Finance news

Federal Reserve Governor Daniel Tarullo, President Barack Obama’s first pick to the U.S. central bank’s board, is leading an overhaul of its bank examinations, aiming to identify potential threats across the industry.

The initiative is aimed at providing an “independent perspective for what is going on among big institutions, but also in the system,” Tarullo said in an interview. It goes beyond the previous reliance on analysis of bank examiners deployed by the Fed’s district banks, using the staff of the Fed’s board in Washington as a new layer of oversight.

Tarullo, a former Clinton administration economic adviser who analyzed bank regulations before taking up his current post in January, intends to address flaws that preceded the 111 bank failures since the crisis erupted in August 2007. The effort is also preparation for a more explicit Fed mandate for financial stability the Obama administration has proposed.

“We are entering a period of tighter regulation, reduced leverage, and very likely lower returns on equity” for banks and other financial companies, said Dino Kos, managing director at Portales Partners LLC in New York and former head of the Federal Reserve Bank of New York’s markets group.

A group of quantitative economists at the Fed board in Washington will use computer models to help estimate how banks’ assets will perform in various scenarios, from accelerating inflation to a falling property market.

Gauging Banks’ Health

Another team, comprising both district bank examiners and board staff and known internally as the coordination group, will seek policy conclusions about the health of banks and the financial system.

The existing structure relies on hundreds of examiners from the 12 district banks, from San Francisco to Boston, visiting lenders overseen by the central bank. Examiners make recommendations on individual banks rather than focusing on the system as a whole.

Treasury Secretary Timothy Geithner fought an earlier attempt to strengthen the role of the Fed’s Board of Governors in bank supervision.

As firms from Bank of America Corp. to JPMorgan Chase & Co. became larger and more complex earlier this decade, former Fed Governor Susan Bies wanted to create centers of expertise and accountability for particular markets and potential dangers, such as derivatives trading and settlement.

Geithner, then New York Fed president, wanted to preserve his bank’s responsibility for activities inside specific firms and capital-markets surveillance. A compromise was reached in the form of a panel known as the Large Financial Institutions Group, staffed by both Fed board and district bank officials, which coordinates supervisory decisions on the biggest lenders.

New Mechanism

Tarullo, 56, aims to go further. The new system “will have a quantitative mechanism which systemically collects, analyzes, and models data for specific institutions but also in the aggregate” to strengthen the ability to detect systemic risks, he said in the interview payday loan.

Before joining the Fed, Tarullo was a professor at Georgetown University’s law school. Last year he criticized the international regulatory and banking capital regime known as Basel II for putting low risk weighting on residential mortgages in a research paper. Earlier in his career he served as President Bill Clinton’s personal representative, or Sherpa, for coordinating summits of the Group of Eight countries.

In an example of gaps Tarullo is trying to plug, the Fed in 2006 failed to detect a build-up of risk across the financial system stemming from mortgage loans with reduced income verification requirements.

2006 Failure

While about half of 48 banks the Fed surveyed said such loans represented more than 10 percent of their portfolios, supervisors were influenced by market measures of banks’ default risks declining and concluded that individual firms remained healthy.

“We started from the observation that markets weren’t worried, and that led to the conclusion that we shouldn’t worry,” said Vincent Reinhart, who was director of the Fed board’s Monetary Affairs division at the time, and is now at the American Enterprise Institute in Washington.

More information on how banks would perform in economic scenarios could give Chairman Ben S. Bernanke greater leverage to demand higher capital or liquidity levels at financial institutions even in boom times. The Obama administration has proposed the biggest revamp of the industry’s regulation since the 1930s, including charging the Fed with overseeing all financial firms that could pose a danger to systemic stability.

Applying Pressure

“It’s difficult for a regulator to move forward and challenge a very large bank, or even a small bank, that is showing great numbers, great capital, great reserves and low defaults,” said Kevin Petrasic, former special counsel at the Office of Thrift Supervision and now an attorney at Paul, Hastings, Janofsky & Walker LLP in Washington.

In one case, the Fed’s Inspector General’s office suggested insufficient oversight of First Georgia Community Bank, a Jackson, Georgia-based lender that failed in December. “More direct and forceful action may have served to reduce an asset concentration” in loans for residential construction, the office said in a report submitted to Tarullo in June.

Getting supervision right “all depends on the leadership,” said former Governor Bies. “You need people that really believe that they have a long-term mission and that long- term mission is to protect the stability of the financial system.”

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Filed under: legal by Finance Boss