Ending the notion that the banking system can be kept safe by on-site examiners

In his Wall Street Journal column, Francesco Guerrera makes the case for doing away with on-site bank examiners and replacing them with disclosure to market participants.

On-site bank examiners have two roles.

First, they are there to ensure compliance with the numerous banking laws.

Second, they are there to try to minimize the exposure of the taxpayers as silent equity partners to losses that the bank incurs on its positions.  In a modern banking system, the taxpayers are a silent equity partner because of the deposit guarantee.

On-site examiners are not there to approve or disapprove of any specific exposure the bank takes as this would be engaging in the capital allocation process of the financial markets.  Rather, they are there to estimate the loss that could arise from the position and determine if the bank has enough book capital to absorb the loss.

Mr. Guerrera presents the argument by the Fed governor who oversees bank supervision and regulation, Daniel Tarullo, for taking away the role of estimating capital adequacy and replacing it with data driven analysis at the Board of Governors' level.

Regular readers know that your humble blogger doesn't think this will solve the problem as the Fed is still substituting its analytical expertise for the markets.  Rather, I think that banks should be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the best analysts in the world, including each bank's competitors, can assess each bank's risk and capital adequacy.  The responsible individuals at the Board of Governors can then incorporate these results into their own assessment of each bank's risk and capital adequacy.

Do bankers really need nannies? ... The financial baby sitters I have in mind wear suits, sit in cubicles and pore over spreadsheets. 

They are called "on-site examiners"—regulators who work in the offices of large banks to oversee their management, risks and operations. 

They are a faceless army—the Office of the Comptroller of the Currency alone has around 500 of them while the Federal Reserve counts hundreds of on-site staff among its 1,800-plus examiners. They are almost unheard of in other sectors. And they are fast becoming an anachronism that should be ended or at least sharply downsized. 

Modern banks' propensity to commit costly mistakes on a periodic basis makes it imperative they are regulated in the most efficient manner....

The most efficient manner is by requiring that the banks provide ultra transparency.  The market knows how to assess this information.

Theory and practice militate against deploying such a large portion of regulators' limited resources this way. 

The theory is easier to grasp: The idea that the 100 or so examiners stationed at J.P. Morgan Chase & Co. may be able to police 260,000 employees sitting on a $2.3 trillion balance sheet is a nonstarter. 

The practical experience is trickier. Recent examples suggest that examiners aren't equipped to spot brewing crises ...

The huge trading losses at J.P. Morgan, for example, went undetected by on-site sleuths.

Remember, on-site examiners are not there to prevent the trading losses, but rather to ensure there is enough book capital to absorb the losses.

And last week the OCC was lambasted by U.S. lawmakers for failing to crack down on money laundering at HSBC Holdings PLC.... 

This was a failure to ensure compliance with banking laws for which the on-site examiners have no excuse.

Some critics argue that examiners sitting in the same bank for several years develop Stockholm syndrome and are unwittingly easy on their subjects. A former regulator was even more explicit: "Name a crisis that was prevented by on-site examiners." 

That criticism isn't completely fair. Examiners aren't expected to detect every loss, fraud or mistake in such complex and opaque institutions.... 

More importantly, it is not their role to approve or disapprove of the position that leads to the loss.

But perceptions count and the perception given by regulators since the crisis is that throwing more bodies at banks ought to prevent a repeat of the 2008-2009 turmoil. 

Aided by the Dodd-Frank law, the number of cops on the financial beat has surged. The Fed, for example, has nearly 40% more examiners today than it did in 2008, but is the financial system 40% safer because of that? 

I doubt it and so do some senior regulators.

On-site examiners are not there to make the financial system safer, but rather to try to minimize the taxpayers' exposure as a silent equity partner.  These are very different focuses.

The success of recent "stress tests" of banks' capital buffers has sparked a debate inside the Fed over the merits of these sectorwide, number-crunching exercises versus the traditional oversight that focuses on specific banks and on-site probes. 

As Fed governor Daniel Tarullo told me: "Prudential regulators certainly need to maintain a presence at the largest bank-holding companies. But I think we may need to devote more of our supervisory resources to data-driven, comparative assessments of capital, liquidity and other conditions in these firms." 

This approach has the advantage of relying on hard data, making it more difficult for banks to hoodwink regulators through obfuscation or malice. It would also produce results that, unlike examiners' assessments, are public and easily comparable by investors.... 

Actually, this approach is fatally flawed as it relies on substituting the Fed's analytical expertise for the market's.

Who do you think would be better at analyzing the JP Morgan's exposures provided under ultra transparency, Deutsche Bank or the Fed?  Given how much Deutsche spends on information systems and salaries for its analysts, I would bet on it.

by reducing the number and the importance of on-site examiners, it would do away with the misleading notion that the banking system can be kept safe by dozens of people who "get their coffee, sit in their offices, and…don't work for us," as Goldman Sachs Group Inc. chief Lloyd Blankfein once put it.

The only thing that can keep the banking system safe is by eliminating opacity and requiring the banks to provide ultra transparency and disclose all their current exposures.