Monday, January 31, 2011

The Federal Reserve's Failure to Supervise

Sometimes, the way to solve a problem is to question your assumptions. That's a lesson the Federal Reserve should take from the Financial Crisis Inquiry Commission's Final Report. There's an interesting tidbit on p. 54, which quotes a former senior Fed staff member as writing, "Supervisors understood that forceful and proactive supervision, especially early intervention before management weaknesses were reflected in poor financial performance, might be viewed as i) overly-intrusive, burdensome, and heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed's public posture." In other words, when a bank was making profits, especially lots of profits, regulatory staff were supposed to hold back.

This is exactly wrong. Undergraduate level economics teaches that any high degree of profitability should be ironed out by competitive forces in the market. Thus, the existence of high profitability may be a sign that something less than entirely desirable may be happening. The bank might be taking a lot of risk (remember that risk comes with reward), such as by underwriting mortgage loans to people whose documented ability to repay is skimpy or nonexistent. Or the bank may be doing something illegal. Fraud, manipulation and other illegal conduct can be immensely profitable. That's why there are so many financial shenanigans. High profitability is a yellow flag, indicating that increased regulatory scrutiny is warranted.

Requiring staff members to hold back until a bank's financial performance has nosedived, as the Fed apparently did, is tantamount to fiddling until disasters burst forth and wreak a full measure of havoc and collateral damage. No glory is attained when the cavalry charges over the hill after the wagon train has been massacred.

The FCIC final report also notes, on p. xvii, that in 1980, the financial sector earned 15% of total corporate profits in America. This figure grew to 27% by 2006. This sustained rise in profitability is another yellow flag. It could indicate a sustained increase in risk levels (uh, duh). Or it could be a sign of illegal behavior. Either way, a sustained rise in profitability should have been seen as a reason for greater regulatory alertness.

Sustained elevated profitability might also indicate cartelization, with large, powerful banks extracting outsized profits by dominating markets. This is also undesirable, as greater oligopoly power would reduce the benefits of competition. Regulators should be vigilant against a shift toward concentration in market power.

The Fed appears to have viewed bank profitability as desirable. Better financial performers would presumably be more stable and less likely to collapse, which would reduce the Fed's worries. But we now know that the sustained increase in bank profitability resulted from high risk and sometimes illegal conduct that exacerbated the instability of the financial sector, ultimately leading to the crisis of 2007-08.

It may be counter-intuitive for regulators to scrutinize their regulatees more closely when the latter are reporting rosier financial performance. But greater profitability is a yellow flag, and perhaps a red flag, for serious problems. Regulators are not supposed to be cheerleaders for management, nor are they supposed to relax when the regulated industry is prosperous. They must apply unrelenting skepticism, 24/7. The history of financial crises preceding the creation of the Federal Reserve well-document that markets are not invariably self-correcting or self-regulating. That's why the Fed was created. One of the root causes of financial bubbles is too much credulity. The civil servants charged with preventing these disasters should never add to the credulity.

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