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U.S. regulators are arguing over how much influence the government should wield over bank management, pitting taxpayer protection against concern at roiling fragile financial markets.

The clash intensified as supervisors completed last week’s stress test results on the biggest U.S. banks. Federal Deposit Insurance Corp. officials sought to make top executives and boards of directors of 10 banks accountable for raising more capital by November. The Federal Reserve insisted that managers’ fates be left to boards and shareholders.

While a compromise left the matter to the companies, FDIC Chairman Sheila Bair signaled the debate isn’t done. “The taxpayer has a right as part-owner to protect itself,” Bair said today on Bloomberg Television’s “Political Capital with Al Hunt,” to be broadcast this weekend. Oversight of bank managements and boards is “absolutely appropriate for regulators to do,” she said.

The exchanges are a contrast with the clear line the U.S. has taken in other industries — the heads of General Motors Corp., American International Group Inc., Fannie Mae and Freddie Mac were all removed — and raises questions about regulators’ handling of the financial rescue.

“It is very clear that we have a special class of corporate citizens,” said Joshua Rosner, managing director at Graham Fisher & Co., a New York research firm. “Banks get special treatment, but we don’t hold them to a higher standard.”

Senate Hearing

Lawmakers may question why bank managers aren’t being held to account by officials when the Senate Banking Committee holds a hearing with Treasury Secretary Timothy Geithner on the financial-rescue efforts May 20.

Geithner said at the conclusion of the stress tests May 7 that any financial firm needing “significant” government aid in future will be subject to a Treasury evaluation on “whether existing board and management are strong enough.”

The commercial bank that’s received the most federal-rescue money is Citigroup Inc., where Chief Executive Officer Vikram Pandit and nine of the bank’s 14 board members remain in office. The New York-based lender received $50 billion in pledges of taxpayer funds last year, with a portfolio of about $301 billion of its assets guaranteed.

Citi’s Losses

Citigroup, the third-largest bank by assets, paid dividends every quarter last year and reported losses every quarter. It wasn’t until February that the Fed restated “guidance” on “prudent” dividend policy. The government stress tests said Citigroup needs to raise $5.5 billion as a capital buffer to support lending even if the economy worsens.

Bank of America Corp. received the second-biggest tally of taxpayer commitments among banks so far, at $45 billion. The Charlotte, North Carolina-based bank’s CEO, Ken Lewis, remains at the helm, even after shareholders stripped him of his board chairmanship in a vote last month.

“The boards of the banks were pathetic,” said Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. “But the solution is investors in those institutions to force changes, not the government.”

The U.S. government oversees about $200 billion in investments in banks through the taxpayer-funded Troubled Asset Relief Program, or TARP. Regulators’ review of the 19 largest institutions found that 10 banks needed to raise a $74.6 billion capital buffer against the risk of a worsening downturn instant payday loan. They set a deadline of Nov. 9 for obtaining that reserve.

Stress Tests

The Fed published the results of the three-month review of the 19 banks May 7, and agency heads issued individual written remarks that differed from their joint statement.

Fed Chairman Ben S. Bernanke and Comptroller of the Currency John Dugan focused on the strength of the banking system and didn’t mention management or corporate governance in their statements.

Bair said in her May 7 statement she looked forward to helping review “corporate governance structures to ensure that institutions that require higher capital buffers take appropriate steps such as conserving cash, issuing new equity, converting existing capital securities, and selling assets and non-core business lines.”

The FDIC doesn’t want government oversight over all bank boards, just those that have received taxpayer-funded support and are at risk of not returning their institutions to financial strength.

FDIC Guarantees

Bair’s position is unique among regulators because her agency has the most at stake. The agency has guaranteed some $342 billion of debt issued by banks, insures about $4.7 trillion of bank deposits and is responsible for managing banks in receivership.

In their May 7 joint statement, the U.S. financial regulators said that the banks “will need to review their existing management and Board in order to assure that the leadership of the firm has sufficient expertise and ability to manage” their challenges.

“We do need bank management and bank boards that know how to work through troubled environments,” Bair said in the interview with Bloomberg Television today.

“In most cases, you want to leave it up to respective boards of directors,” Gary Stern, president of the Minneapolis Fed, said in a separate Bloomberg Television interview today. “These are not simple organizations to lead and to run. If you want to dismiss management, you’ve got to ask yourself, who can you get to do this?”

Government Role

While financial shares soared as the results of the stress tests were released last week, some investors remain concerned at the government’s role in bank management.

Officials still lack a single, coherent framework and it’s “very disconcerting,” said Richard Schlanger, a portfolio manager at Pioneer Investment Management USA Inc. in Boston, who helps manage $13 billion. Government action “is a wild card.”

In the case of GM, the Obama administration ousted CEO Rick Wagoner in March as the automaker’s reliance on Treasury loans deepened. When the former Bush administration in September seized Fannie Mae and Freddie Mac, the federally chartered housing finance companies, chief executives Daniel Mudd and Richard Syron were also removed.

AIG, the insurer that required a rescue in September after it made bad bets on credit derivatives, agreed to replace Robert Willumstad after its bailout.

“It is a very delicate balancing act,” said Kevin Petrasic, former special counsel at the Office of Thrift Supervision who is now an attorney at Paul Hastings in Washington. “You don’t want to usurp the rights of shareholders or the direction the institution is heading. You do want the government to step in and protect the taxpayer.”

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Filed under: business by Finance Boss