We-Know-Best Attitude at the Fed Is Rankling Bankers

"It's not the Fed I knew."

That was the simple ending to an email I received last week from a banker frustrated by what he perceives as intrusive oversight by the Federal Reserve Board.

"They are accreting incredible power in a group of economists that has no experience in markets and little tolerance for dissent," the banker said.

Barbara A. Rehm

Without prompting, two other sources said nearly the same thing in recent days. It got me thinking: how has the Fed's approach to bank supervision changed since American Banker hired me to cover the central bank in April 1987?

Back then Paul Volcker was chairman and his right-hand supervision man was Bill Taylor. Taylor, who is from Chicago's South Side, had a tough, don't-test-me core wrapped in a chipper personality. A seasoned examiner, he worked closely with the Fed's 12 regional banks, and knew exactly what was going on inside each of the largest banks.

Obviously, that was a whole lot easier back then — the banks were smaller and the business was much less complex. But Volcker and Taylor commanded respect and confidence. When they told you the banking system was safe, you believed them. When something went wrong at a bank, the Fed knew, demanded a fix, the bank complied and rarely did anything about the problem surface publicly.

Of course Fed oversight has evolved a lot in 25 years. It had to. Congress enacted detailed reforms after the S&L crisis that put supervision on a more mechanistic and punitive path. Congress doubled down on that approach in the Dodd-Frank Act of 2010.

Still, the Fed is making choices that change supervision in fundamental ways, and those decisions merit debate.

Among the clearest is the concentration of power in Washington. Supervisory matters begin and end with the Board of Governors, and more specifically with Gov. Daniel Tarullo. Why the White House has never made him vice chairman of supervision, a position Dodd-Frank created, is a mystery. But it's clear Tarullo is filling the role even if he doesn't have the title.

What's more, issues get little public airing and Fed officials (the ones in Washington) all read from the same page. No one questions the wisdom or workability of any of Dodd-Frank's numerous provisions. (The exception here is the law's ban on the use of credit ratings, but all the agencies have complained about that.)

Perhaps Fed officials are putting up a united front as a way to build confidence that Dodd-Frank will succeed in preventing a massive financial institution from imperiling the whole system.

But the lack of public debate, much less disagreement, undermines confidence that the consequences of such massive regulatory changes are being fully considered.

A front-page story in The Wall Street Journal two months ago weighed in on an obvious, but unquestioned fact: the Fed no longer routinely holds open meetings to debate the rules it proposes. It just circulates documents among the board members who email their votes to the board's secretary.

That is not the best way to make public policies with far-reaching impacts on financial institutions and in turn consumers.

The Fed's "cloistered approach deprives the public of insight into how rules are being written and makes it harder for Congress and others to hold them accountable for their decisions," according to the Journal's story.

Tarullo told the Journal that "scripted" public meetings don't add value, and the newspaper noted that the Fed only has five governors right now and they are quite busy. But who says public meetings must be scripted, and shouldn't governors be able to find the time for something as important as bank supervision?

Among the more controversial rules on the Fed's plate right now is how best to curb proprietary trading as mandated by Dodd-Frank. Fed Gov. Sarah Bloom Raskin voted against the proposed Volcker Rule in October when it was put it out for comment. Guess when the Fed disclosed her vote? In February, when the Journal asked about it.

Wouldn't you like to know what Raskin doesn't like about the plan? Or what Betsy Duke or Janet Yellen thinks of the sweeping Section 165 proposal? We don't know because the Fed has held just two public meetings since July 2010 when Dodd-Frank passed and because the only board members who really engage in the debate over supervision are Tarullo and Chairman Ben Bernanke — and they agree on everything, at least in public.

Other agencies, like the FDIC, the SEC and the CFTC, hold regular open meetings where members of their boards actually engage each other on the merits of rules. They also hold roundtables and use public meetings of advisory boards to let the sun shine in on their decision-making process. (In a speech April 10 Tarullo said the Fed will use a roundtable later this year to improve its stress-testing process.) The Fed's insular, we-know-best approach irks bankers because, while the Fed's way may indeed be the best way, it isn't giving outsiders enough information to reach that conclusion.

"They are really trying to consolidate power and dictate to the banks in ways that we just haven't seen in the past," said a policymaker turned consultant.

Another clear shift is the move to embrace PhD economists as supervisors.

The Fed broke with the tradition of promoting from within the supervision division in October 2009 when it plucked Pat Parkinson from the research division. When Parkinson left last year, the Fed reached back into research and promoted Mike Gibson to lead supervision.

Clearly these are smart men, but this shift likely explains the added complexity of the proposed rules we've been seeing from the Fed.

"What we're getting are doctoral dissertations, rewritten by lawyers, and what you end up with is 300 pages of, Huh?" one veteran Fed watcher says. "No one is stepping back at the board level and saying, Does the peg fit the hole?"

The Fed also is using a belt-and-suspenders approach to many of the risks it's trying to rein in. Stress tests and horizontal reviews, systemic surcharges, living wills, macroprudential standards, crackdowns on counterparty exposures lead the list of moves the Fed is making to wring risk from the system.

"It's not so much that each of the rules is wrong, it's doing them all together that I find so problematic, especially given all the impenetrable details in each of them," says the veteran Fed watcher. "I am not sure why you need Volcker if you have good trading-book capital rules. If it's so risky, why not just control the risk? Those are the types of questions that no one at the Fed is asking."

Indeed, Fed officials are simply forging ahead and not questioning how much reform is enough. It's a little ironic given it argued during the Dodd-Frank debate that it must retain the authority to supervise banks because it is integral to the execution of monetary policy. You can't have a strong economy without a strong banking system.

But what if all this regulation throttles banks and shrinks credit? I'm not making that argument, but I would like to hear Fed officials debate the question.

The Fed appears to be more concerned with the process — implementing Dodd-Frank to the letter — than the endgame of making the financial system safer.

"They are taking a bad statute and making it worse," says a former Fed official who now represents banks at a major law firm. "The statute is too rigid and the proposals have been even more rigid. You normally count on the agencies to temper congressional actions, smooth them out and make them work. I don't see that so far."

A literal implementation of Dodd-Frank may shield the Fed from criticism from Capitol Hill during the next crisis, but a better strategy would be to identify weaknesses among the largest players and quietly pressure them to improve.

Maybe that's already happening, but in that same April 10 speech, Tarullo, speaking about capital planning, said "there appears to be room for improvement at virtually every firm, and at some firms the amount of work needed is still significant."

Why haven't regulators demanded such basic risk management improvements by now? Tarullo's comment raises the question: are too many Fed resources going into writing rules versus doing the real work of supervision?

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