Research AreasFinance, Jobs & MacroeconomicsSAFER Financial ReformFocal Points for Commission InquiriesThe Federal Reserve’s Role in Financial Supervision and Regulation

The Federal Reserve’s Role in Financial Supervision and Regulation

Tom Schlesinger, FCIC Watch Coordinator

Issue Overview

Over the past quarter-century, several characteristics emerged as central features of the federal government’s approach to overseeing the financial sector.  These included: a) a refusal to establish meaningful limits or controls on new products, market segments and intermediaries (such as payday loans, OTC derivatives and hedge funds); b) a willingness to tolerate regulatory gaps and inequalities within the marketplace; c) an emphasis on self-policing, market discipline and internal risk management systems as substitutes for traditional cop-on-the-beat oversight; d) an insistence on “principles”-based oversight – that is, rules and guidance that seek to influence regulated entities’ behavior by recommending broad operating principles rather than specifying permissible and prohibited activities; e) a strong preference for maintaining consultative – even therapeutic – relationships with regulated firms; and f) support for financial-institution mergers and new risk-shifting instruments and markets that had the effect of increasing risk concentrations within portfolios and across industry segments.  All these features of regulatory minimalism shared the common presumptions that financial innovation is good, the benefits of financial dynamism outweigh the benefits of financial stability and markets should be trusted to manage the emergence of new products and institutions smoothly.

No actor played a more important role in establishing this regime than did the Federal Reserve, the centerpiece of America’s regulatory system and the agency charged with umbrella supervision responsibilities for large, complex financial organizations.  In his capacity as Fed chairman from 1987 to 2005 Alan Greenspan reigned as the most prominent advocate and implementer of diminished public-sector oversight of the financial industry.  For the most part, current chairman Ben Bernanke embraced his predecessor’s stance on regulation.  Subsequent appointees like Governor Randall Kroszner came to the Board as even more doctrinaire deregulators.

Prior to his nomination to the Federal Reserve Board in 2005, Governor Randall Kroszner was widely recognized as a proponent of weakening or eliminating public-purpose limits and controls on financial enterprise.  Dr. Kroszner had written extensively about the merits of “free banking” as practiced in Scotland during the first half of the 19th century, recommending that model of unregulated finance for emerging economies today.  He also had served as a member of the Shadow Financial Regulatory Committee, a group that endorsed repealing the Community Reinvestment Act, removing concentration limits on banks, dismantling the remaining barriers between banking and commerce, and shutting down the Public Company Accounting Oversight Board.  In addition, disclosure statements filed by Dr. Kroszner show that in the year before his nomination to the Board he received nearly $100,000 in outside income from consulting firms such as Lexecon (now Compass Lexecon) and the Lindsey Group that aid clients seeking to soften, circumvent or thwart financial regulations.  Despite this background, Dr. Kroszner’s confirmation hearing before the Senate Banking Committee was perfunctory.  Soon after his arrival at the Fed, he became the Board’s point person on supervisory and regulatory affairs and on consumer protection issues.

During the years leading up to the financial crisis under investigation by the Angelides Commission, the permissive views of leading Fed officials manifested themselves in numerous actions (and inaction) by the central bank.  Such actions ran the gamut from rulemaking (where, for example, the central bank collaborated with its sister agencies to water down an already lenient guidance on structured finance transactions to the point where a group of legal scholars concluded it would “encourage and condone illegal conduct”) to enforcement (where, for example, the Federal Reserve Bank of New York lifted an order requiring Citigroup to strengthen its compliance programs three days after Australian authorities initiated proceedings against the chronically transgressive company for breaching prohibitions on conflicts of interest and insider trading) to communication with regulated firms (where, for example, the president of FRB Richmond derided the merits of tougher regulation before an audience of bankers that had just heard Governor Susan Bies make a plea for more responsible mortgage lending practices).   (Such examples, of course, represent only a tiny glimpse into the broader sweep of Federal Reserve activity.)

Since 2007, congressional hearings have examined selected aspects of the Fed’s supervisory and regulatory (S&R) activities.  As a result, some public attention has focused on a few consequences of lax oversight by the central bank – notably in its failure to exercise authority granted in the Home Ownership and Equity Protection Act (HOEPA) for policing abusive mortgage lending practices. 

However, neither those hearings nor other parts of the public record have provided an overall examination of monitoring, enforcement, rulemaking and other facets of the agency’s S&R work.  Nor have congressional investigators or independent analysts fully assessed the performance of Fed supervision at institutions whose failure helped precipitate and prolong the crisis.  In addition, the public record reveals little if anything about the process through which officials at the central bank – including its top leaders – influenced the conduct of these S&R activities. 

“We are not likely to ever be in a position where we have the capacity to identify the source and estimate the probability of future financial shocks. And policymakers are unlikely to ever be in a position to diffuse concentrations of risk or crowded trades ahead of a crisis. The most sensible thing we can do is to improve the capacity of the core of the financial system to handle adversity…”

– Timothy Geithner, President, Federal Reserve Bank of New York, “Liquidity and Financial Markets,” February 28, 2007

“Our mindset is not to play ‘gotcha’ on the [compliance] problem, but rather to weigh the severity of the specific problem with the effectiveness of how [the bank’s] control processes works.  Did you discover the problem yourself?  Did you communicate with us at an early stage?  Did you set in motion a careful effort to fully understand the issue and its ramifications?  Did you learn from a specific problem to make broader changes that would allow your organization to be more proactive, rather than reactive, going forward?”

William Rutledge, Executive Vice President, Federal Reserve Bank of New York, “Supervisory Perspectives on Compliance for International Banks Operating in the United States,” July 25, 2006

“Some regulators refer to themselves as ‘cops.’ I regard a regulator as a flag man on the highway telling motorists when to stop and when to go and under what conditions they may use the highway. (In this analogy, the bank examiner is a backseat driver.) The problem is that, if the flag man is not up to the job, traffic backs up and motorists switch to other highways or to airplanes.  I do not regard the supervisory process as an adversarial proceeding.”

– Ernest Patrikis, First Vice President, Federal Reserve Bank of New York, “Supervision and Regulation,” March 1, 1997

“The invisible-hand approach to regulation aims to align the incentives of market participants with the objectives of the regulator, thereby harnessing the same powerful forces that allow markets to work so efficiently. In the financial arena, as I will discuss, this approach often takes the form of creating incentives for market participants to monitor and control the risk-taking behavior of financial firms – that is, to exert market discipline – thereby reducing the need for direct oversight by the government...In a system of market-based discipline, hedge-fund managers themselves have both the incentive and the responsibility to manage risk effectively, to develop consistent methods for valuing assets and liabilities, and to provide timely and accurate information to their investors, creditors, and counterparties.”

Chairman Ben Bernanke, “Financial Regulation and the Invisible Hand,” April 11, 2007

“[T]he actions of private parties to protect themselves--what Chairman Greenspan has called private regulation – are generally quite effective. Government regulation risks undermining private regulation and financial stability itself by distorting incentives through moral hazard and by promising a more effective role in promoting financial stability than it can deliver… [A]t times rolling back regulation – for example, by lifting the Glass-Steagall restrictions on banking organizations – will benefit competition and help the financial sector deliver services more efficiently and effectively. Moreover, regulation itself can benefit from competition. Running regulated and unregulated markets side by side gives people a choice of whether they want protection and helps to constrain regulation. Some of the same purposes can be served by having multiple regulators for the same function; in some circumstances, the possible adverse consequences of competition in laxity may be smaller than the potential for regulatory conformity and regulator risk-aversion to impinge on innovation and change.”

– Vice Chairman Donald Kohn, “Remarks” at annual Jackson Hole conference, August 27, 2005

“In my view, regulations should be imposed only when market participants do not have the incentive or the capability to effectively manage the risks created by financial innovation...Making a case for early regulatory intervention is particularly difficult when the private parties involved in an innovation are sophisticated because, in many cases, they will be the first to recognize possible problems and will have strong incentives to fix them and also to protect themselves against fraud or unfair dealing…[P]olicymakers should have a bias toward trusting financial markets to manage the introduction of new products and the development of new institutions smoothly and without undue stress to the financial system…In [some] cases, policymakers may need to work with markets and their participants, and on occasion regulate them, to achieve the desired outcomes. However, policymakers should, wherever possible, avoid premature regulation that could stifle innovation. I would note that a significant number of substantial shocks to financial markets have occurred in recent years...and yet the broader effects on the real economy have ultimately been quite small. Our financial markets are flexible and resilient, and they can absorb shocks surprisingly well. As a result, most risks caused by new developments in financial markets should be manageable without heavy-handed regulation…”

– Vice Chairman Roger Ferguson, Financial Regulation: Seeking the Middle Way,November 8, 2005

“From an economist’s perspective, the proper objective of consumer protection regulation is not to prohibit voluntary financial transactions but to ensure that consumers receive the information they need to make rational decisions at the lowest possible social cost…Ideally, a regulator like the Federal Reserve serves as a coordinating device to help financial institutions as well as consumers minimize informational problems and transaction costs in the financial marketplace. Following guidelines established by the Congress, the Fed and other regulators can also improve market functioning by clarifying property rights of various kinds – for example, by making rules about the use of personal information collected in the course of financial relationships.”

– Governor Ben Bernanke, “The Transition from Academic to Policymaker,” January 7, 2005

“Over the past half-century, societies have embraced the protections of the myriad initiatives that have partially substituted government financial guarantees and implied certifications of integrity for business reputation…Most analysts believe that the world is better off as a consequence of these governmental protections. But corporate scandals in the United States and elsewhere have clearly shown that the plethora of laws of the past century have not eliminated the less-savory side of human behavior. We should not be surprised, then, to see a reemergence in recent years of the value placed by markets on trust and personal reputation in business practice. After the recent revelations of corporate malfeasance, the market punished the stock prices of those corporations whose behavior had cast doubt on the reliability of their reputations. There may be no better antidote for business and financial transgression.”

– Chairman Alan Greenspan, “Remarks” accepting an honorary degree, December 14, 2005

Questions for the Commission

Due to its central role in our regulatory system the Fed’s management of its oversight responsibilities in the areas of consumer protection, safety and soundness and competition/antitrust ought to merit careful scrutiny by the Angelides Commission.  By conducting a thorough inspection of internal agency records and interviewing relevant Federal Reserve personnel the Commission should pursue the following kinds of questions.

  • Under the leadership of Governor Kroszner and his immediate predecessors what was the nature and frequency of communication between the Board’s Committee on Supervisory and Regulatory Affairs, the Board’s Divisions of Bank Supervision and Regulation and Community and Consumer Affairs and frontline supervisors at the Reserve Banks (particularly FRBNY) with respect to market developments and practices that later proved to be major drivers of the financial crisis? 
  • Looking at each of these major drivers separately, to what extent were supervisory actions that might have prevented or minimized the crisis encouraged or compromised by senior policymakers and managers in the System?
  • To what degree, if any, did the Board and the Reserve Banks use their considerable resources and contacts – including research capacities, visiting scholar programs, interactions with other monetary authorities and multilateral institutions – to solicit, consider or seriously debate informed views that ran counter to prevailing doctrines favoring loose/ permissive/ approaches to regulation?
  • What did the Board’s routine audits of the Reserve Banks reveal about the quality of their S&R activities?  In retrospect, did the audits do an adequate job of assessing the Reserve Banks’ supervisory capacities?
  • What role, if any, did Reserve Bank board members play either in enhancing the accountability of the Banks’ frontline supervisors or improperly interfering in their activities?
  • To what extent, if any, did the Fed’s S&R operational methods include incentives that encouraged examiners, analysts or enforcement personnel to detect or help correct potentially dangerous risk concentrations at Fed-regulated firms in the period leading up to the crisis?
  • In what instances, if any, have senior staff been fired or reassigned from S&R functions at the Federal Reserve as a result of failures to detect or deter problems at regulated firms that helped create the crisis?

Witness List:

Board of Governors: Alan Greenspan, Ben Bernanke, Randall Kroszner, Susan Bies [Governors]; Richard Spillenkothen, Roger Cole [Division of Banking Supervision and Regulation]; Dolores Smith, Sandra Braunstein [Division of Consumer and Community Affairs]; Louise Rosenman [Division of Reserve Bank Operations and Payment Systems], Barry Snyder, Elizabeth Coleman [Inspectors General].

Federal Reserve Bank of New York: William McDonough, Timothy Geithner [Presidents]; Ernest Patrikis, William Rutledge.

>>Back to Focal Points