting professor at Georgetown University's McDonough School of Business.

But publicly at least, regulators have largely appeared more interested in either deflecting blame or admitting it only in the context that everyone else — fellow bank regulators, bank executives, nonbank lenders — was culpable, too.

"With the benefit of hindsight, it is clear that the Fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and the large number of self-amplifying mechanisms that were embedded within the system," Bill Dudley, the president of the Federal Reserve Bank of New York, said in a December speech. At the time, it was as strong a mea culpa as anyone had heard from the institution charged with supervising the money-center banks headquartered in New York.

Dudley offered a somewhat stronger apology in March, when it looked like Congress might reduce the Fed's role in bank supervision. "The Federal Reserve made mistakes, as did others, in the run-up to the crisis," he allowed in a London speech to economists in which he promised that the supervision process was getting revamped.

The Fed, of course, would remain an important player in bank supervision, retaining oversight of bank holding companies and some state-chartered banks, and policing nonbank institutions deemed systemically important, under the compromise bill passed by the House last week. But the legislation would put an important check on the Fed by giving backup examination authority to the agency overseeing the lead depository institution of a holding company. That agency — for example, the Office of the Comptroller of the Currency in the case of a national bank — could recommend that the Fed examine the activities of a nondepository affiliate if it believes examinations are not carried out with the same frequency and standards it would use if it were the one responsible for the exams. And in some circumstances, if the Fed does not reply to the request within 60 days, the lead depository institution's agency can commence the examinations itself.

This provision could improve the line of sight that a bank regulator has within an individual holding company. But it would further muddy the waters for anyone trying to assign ultimate responsibility to a specific agency. Now, instead of nobody being held accountable for missing red flags, everybody could be.

Meanwhile, it's unclear whether any agency would be bold enough to disturb the regulatory detente, which has long existed with the acknowledgement that a certain level of turf battles is to be expected, by actually employing backup examination authority.

The stakes are high, not just for regulators but for a national economy that has proven itself dependent on the efficient functioning of financial institutions.

"The crisis showed that risk concentrations can accumulate across product, business lines and legal entities within a firm, and that complex products containing the same types of risks under different labels can obfuscate aggregate exposures," Comptroller John Dugan testified in April to the Financial Crisis Inquiry Commission. "Banking companies, and their regulators, also failed to appreciate the ramifications of different lending standards and risk tolerances in different segments of large companies, and how banks could end up bearing risks that they would not otherwise directly accept."

Dugan was responding to questions about subprime lending and securitization, and about the failures that led Citigroup Inc. to seek special federal assistance.

Citi serves as a vivid case study in the effects of patchwork regulation.