Thursday, May 17, 2012

Financial regulators are not designed to be whistle-blowers

Financial regulators are not designed to be whistle-blowers.

Regular readers know from previous posts (see here, here and here) that the longstanding Fed policy is
  • that it is not their role to approve or reject individual trades at banks, rather
  • their job is to ensure that banks have sufficient capital to absorb losses.
It is not a question of the regulators being asleep.  The regulators don't see it as their job to 'watch the store' as the banks are gambling or to blow the whistle on these activities.

Rather, regulators see their job as estimating how much capital is needed to cover losses at the bank and only step in if the losses materialize and threaten the solvency of the bank.

This policy leaves a large gap between what the market assumes is meant by supervision and what is actually happening.

The market assumes that the regulators are looking at the banks constantly and stepping in proactively when they see something that might cause a problem.  This is simply not true.

This fact is not limited to US bank regulators.  For example, the Nyberg Report on the Irish financial crisis reached the same conclusion.
[T]he regulatory authorities were aware that banks were engaging in "risky" behaviour ahead of the recession but did little to stop it. 
... Both the Financial Regulator and the Central Bank either failed to detect or “seriously misjudged” the risks associated with the property boom. Both regulatory bodies were aware of the "macroeconomic risks" and of risky bank behaviour but appear to have judged them “insufficiently alarming” to take major restraining policy measures, his report concluded. 
... The report notes that only a small number of individuals working in regulatory authorities saw the risks taken by banks as significant and actively argued for stronger measures to be introduced. However, it says that in all cases they failed to convince their colleagues or superiors of the need to take action.

... External organisations such as the IMF, the EU and OECD are also noted for being at most, "modestly critical and often complimentary" regarding Irish developments and institutions.
Not only did all the national financial regulators fail to properly assess the risk, but so too did the international financial regulators.

The report highlights a fatal flaw in regulators focusing on ensuring that banks have sufficient capital to absorb losses.  What happens when the regulators misjudge the risk and therefore the size of the loss and as a result the size of the loss exceeds the capacity of the bank's existing capital to absorb?

Are financial regulators really going to talk about a problem given their focus on safety and soundness and their concern that any suggestion that all is not well at a bank will trigger a run?

Finally, the report discussed the internal barrier to financial regulators whistle-blowing.  This barrier is the requirement of the individual who identifies the problem to convince all of their superiors that the problem exists and needs to be dealt with.  It is only then that the regulator, which speaks with only one voice, might talk about the problem.

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