Bloomberg News

Fed’s Stress-Test Champion Reshapes Regulation of Biggest Banks

March 15, 2012

Daniel Tarullo, governor of the Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Daniel Tarullo, governor of the Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Not long after President Barack Obama picked Daniel Tarullo for a seat on the Federal Reserve Board, he sat down for the standard briefing with the staff and promptly turned the tables on them.

Tarullo told them they had made mistakes in supervision, and he wouldn’t defend their past actions. Later, he told Richard Shelby, the leading Republican on the Senate Banking Committee, he endorsed Shelby’s view that regulators had fallen down. He said it was time to “reshape” regulation.

In the past three years, no one has done more to strengthen government’s grip on the financial system. A former law professor and aide to President Bill Clinton, Tarullo, 59, has piloted implementation of the Dodd-Frank Act, the most sweeping overhaul of financial regulation since the 1930s. He has a larger say in banks’ day-to-day decisions on compensation, dividends, stock buybacks, mergers and risk-taking. And he has buried former Chairman Alan Greenspan’s light-touch regulation that kept the Fed from doing more about risky mortgage practices in the last decade.

“Dan is tough and independent; his sole priorities are financial stability and the public interest,” said Sheila Bair, chairman of the Federal Deposit Insurance Corp. from 2006 to 2011 and now a senior adviser at the Pew Charitable Trusts. “That said, he has his hands full trying to change the regulatory culture at the Fed and dealing with the sometimes competing views” of its 12 district banks.

Rigorous Stress Tests

Tarullo and the Fed staff’s rigorous stress-testing of bank portfolios against dire economic scenarios has strengthened the banking system. In the third round of tests since Tarullo took office in January 2009, 15 of the 19 largest banks would maintain sufficient capital even during a deep recession with 13 percent unemployment and a 50 percent drop in stock prices, the Fed said March 13.

Tarullo, Obama’s first Fed appointee, says he sees no need to apologize for an aggressive new approach.

“It is hardly illegitimate for the Fed or the Congress or the country as a whole to be concerned about the liquidity and capital practices of large financial institutions,” the Fed governor said in an interview. “If bankers look at the relatively recent history of their firms, some would see that senior management didn’t do a great job managing risk.”

Investors staged a punishing retreat from financial stocks in 2011, concerned about banks’ ability to make money amid higher regulatory costs and risks from Europe’s sovereign-debt crisis. The KBW Bank Index (BKX) -- which tracks shares of 24 U.S. companies, including Bank of America Corp. and Capital One Financial Corp. (COF) -- fell 25 percent in 2011, when the Standard & Poor’s 500 Index was unchanged.

Improving Economic Forecasts

As forecasts for economic growth have improved, the KBW index has recovered: up 22 percent so far this year versus 11 percent (SPX) for the S&P 500.

“There is no question that there is a view at the Fed that they are going to be both more rigorous and more intrusive,” said H. Rodgin Cohen, senior chairman at Sullivan & Cromwell LLP, a New York law firm whose clients include JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS) and other of the world’s largest banks. “They are telling boards what they have to do.” The changes represent “a true revolution in regulation, and Governor Tarullo is the Fed point person on this.”

Executives face dozens of changes to fundamental business decisions, including a ban on proprietary trading under the so- called Volcker Rule, which becomes effective July 21 and could take five years to implement fully.

Additional Capital Buffer

International regulators, including Tarullo, also agreed last year to require Deutsche Bank AG (DBK), BNP Paribas SA (BNP), Citigroup Inc. (C) and the other 26 largest global banks to hold an additional capital buffer equal to as much as 2.5 percent of risk-weighted assets because of the potential threat they pose to the world financial system.

The new regulations are “not great for the recovery of the global market,” JPMorgan Chairman and Chief Executive Officer Jamie Dimon said when asked by an analyst in a January conference call if capital rules were becoming clearer after U.S. regulators announced how international standards would mesh with Dodd-Frank. “They’re clearer bad.”

Greenspan also has weighed in. Dodd-Frank may “create the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971,” he wrote in a Financial Times column last year. He hasn’t changed his views, according to spokeswoman Katie Broom.

Stifle Innovation

Bankers say the Fed’s new approach is intrusive and threatens to stifle innovation and the flow of credit at a time when the U.S. needs faster expansion to create more jobs. Research by Standard & Poor’s shows that loan growth in the 30 months following the recession’s end in June 2009 was the slowest of any recovery since World War II.

“If you take a major segment of your economy, and all it is trying to do is preserve itself, then that slows economic growth, it slows employment creation and it probably, over time, drives big chunks of that business to someplace else,” said John Allison, a BB&T Corp. (BBT) director and former chairman and CEO of the Winston-Salem, North Carolina banking group. The Fed’s incursion into bank boardroom decision-making is “dramatically more than it has ever been.”

When challenged on the costs of regulation, Tarullo points to the costs of the previous decade’s light-touch regulation. The last recession was the deepest since the Great Depression, lasting 18 months and costing 8.8 million Americans their jobs. Unemployment has remained above 8 percent since February 2009, even though the expansion will be three years old in June.

‘Poor Risk Management’

“It is very important not to lose sight of what happened,” Tarullo told the American Bar Association’s Banking Law Committee on Nov. 4 in Washington. Before the crisis, financial institutions had “substantially inadequate capital, poor liquidity management and, in a lot of cases, poor risk management as well.”

A Boston native, Tarullo can easily slip into his hometown accent and hangs a picture of the Red Sox’s Fenway Park on his wall. He is also a basketball fan and has held season tickets for the Hoyas at Georgetown University in Washington, where he received a bachelor’s degree and worked on the law faculty before starting his job at the Fed.

Unlike Chairman Ben S. Bernanke and Vice Chairman Janet Yellen, who have doctorates in economics, or Governor Elizabeth Duke, a former banker, Tarullo is an expert on financial regulation, with a book on the topic, “Banking on Basel,” published in 2008. He has taken a sprawling bureaucracy with powerful regional centers of expertise, such as the New York Fed, and focused it on an overarching mission: preventing the next financial catastrophe.

‘Dictated Policy’

“Dan is the first governor that I can recall in recent memory that has taken on an issue, run the staff and dictated policy,” said Karen Shaw Petrou, who has watched financial policy for 27 years as head of Federal Financial Analytics in Washington. “Supervision and regulation has been an afterthought for most governors.”

When Tarullo joined the Fed eight days after Obama’s inauguration on Jan. 20, 2009, Bernanke already had begun to look at developing an internal assessment of financial stability, and the staff was trying to measure the maximum potential losses faced by the biggest banks. That analysis evolved into the first stress test in 2009.

The Fed combined some of its 275 Ph.D. economists from board staff with district supervisors to test the capital of 19 banks against an adverse forecast of 10.3 percent unemployment and 0.5 percent growth in 2010.

New Approach

Tarullo said that test, with its focus on how the banks would fare individually and as a group, helped him design a new approach to systemic-risk oversight.

“I thought then, and continue to think now, that for the very largest institutions, this is the only way in which supervision is going to be effective from both a macro- and micro-prudential perspective,” he said in the interview.

Tarullo also has been an aggressive advocate of making the stress tests public, which raised concerns for some Fed staff.

“I can remember saying a little prayer,” said Coryann Stefansson, who co-lead the first test and is now a director in PricewaterhouseCoopers LLP’s Financial Services Regulatory Practice. “Please dear God, don’t let what I am doing end up being the cause of the demise of the U.S. financial system.”

So-called horizontal reviews are now the Fed standard for large bank supervision. Stress tests have expanded to include an emphasis on capital planning, giving the central bank influence over decisions on dividends and stock buybacks.

Interacting Staffs

The stress-test discipline also pulled analysis of the biggest banks back to Washington from the Fed branches, which historically defended their expertise in markets and specific institutions. Now, multiple big banks are analyzed at once, with board and regional staffs interacting.

For all the focus on centralized risk detection, Tarullo still must count on thousands of individual examiners spread around the country. He has tried to elevate their status and invited some teams to Washington to speak with him personally.

When he arrived, their work was “often regarded as mid- level supervisory tasks, and I said to myself, ‘Gee, these are our people on the ground. Shouldn’t they be regarded as supervisory stars?’” Tarullo said.

The number of these employees at Fed branches is budgeted to jump to 3,688 this year from 2,657 in 2007 and to 383 from 258 for supervision and regulation staff in Washington.

High-Level Managers

Tarullo still counts on high-level managers such as Sarah Dahlgren and Jennifer Burns, heads of supervision at the New York and Richmond district banks.

Dahlgren, in New York, has replaced most of the senior supervisors in charge of her largest banks, which include Goldman Sachs and Citigroup, and has doubled her on-site teams to about 35 people. She has redefined their mission as one of business-line analysis, management communication and risk detection instead of back-office compliance. Serious risks often are viewed in the context of practices at other banks and may be brought to the attention of a group of economists and supervisors in Washington.

Burns has more than 30 of the Richmond examiners assigned to Charlotte, North Carolina-based Bank of America, the nation’s second-largest bank after JPMorgan by assets. She has teams charged with monitoring credit, market, operational and compliance risk, as well as teams focused on capital and liquidity.

‘Complete Paradigm Shift’

For all the sheer force aimed at the banks, Shaw Petrou says she wonders if they are being redefined into financial utilities. That business model “isn’t coherent” for institutions that have invested millions in making markets and finding innovative ways to channel credit, she said. “It is a complete paradigm shift.”

Tarullo said he understands the fine balance the Fed must achieve.

“There is a necessary level of judgment to make in setting prudential standards,” he said. “With sufficiently stringent regulation, you could have an incredibly stable banking system, but it wouldn’t be lending to too many people.”

Banks should be in the business of providing credit and taking well-managed risks, he said. This time the Fed will be watching for excesses and bubbles, “because what happened in the 2000s was a rapid build-up of certain kinds of lending without the recognition that it was built on a house of cards.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Cheyenne Hopkins in Washington at chopkins19@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net


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