In Fed we trust?

The Obama administration proposes to make the Federal Reserve the new power broker in preventing systemic risk in the nation’s financial system. But in order for the Fed to ward off a cascade of bank failures, it has to pay more attention to advice from abroad than it has in the past.

Banks must become “smaller, simpler and safer” said the Bank for International Settlements (BIS), in its annual report issued last week. The BIS, the world’s oldest international financial organization, was established in 1930 and serves as the bank to central banks. It warned that “short-run government actions are increasing financial sector concentration and adding to systemic risk.”

Yet, in his recent testimony before Congress, Fed Chairman Ben Bernanke said there was little chance of U.S. banks becoming smaller. He said that large banks provide a valuable service for the global economy.

They do provide the highway system through which money travels around the globe. A healthy international financial system speeds transactions, which increases the number of deals that can be made and thereby spurs trade and development. If the number of roads on that system were reduced, transactions might take longer. If tolls were imposed, the cost of moving money might increase.

On its website, Citigroup claims to serve 200 million customers in 100 countries. Bank of America is active in at least 150 countries and has relationships with 83 percent of the “Fortune” Global 500 companies. JP Morgan Chase says it has assets of $2.1 trillion and operations in more than 60 countries.

But do we need all of the 10 mega banks?

To Congress, Bernanke said his job as Fed chairman is to protect the financial system. But on the other side of the system are the consumers, the small businesses, the corporations who use the financial thoroughfares all times of day and night. A road that is poorly maintained will cause crashes that will hurt these drivers. The cost of recovering from and repairing a battered, pot-holed financial highway will fall to those who use it, not just those who created it.

The Fed for too long has ignored both the maintenance of the system and those who use it. “The Fed has never been a successful regulator,” said Allan Meltzer, a professor at Carnegie Mellon University who has written a history of the Federal Reserve. “I can’t think of an example when they anticipated a crisis.”

Back in 1999, Chairman Alan Greenspan knew that many banks had outgrown the old rules of the road. “A one-size-fits-all approach to regulation and supervision is inefficient and, frankly, untenable in a world in which banks vary dramatically in terms of size, business mix, and appetite for risk,” he said. “Even among the largest banks, no two institutions have exactly the same risk profiles, risk controls, or organizational and management structure.”

The old rules were issued in 1988 and called Basel I, after the Swiss city where a committee of bankers from 10 nations with the largest economies met at the BIS and suggested regulations for all banks to follow. They basically advised banks to hold in capital, or cash reserves, 8 percent of the amount of their loans.

In 1999, the committee issued a new set of proposals, called Basel II. The guidelines recommended that institutions hold different levels of capital for different activities, arguing that lending, securitization, trading securities and derivatives entailed different levels of risk. It assigned a bank’s managers to determine how much capital it needed to absorb its risks, with the review of supervisors.

The Fed solicited feedback from all sectors of the industry that would be affected by the new rules. Small- and medium-sized banks argued that the Basel II formulas were too complicated and would be too costly to comply with. Some large banks said they couldn’t compete with other international banks. Many experts said it was crazy to allow banks to mange their own risk.

The process dragged on for years. FDIC Chairman Sheila Bair joked that the real question was when the U.S. would ever come up with a set of standards that could be implemented so that a global set of rules might be achieved.

When Bernanke succeeded Greenspan in 2006, Bernanke said the method for determining proper capital requirements “has become increasingly inadequate for capturing the risks at large, complex U.S. banking organizations.”

In November of 2007, the Fed finally emerged with a set of rules to be used only by the biggest banks. By then, the subprime market was crashing. Citigroup had fourth quarter net losses of $9.83 billion. The banks were supposed to begin to implement Basel II in summer of 2008, but the plan was scrapped when they found themselves in the middle of a huge capital and liquidity crisis.

No U.S. banks are operating under Basel II today, according to a spokesman at the Federal Reserve. But it has been implemented in Japan, Canada, Europe, Israel and dozens of other nations. The U.S., which has the largest financial system in the world, dragged its feet in modernizing how it assessed and backstopped risk.

“Those countries that have had Basel II in place have reported very favourable results,” Bill Coen wrote in an email. Coen is deputy secretary general of the Basel Committee on Banking Supervision, for the BIS in Switzerland.

Simply implementing Basel II, however, would not have necessarily guaranteed a better outcome for the U.S. Although it was intended to create a uniform standard among countries, each country was left to impose its own schedule and methods.

The crisis revealed weaknesses in the general Basel II formula, which is being redesigned. Most of the losses during this crisis were in the banks’ trading books. As a result, the committee has recommended that capital reserves of 8 percent be held against trades, instead of the 4 percent previously suggested.

The global financial system is so complicated that no one person can understand it, writes the BIS in its annual report. It’s time to listen and learn from the ideas from abroad, not only about reducing bank size, but how other countries intervened before the meltdown. Spain’s central bank strengthened its monitoring of loan evaluations, India tightened capital requirements, some Asian countries moderated the credit boom, and Canada limited bank leverage.

If the Fed becomes the systemic regulator, the chairman must be willing to be the traffic cop, chasing speeders, arresting reckless drivers, requiring maintenance, enforcing rules and keeping the system from crashing. If he waits another 10 years to implement what is quickly becoming the new Basel III, the too-big-to-fix banks could wind up causing another multi-country pileup.

Susan E. Reed has covered business and international affairs for CBS News, The New York Times, The New Republic and other news organizations.

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