by Calculated Risk on 3/17/2010 02:52:00 PM

Fed Chairman Ben Bernanke: The Federal Reserve's role in bank supervision

Professor Hamilton supports Bernanke's view: Bank supervision and the Federal Reserve

The Fed employs hundreds of extremely bright and very well-informed economists. On my visits to the Federal Reserve, I've been amazed at how well the staff work together to assimilate information and perspectives. In my experience, you can ask any one of them a question about pretty much anything, and although the person you're talking with may not know the answer, he or she will know the name of the person within the Fed who does know. I've interacted with lots of different institutions over the years, and have never seen another one that functions so effectively as a single, cohesive neural processor. Certainly the objective record of Federal Reserve forecasts is pretty impressive; see for example the assessments by Christina and David Romer and Faust and Wright.

Doubtless others will be skeptical, trotting out the Fed's spectacular underestimation of financial problems during 2005-2007. That criticism is of course well taken, and both the Fed and the economics profession as a whole have much more work to do in terms of recognizing exactly what should have been done differently. But let's be practical. What other institution did a better job? Where in Washington today do you see an agency with the intellectual resources to get this right?

From CR: The Fed has a number of roles and they are all somewhat related: monetary policy, lender of last resort, bank supervision and consumer financial protection.

Clearly something went wrong with bank supervision during the recent bubble and bust. And here are the improvements Bernanke outlined today:

To improve both our consolidated supervision and our ability to identify potential risks to the financial system, we have made substantial changes to our supervisory framework. So that we can better understand linkages among firms and markets that have the potential to undermine the stability of the financial system, we have adopted a more explicitly multidisciplinary approach, making use of the Federal Reserve's broad expertise in economics, financial markets, payment systems, and bank supervision to which I alluded earlier. We are also augmenting our traditional supervisory approach that focuses on firm-by-firm examinations with greater use of horizontal reviews that look across a group of firms to identify common sources of risks and best practices for managing those risks. To supplement information from examiners in the field, we are developing an off-site, enhanced quantitative surveillance program for large bank holding companies that will use data analysis and formal modeling to help identify vulnerabilities at both the firm level and for the financial sector as a whole. This analysis will be supported by the collection of more timely, detailed, and consistent data from regulated firms.

Many of these changes draw on the successful experience of the Supervisory Capital Assessment Program (SCAP), also known as the banking stress test, which the Federal Reserve led last year. As in the SCAP, representatives of primary and functional supervisors will be fully integrated in the process, participating in the planning and execution of horizontal exams and consolidated supervisory activities.

Improvements in the supervisory framework will lead to better outcomes only if day-to-day supervision is well executed, with risks identified early and promptly remediated. Our internal reviews have identified a number of directions for improvement. In the future, to facilitate swifter, more-effective supervisory responses, the oversight and control of our supervisory function will be more centralized, with shared accountability by senior Board and Reserve Bank supervisory staff and active oversight by the Board of Governors. Supervisory concerns will be communicated to firms promptly and at a high level, with more-frequent involvement of senior bank managers and boards of directors and senior Federal Reserve officials. Greater involvement of senior Federal Reserve officials and strong, systematic follow-through will facilitate more vigorous remediation by firms. Where necessary, we will increase the use of formal and informal enforcement actions to ensure prompt and effective remediation of serious issues.

I think the key question is: How much sooner would these changes have caught the lending problems? I think the answer might be 2007 - and that was already too late.

Hamilton asks who did a better job? Unfortunately all the regulators missed the problems.