I can highly recommend Nick Dunbar’s new book on the financial crisis; I’ll have a full review of it soon, but for the time being let’s just say that for my money it’s the best crisis book so far. Fair, detailed, unsparing, and — most importantly — written by someone who was reporting on the structured-products market all the way through the boom, instead of just looking back after the bust and asking what happened.
There’s a lot of reporting in this book, too, and today Reuters has an excerpt of how the Federal Reserve in general, and the New York Fed in particular, failed in its job of overseeing Citigroup (NYSE:C). When DC-based examiners started asking tough questions, they were met with stonewalling from the New York Fed, which behaved exactly as you would expect from an institution captured by its big-bank shareholders.
The market and liquidity risk team and others in the Federal Reserve Board supervision division had grown concerned that as large banks built up their trading businesses and accounting rules gravitated to fair value measurement, bank balance sheets were increasingly subject to short-term market moves that could lead to rapid falls in regulatory capital. A memo produced by the team pointed out the issues and risks involved in increased use of fair value and warned that a sudden freeze in certain markets might imperil bank solvency. But when the market and liquidity risk team tried to interest Dahlgren in their findings, she retorted, “I think our banks know how to manage to fair value,” ending the discussion.
In 2006, the market and liquidity risk team attended a Citigroup risk assessment presentation to a committee of Fed examiners. When asked for the rationale supporting the designated satisfactory rating for interest rate risk, the New York Fed team could not provide any information. At another Citi meeting the market and liquidity risk team attended, the New York Fed examiners had been asked to come up with a list of supervisory priorities for the bank. They identified approximately twenty items and patiently explained why each one was important. Near the end, Peters interrupted and told his staff to cut the number of priorities to five or six because twenty was “too many.” The Washington, D.C., team was stunned—twenty was too many things to check regarding the largest and most complex bank in the United States?
This is a perennial problem — and the only reason we know how bad things were is because one small group of examiners, in Washington, was marginally less bad at regulating banks than another group in New York. Most of the time, there’s only one group of bank examiners, and they never blow the whistle on themselves.
At the end of the passage, Dunbar reveals that even if the full list of 20 priorities had been implemented in full, Citi would still have blown up, since no examiners had a clue that Citi was hiding $43 billion of CDO exposure off its balance sheet and outside its value-at-risk calculations.
Dunbar reports one particularly vivid conversation, in the wake of a carbon-trading desk blowing up:
One person on the market and liquidity risk team vividly remembers a New York Fed bank examiner shrugging off the emission trading losses, arguing, “Don’t worry about that. We just have to respond to these things when they happen. We can’t get ahead of these problems. We don’t have enough people, and the bankers have a lot of smart people.”
The sad thing is that the New York Fed examiner is probably right. They couldn’t get ahead of these things. And they still can’t.
An ounce of prevention, we’re all taught at an early age, is worth a pound of cure. But central banks are really bad at the prevention side of things. Which is why they have to put so much effort into their attempted cures.