WASHINGTON — Not even quite a year into her tenure as head of the Federal Reserve Bank of Cleveland, Loretta Mester has joined the growing ranks of policymakers reaching a key conclusion: there needs to be a two-tiered regulatory system that treats small banks with a lighter touch.

Mester spoke last week at a conference in Columbus, Ohio, advocating for a more "right-sized" regulatory regime for smaller banks in addition to the robust capital rules being put in place for systemically risky ones. Afterward, in a wide-ranging interview with American Banker, she expounded on the idea while tackling a host of other issues, including the biggest threats facing the system, bank culture, interest-rate risk, cybersecurity and shadow banking.

Overall, Mester, who was most recently the research director and chief policy advisor at the Philadelphia Fed before joining the Cleveland Fed, is optimistic about the future of regulatory reform and the economy. But she sees potential problems ahead — and worries about what regulators won't see coming.

Following is an edited transcript of the Q&A.

What are the biggest sources of systemic risk you're seeing today?
We have stepped up efforts within the Federal Reserve System to start monitoring risk. There are qualitative and quantitative models that are being brought to bear to look at risk. In fact the Cleveland Fed as a financial stress index, which looks at financial stresses in markets. So right now I would say there aren't large pockets of risk out there.

Leveraged lending is one of the things we have been monitoring, in fact the Federal agencies put out that guidance on leveraged lending [in March 2013] and I think that's having an impact. I think banks are being more cognizant of the risks. Early on we had some anecdotal information about commercial real estate lending -- maybe there's pockets of where it's heating up a little too much, and spec lending, but I wouldn't say any of those things are rising to the level [of the crisis], not anywhere near that. My thinking is that whenever a liftoff of interest rates comes, it's going to really be based on progress to our monetary policy goals.

Are you concerned that the low interest rate environment is spurring banks to riskier areas in search of higher yields?
I think it's certainly something we are carefully monitoring. But I've spoken to bankers, and they would say they are trying to look for places where they can make yield. But they are also cognizant of the fact that they don't want to go too far afield because, what's the payoff in the long run? They're aware, because of what happened, that you don't want to take risks that are [excessive] — you have to understand the risk. And so it's certainly something we want to monitor very carefully, because we do know that at zero interest rates, there is this incentive to look for yield and be further out in the yield curve … but again I don't think it's risen to the level where they are a large concern in the economy.

Is the Fed concerned that its rules may be creating risks in some places while it looks to mitigate risks elsewhere? Shadow banking comes to mind.
I think one of the things that became very apparent in the financial crisis is that we did have this unregulated part of the financial system, and the incentives to move things off balance sheet… is still an issue. Less so than it was before, but I think it's still an issue. The Office of Financial Research is starting to collect data on that part of the financial system. But I'd say that's an issue that's harder to monitor, because we just don't have the data. And as policy makers we have to realize that there could be unintended consequences of some of the things we're doing, for precisely the reasons you're talking about. The fact that we know it — that bank supervision people know it — I think helps, but again I think it's still important for OFR to get the data that is necessarily to monitor these types of risk.

So you're aware of the concern but you think, on balance, the Fed's actions haven't created excessive risk?
You don't want to be overly complacent that you have the tools necessary to identify risk. Because I'm pretty sure the next risk probably won't be housing, it's going to be something else. And understanding the role of monetary policy — as you pointed out, one of the issues now with zero interest rates is [whether it is] creating financial stability risk. The reason I advocate trying the macroprudential tools first but still being open [to monetary policy changes] is because you want to not use monetary policy first because it is very broad. You wouldn't want to choke off credit I think this interplay between financial stability and monetary policy is very important to worry about. But at some point if financial stability risk becomes too great, they also become risk to the real economy and inflation. I think that's something that policymakers have to think very carefully about.

You just gave a speech about the need for tiered regulation — why is that important?
It is important to right-size the regulation and supervision, partly because we don't want to put undue burden on community banks, because they are very important to the economy, they are very important to our communities. We want appropriate risk to be taken, because that's what banks do — banks take risk. You wouldn't want to have a bank that doesn't take any risk. They wouldn't be doing a good job. So the question is, how do you set up a regulatory structure that allows banks to do appropriate risk taking, extending credit and services to their communities at the same time setting appropriate regulation for systemically important firms? That's something that we're developing and working towards.

Regarding the various capital rules for systemically important banks, does the Fed consider the cumulative effect of those rules? Is there a big-picture capital regime that the Fed is building towards?
We can argue whether we think it's effective or not, but I do think there's a rationale for the capital [rules]. Partly it was recognition that capital levels were too low. But partly also it was to build a countercyclical capital buffer. So those are two different things … so you want higher capital level, that's sort of secular, and you want this countercyclical [buffer] that is more dynamic and goes with the risks that are in the economy. That's the overarching theme. I've heard, and I have to ascribe to this, it is a pretty complicated scheme. But the institutions itself are complex. So the idea of some of the surcharges is to price-in some of the systemic risk that these large institutions impose on the economy. And they'll adjust. If it costs more to take on the risk, then they'll make decisions based on the cost.

Do you have an opinion on whether the $50 billion threshold is appropriate or whether the Fed should raise the limit on its own without Congress?
I think [Fed Gov. Daniel] Tarullo had a speech or in public comments said that he's thinking about what the appropriate level would be. I think we would be open to increasing it. How much, I think different people in the Fed and different regulators would probably have a different size [in mind], but I think it makes sense to do it because there are certain places where the likelihood of a systemic problem is very small, and we'd be better off to focus on places where those risks really apply. And the distribution of banks size and complexity in the economy is very skewed. So in that sense it makes sense. And for community banks, it may be that the compliance cost goes up and so the average size of the community bank may be a bit bigger than it was. So I'd be open to increasing it. I don't have a particular view on what level it should be, but I do think it's worth discussing.

Is that something the Fed is actively discussing?

There's a lot of discussion about culture at the big banks. What can regulators can do to incentivize responsibility?
I'm an economist, and we're trained that incentives matter and I believe they do matter. The culture has to start at the top of the organization. I think from the CEO on down, the emphasis has to be, 'We're banks, we operate with leverage, and we take risk. We want to do that in an appropriate manner that ensures our safety and soundness.' That to me is the right culture for the bank. To the extent that we might be able to set up things like how we do rules about incentive compensation and callbacks, regulators can affect that, but that's not the full thing about culture. The culture really starts with, do you understand what our role in the economy is, what our value-added is? And that we're in it for the long run, not some short run, take a risk, get a payoff and to hell with the rest of the economy. I think that's what I think of when I think of culture.

Is regulatory capture at the Fed a real concern? And if so, how do you address it?
I think that's always a risk. It's a risk in regulated firms. I think George Stigler [the late University of Chicago professor and Nobel Laureate] coined that, and he wasn't talking about banks, he was talking about other regulated industries. It's certainly something that we should be concerned about. I know within the Cleveland Fed there are regular meetings with the examiners to talk about their role and appropriate relationships and all that. Again, making sure that examination issues are brought to the forefront — that people feel comfortable talking about what kind of problems [examiners] saw at the bank, so there's not this sense that people don't have a release. But remember, we want to hire people who want to be regulators and examiners and supervisors who have the necessary skill sets. Some of them work at banks now, but if they want to see the other side we would hire them.

How big of a risk is cybersecurity?
The Fed just put out their paper of the payment system, and part of that is the security of the payment system — something that we take very seriously. We're going to have a payment security task force that's going to be set up, to convene parties that are in the payment system. It's certainly something that we're aware of. But it's going to take a wide effort, for industry, for consumers, for the retail side of things, the payment side of things to come together and share the best ideas to make sure we have a secure payment system.

What keeps you up at night?
I still worry that we're not going to see the emerging risk. That maybe we don't have the information we need. I think that's something that, given what happened, are we monitoring … I think one of the things we learned is you have to be continually monitoring. I remember vividly no-doc lending [where borrowers did not need to provide proof of income], early on [when] I was a research economist. People looked into it and it turned out that [customers] getting it were very good credit risk — extremely high credit. And that was true when it was looked at, and then the world changes. And then it turns out that … because it was not as well monitored, it changed, and the people who were getting [no-doc lending] were not necessarily the ones with pristine credit scores. So I think part of it is just the continuing work on monitoring things and recognizing when things are emerging, and having the will to do something before it's a crisis. I think those are the kinds of things I worry about.

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