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

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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.

As Dugan pointed out, it was the Fed and the Securities and Exchange Commission that supervised the division through which Citi packaged subprime loans into bonds. The OCC, meanwhile, watched over the Citi affiliate providing the liquidity backstop for the securities. Still other agencies kept tabs on the parts of Citi that originated subprime mortgages.

A broad message that could be inferred from his testimony is that the arcane system for regulating sophisticated financial institutions simply failed. But the subtext of his remarks was that one could not draw a straight line from the primary trouble spots at Citi back to the OCC, whose supervisory power over Citi was limited to the company's national bank affiliate.

Certainly the national affiliate took its lumps as the market crisis, which unleashed the severest damage on Citi's securities-related businesses, morphed into a recession that hurt the loans housed within the bank. But Jane D'Arista, a research associate with the Political Economy Research Institute at the University of Massachusetts Amherst, said the responsibility for regulatory oversight at Citi ultimately sits with the Fed, which has authority over the bank holding company as a whole.

"The fact is, the Fed just fell down," said D'Arista, a 20-year Capitol Hill staffer who worked on the then-House Banking Committee before entering academia in 1986. "They'll continue to have a big role, and they should. But it's very difficult for a single regulator to take a stand," she said, especially when that stand clashes with conventional thinking.

In the buildup to the latest crisis, one obstacle was the countervailing force of the market, which seemed certain in the gravity-defying powers of housing prices and appreciative of the government's focus at the time on deregulation.

Another obstacle was the regulatory community itself. "There have always been turf battles between regulators. Some bank holding companies have been adept at using that regulatory tension to their benefit," said Sandy Brown, a lawyer at Bracewell & Giuliani LLP in Dallas who spent two years at the OCC. "I don't know whether Citi did that or not, but it certainly seems they were able to structure their business so that neither agency knew what they needed to know to effectively regulate the company."

Citi's public disclosures do not make it any easier for investors or taxpayers to identify the regulator whose feet would be most appropriate to hold to the fire. The company, which at the end of its disastrous 2008 had enough subsidiaries to fill a list more than 65 pages long, made it clear in the 10-K filing for that year that the bulk of its mortgage-related losses were concentrated in its institutional clients group. But that department is a corporate construct cutting across regulatory and legal-entity lines. The summary figures provided for specific legal entities, such as the national bank affiliate overseen by the OCC, gave no sense of what proportion of the institutional clients group was housed in the various subsidiaries.

Oliver Ireland, a banking lawyer with Morrison & Foerster LLP in Washington, said regulators would not be precluded by any gaps in public disclosure from doing their job. "The entity can tell where it lost the money. They have live-in examiners from the agencies that … can figure out where the problems are or where they are incurring losses," he said.

But there is not much room in that for a public accounting of the regulators' handiwork.

"There's no question that the U.S. system is very complicated and that the structures of these institutions are very complicated — that's why some people have said these institutions are too big to manage, and others have said they potentially ought to be broken up," said Andrea Corcoran, a former Commodity Futures Trading Commission official who runs Align International LLC, a financial regulation consultant to public and private entities. "But maybe a step back from that is to say that it ought to be more transparent as to who's accountable to whom."

With Congress bypassing the chance to institute a greater sense of accountability for the agencies, it is up to the agencies themselves to identify where they fell short and to rework their processes to avoid a repeat performance.

Dugan testified in March that the OCC, working with other regulators, has directed banks to upgrade reporting systems and risk management to address some of the problems that led to the crisis. The Fed, meanwhile, is bringing together supervisors, economists and staff experts in markets and payment systems to conduct stronger surveillance of the most complex financial firms.

"A systemic approach to regulation, which of necessity involves the monitoring of the interactions of a range of financial firms, markets and instruments, requires a multidisciplinary perspective," Fed Chairman Ben Bernanke said in a May speech marking the one-year anniversary of the stress tests conducted under the Supervisory Capital Assessment Program. "The SCAP demonstrated the feasibility and benefits of employing such a perspective, and we are working to ensure that all aspects of our supervision employ it fully."

The SEC, having done away in 2008 with its much-maligned Consolidated Supervised Entity program for the five largest investment banks, replaced leadership, took steps to streamline enforcement and created a division of risk, strategy and financial innovation.

Maybe these kinds of measures, in concert with the changes proposed in the financial reform bill — especially the sections that leave supervisors better equipped to take a high-level view of risks through the Financial Stability Oversight Council — will prevent a repeat of the regulatory failures that contributed to the crisis.

But if they don't, it's unclear who — if anyone — will be held accountable.

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