Regulators have taken a lot of heat on both sides of the political aisle after the rapid failure of three U.S. banks…Bank of Silicon Valley, Signature Bank and Silvergate Bank—this month. Massachusetts Senator Elizabeth Warren, a Democrat, argued that regulators “clearly failed at the job” at Silicon Valley Bank (SVB) on Sunday CBS News interview and called for “responsibility”. And South Carolina Senator Tim Scott, a Republican, echoes those comments during a Senate Banking Committee hearing on Tuesday, saying that “obviously our regulators seem to have fallen asleep at the wheel.”
On the other hand, Michael Barr, the Federal Reserve’s chief banking regulator, told Congress Tuesday that SVB’s failure was the result of a “textbook case of mismanagement”. But Barr also admitted that “events of the past few weeks raise questions about evolving risks and what more can and should be done” by regulators, adding that it is essential “that we fully correct what is did not work”. He added that he was considering tightening banking regulations.
Now two former Fed officials who spent decades at the central bank argue regulators’ oversight of U.S. lenders has eroded for years amid a culture shift.
“In the mid-2000s, one of the visiting macroeconomics researchers at the Cleveland Fed told us that today’s macroeconomics is like science fiction movies: it’s mostly special effects. Unfortunately, the same can be said for today’s model-based financial supervision, which is abstracted from institutional details and fundamental financial structures,” said James Thomson, associate dean of the College of Business at the University of ‘Akron, who was previously vice chairman 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 finance professor from Middle Tennessee State University and a former lawyer at the Federal Reserve Bank of New York, detailed regulators’ abandonment of an “audit model /compliance” that involved “over-on-site ground checks” and financial audits led by regulators over the past decades. They say that, now, regulators are using a “more consultative approach” that relies on banks’ own theoretical risk models to supervise them.
“The problems with this approach are that institutions’ own models might be easy to influence or change, important institutional structural details might be overlooked, and over time institutional knowledge would be lost,” they wrote.
Todd and Thomson say the current, more confident approach to banking regulation began to take hold after “tough-minded supervisor” William Taylor left his post as director of the Supervision and banking regulation to the Fed Board of Governors. Taylor’s absence left the Fed’s top banking regulator a power vacuum, and “policy watchdog power” was eventually transferred to the Research and Statistics Division after the Fed came to power. former Fed Chairman Alan Greenspan in the 1990s.
“The explanation for the systematic breakdowns in prudential supervision 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 has caused regulators to rely on a more academic, model-based approach that uses banks’ own forecasts and data to oversee them, according to Todd and Thomson. And even after the global financial crisis of 2008, regulators decided to “redouble their efforts in model-based supervision”, relying on banks’ own risk models to implement their stress tests— which assess whether lenders can withstand losses in times of economic difficulty.
Todd and Thomson say the change in regulatory culture at the Fed has “damaged banking supervision” and could very well be one of the reasons banks have faced instability lately.