Bank supervision is ‘mostly special effects,’ 2 former Fed officials warn

Bank supervision is 'mostly special effects,' 2 former Fed officials warn

Regulators have taken a lot of heat from both sides of the political aisle after the rapid failure of three U.S. banks—Silicon Valley Bank, Signature Bank and Silvergate Bank—this month. Massachusetts Sen. Elizabeth Warren, a democrat, argued regulators “clearly fell down on the job” at Silicon Valley Bank (SVB) in a Sunday CBS News interview and called for “accountability.” And South Carolina Sen. Tim Scott, a republican, echoed those comments at a Senate Banking Committee hearing Tuesday, saying that “by all accounts, our regulators appear to have been asleep at the wheel.” 

On the other hand, Michael Barr, the Federal Reserve’s top banking regulator, told Congress Tuesday that SVB’s failure was the result of a “textbook case of mismanagement.” But Barr also admitted that “the events of the last few weeks raise questions about evolving risks and what more can and should be done” by regulators, adding that it’s critical “we fully address what went wrong.” He added that he’s considering strengthening banking regulations.  

Now, two former Fed officials who spent decades with the central bank are making the case that regulators’ supervision of U.S. lenders has been eroding for years amid a culture shift.

“In the mid-2000s, one of the visiting scholars in macroeconomics at the Cleveland Fed told us that macroeconomics today is like SciFi movies: It is mostly special effects. Sadly, the same can be said for the model-based financial supervision of today that is abstracted from institutional details and fundamental financial structures,” James Thomson, associate dean at the University of Akron’s College of Business, who previously served as vice president of the research department at the Federal Reserve Bank of Cleveland, wrote in an Institute for New Economic Thinking article Monday. 

Thomson and his co-author, Walker Todd, a retired Middle Tennessee State University finance lecturer and former legal officer at the Federal Reserve Bank of New York, detailed regulators’ shift away from an “audit/compliance model” that involved stringent “on-site field checks” and regulator-led financial audits over the past few decades. They say that, now, regulators use a more “consultative approach” which relies on banks’ own theoretical risk models to supervise them.

“The problems with this approach are that the institutions’ own models might be easy to influence or alter, important institutional structural details might be ignored, and over time institutional knowledge would be lost,” they wrote.

Todd and Thomson argue that the current, more trusting approach to bank regulation began to take hold after the “tough-minded supervisor” William Taylor left his role as the director of the Division of Banking Supervision and Regulation at the Fed’s Board of Governors. Taylor’s absence left a power vacuum at the Fed’s main banking regulator, and “supervisory policy making power” eventually shifted to the Division of Research and Statistics after former Fed Chair Alan Greenspan took power in the 1990s. 

“The explanation of systematic breakdowns in supervisory oversight over time must include the shift in Federal Reserve culture during and after the 1990s,” Todd and Thomson wrote.

The growing influence of the Fed’s research division caused regulators to rely on a more academic, model-based approach that uses banks’ own forecasts and data to supervise them, according to Todd and Thomson. And even after the Global Financial Crisis of 2008, regulators decided to “double down on model-based supervision,” relying on banks’ own risk models to implement their stress tests—which evaluate if lenders can withstand losses during times of economic hardship.

Todd and Thomson argue that the shift in regulatory culture at the Fed has “hurt bank supervision” and may very well be one of the reasons why banks have faced instability of late.

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