Research AreasFinance, Jobs & MacroeconomicsSAFER Financial ReformFocal Points for Commission InquiriesQuestions for the FCIC

Questions for the FCIC

May 4, 2010
Jane D'Arista, SAFER Co-Coordinator

There is general agreement, even among regulators, that lax regulation and oversight contributed to the financial crisis. While the Commission’s questioning of witnesses has revealed some evidence of regulatory failure, a more detailed narrative of interactions between regulators and financial institutions is either missing or has not been made available to the public. A full account of the nature of those interactions must be compiled and disclosed in order to ensure that regulation and supervision will be more effective in the future. This will require an assessment of how regulators gathered information, structured their reports and communicated their findings to top management of the regulatory agencies and financial institutions involved. Instances when warnings were given but no follow-up was made are among the more obvious indications of failure that might be turned up by such an assessment. But equally important would be evidence that regulators had not adapted the process to changes in institutional structures and products.

The model for this line of inquiry could be tested by applying it to the Federal Reserve Bank of New York’s regulation of bank holding companies and some of the largest banks in the system. Since banks are, presumably, the most regulated financial entities and received the majority of the escalating volume of government support provided in the wake of the crisis, a profile of regulation at the New York Fed over a period of at least three years before the outbreak of the crisis in 2007 would be a particularly useful way to assess how regulatory failure caused or contributed to the crisis. If properly constructed and sufficiently detailed, such a profile would help clarify:

  • how regulation was conducted,
  • what institutions, transactions and markets were covered,
  • who was responsible for general oversight and supervision in terms of structuring regulatory interactions and reports and receiving and acting on them.

Some general areas of inquiry should include:

  • The number of regulators assigned to the largest institutions
  • The frequency of regulatory visits and reports
  • The number and nature of concerns raised in regulatory reports and the frequency and nature of the feedback to the regulated institutions

In addition, there are several areas where the amount and depth of regulatory scrutiny or its absence should be assessed:

The size and nature of banks’ off-balance sheet activity: Did the New York Fed (or other parts of the Federal Reserve System) collect information about off-balance sheet activities by individual banks and by the banking system as a whole? If so, was data compiled showing the ratios of off-balance- and on-balance sheet activity, the types of activities and their relative importance in terms of size? Were there reports on the sources and amounts of funding supporting off-balance-sheet positions? Were the liabilities incurred as a result of off-balance-sheet transactions a factor in determining the adequacy of an institution’s capital ratio?

Banks’ trading books and proprietary trading: Were there routine assessments of banks’ trading books? Do reports note growth in the volume of trades and, if so, were there expressions of concern? Were concerns expressed about banks’ trading for their own account? Were questions raised about actual or potential conflicts of interest with customers involving proprietary trading activities?

The increase in non-deposit liabilities on banks’ balance sheets: Off-balance-sheet activities cannot be backed by deposits and must therefore be supported by non-deposit liabilities such as borrowed funds. However, data in the Federal Reserve’s Flow of Funds Accounts indicate that such liabilities also played a growing role in funding banks’ on-balance-sheet positions. Did supervisory efforts include tracking changes in the ratio of non-deposit liabilities to deposits for individual banks or the system as a whole? Did examiners assigned to the largest banks attempt to quantify the maturity of non-deposit liabilities? Did any of these examiners express concern that one or more banks (or the system as a whole) might be unable to roll over funding if a disruption like the Long Term Capital Management collapse in 1998 were to recur?

The tightening web of counterparty relationships: Flow of Funds data showing a rapid increase in outstanding repurchase agreements in recent years also provides evidence of an increase in systemic interdependence. At least half the liabilities for repurchase agreements of financial institutions were held as assets of other financial institutions. Was there an attempt to assess concentrations in the amounts banks’ borrowed from and loaned to other financial institutions through repurchase and reverse repurchase agreements? Were banks admonished to diversity their borrowing and lending in this market?

The growth in size of the largest banks: As one observer (Simon Johnson) has noted, the assets of the six largest U.S. banks grew from 17 percent to over 60 percent of GDP from 1994 to the present. Do regulatory reports comment on the pace, scale and possible causes of their expansion? Was there concern about increased concentration of financial resources? Were there questions about the Federal Reserve’s ability to manage a disruption affecting one or more of the largest banks? The above questions are by no means the only ones that should be asked in profiling how regulators may have identified or overlooked developments that contributed to the crisis. They are, however, the kinds of questions that must be asked if regulatory strategies are to be refashioned to anticipate serious problems in the future. Documenting and assessing the actual strategies that were used – the information that was examined and the benchmarks used to rate institutions for regulatory purposes – would provide a basis for determining whether or not regulators in the future are meeting the challenges posed by their failures.

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