I recently came across the following article I had written for the American Banker just about five years ago to the day (in the heady boom year of 2006). The article describes how the regulatory system had gotten significantly weaker over the previous twenty years while the banks had grown far more powerful and complex. It’s an interesting read, particularly in view of the subsequent financial collapse followed by a toothless regulatory reform bill that fixed nothing of consequence.

BANK REGULATORY SYSTEM OUT OF BALANCE

February 2, 2006

The retirement of Federal Reserve Chairman Alan Greenspan marks the end of a golden era in which the Fed has enjoyed remarkable stability and enviable stature under the leadership of two of the greatest Fed chairmen in history, Paul Volcker (1979-1987) and Alan Greenspan (1987-2006).  Remarkably, the Fed has had just two chairmen in 27 years compared to five Presidents, eight chairmen of the Federal Deposit Insurance Corporation, and six Comptrollers of the Currency (not counting acting agency heads).

The troubling irony is that while the Fed’s prestige in the monetary policy arena has never been stronger, changes in the structure of the banking industry are making the Fed less relevant in the regulation and supervision of banking institutions.  As someone who has argued for many years against concentrating too much power in the Fed, I have difficulty adjusting to the reality that the Fed has lost a great deal of its regulatory clout.

The banking world of 1979, when Paul Volcker became chairman of the Fed, bears little resemblance to the reality of 2006.  While the Depression-era restrictions imposed on competition in banking were beginning to crack under the relentless pressure of marketplace forces, banks remained tightly regulated.

Bank holding companies were the primary means by which banking companies expanded in 1979.  Banks could not open branches freely, so they formed bank holding companies to acquire and operate free-standing banks.  Banks could not engage in non-banking financial activities, so they used their holding companies to expand into activities “closely related” to banking.

The Fed was the exclusive regulator of bank holding companies, and its approval was required for every acquisition by every bank holding company.  The Fed had nearly unfettered power over expansion-minded banking companies.  If the Fed decided that banking companies were growing too fast for their own good or the good of the economy, it would sit on expansion applications until the Fed’s cautionary message was absorbed.

The regulatory world that new Fed chairman Ben Bernanke enters in 2006 is one in which bank holding companies are much less vital.  With the advent of interstate branch banking, holding companies are no longer required for geographic expansion.  Moreover, the permissible activities of banks have been broadened to the point that holding companies are no longer needed for product expansion.

Expansion-minded banks no longer need Fed approval of most of their acquisitions.  They increasingly turn to their primary bank regulator, which for the largest banks is the Comptroller of the Currency.  Indeed, few of the Federal Reserve Banks have a single large bank under their supervisory jurisdiction today.

This transformation has been accompanied by a massive consolidation of the banking industry.  Thousands of banks have failed or been acquired, leaving close to 70% (nearly $6 trillion) of the nation’s banking assets in the hands of the 25 largest companies.  The three largest companies control 35% of banking assets.

The federal bank regulatory structure in Paul Volcker’s era was a partnership among the Fed, the OCC and the FDIC.  The Fed was the senior partner, to be sure, but each agency had an important role and clear authority.  The OCC, as a bureau of Treasury, was part of the executive branch.  The Fed and the FDIC were independent agencies.  In short, the federal regulatory structure was more or less in balance and had checks and balances.

The FDIC’s authority as an independent watchdog on the banking system has also been diminished in recent years.  The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) increased the FDIC’s board of directors from three to five members, and added the Director of the Office of Thrift Supervision (also a bureau of the Treasury) to serve on the FDIC board alongside the Comptroller of the Currency.

The OCC and OTS are charged by statute with promoting the interests of national banks and federal thrifts.  The FDIC is charged by statute with ensuring stability in the banking system and picking up the pieces when things go awry.  The FDIC, when it is functioning as it should, second guesses the examinations, ratings, and actions of the primary regulators.

This creates what I consider a healthy tension between the OCC or the OTS, on the one hand, and the FDIC, on the other.  That tension is defused, to the detriment of the banking system, with those two agencies sitting on the FDIC’s board.

Not only do these two Treasury agencies have seats on the FDIC board, they have had outsized influence over the FDIC most of the time since FIRREA became law.  Whenever there is a vacancy on the FDIC board – and there have been one or more vacancies in 9 ½ of the 16 ½ years since FIRREA’s enactment – the FDIC board can take no action without approval from the OCC and the OTS.

A glaring example of the conflict of interest inherent in this governance structure occurred in the 1993, when the FDIC had two vacancies and an acting chairman.  The OCC and OTS used their majority board position to revoke the FDIC’s standby examination authority with respect to national banks and federal thrifts.  Due to continuing vacancies on the board, it took the FDIC nearly a decade to restore some semblance of this critically important authority.

I have been a big supporter of the Comptroller of the Currency and the national banking system for my entire professional life.  I also believe strongly in checks and balances within government and between industry and government.

I believe the checks and balances in effect for most of the past century have been seriously eroded.  Our nation’s largest banks have grown geometrically, while the Fed and the FDIC – the two independent banking agencies charged with maintaining a stable banking system and picking up the tab when problems arise – have watched much of their authority slip from their hands.

The FDIC’s governance problems can be fixed relatively easily.  Congress should return the agency to a three-member board by eliminating the seats held by the OCC and the OTS.

Solutions for the Fed’s waning authority are less obvious.  It has lost most of the large banks it used to supervise, and the importance of its role in approving expansion by bank holding companies is clearly not what it used to be.

It is difficult to see how the Fed’s issues get resolved without meaningful regulatory reform and restructuring.  But that is a subject for another day.