What’s really wrong with bank supervision

The banks treat supervisors like punks, and the supervisors let them

Dan Davies
Sep 29, 2014 · 5 min read

The root of the problem, the alpha and omega of how our financial system goes wrong so often, in my opinion, can be found in perfect example in the “Segarra Tapes”, recorded by a lawyer who went to work for the Federal Reserve and now reported by ProPublica and by This American Life. The basic problem is — all too often, banks treat their supervisors like punks and all too often, the supervisors let them.

The central incident of the TAL show is pretty easy to explain — it’s on p8 of the transcript linked above. Goldman Sachs (as it happened to be), had given the supervisors some documents relating to a somewhat complicated deal (a transaction which was motivated by another bank’s desire to keep a favourable regulatory treatment which was being taken away from a previous transaction). That’s not really the scandal — the rules are complicated, and half the time these deals are about mitigating unintended consequences of their frequent changes.

What’s the scandal is something much easier to understand and entirely familiar to anyone who’s worked in an office. The documentation had a passage in it which noted something like “This deal will require the approval of the New York Fed”. The deal had already been done by the time the documents were given to the NY Fed. Approval had never been sought.

Punk’d!

It isn’t even really an issue about whether the deal actually did or didn’t need approval. What’s shocking here is that the bank didn’t feel the need to remove, qualify or explain this reference before they gave the documents to the regulator and didn’t seem to be in any way embarrassed about it when it was noticed — in fact it was the supervisor who was embarrassed for bringing it up.

As I say, if you’ve any familiarity with office politics at all, you’ll recognise this as a situation. Effectively, they said “we thought we ought to consult you, but then we decided not to bother, you OK with that?”. As a bureaucratic insult, it’s the equivalent of walking up to someone and flicking their nose. It’s one step away from just cutting out the pretence and writing “OUR SUPERVISOR IS A WET AND A WEED AND WE DON’T CARE WHO KNOWS IT” in chalk on the pavement of Maiden Lane.

And, as the tapes make clear, the supervisor was, originally in the privacy of his office and talking to his own team, outraged. But then when he went to meet with the bank, all the vim and vinegar went out of him. I don’t want to put any blame on the guy concerned, by the way, which is why I’m not naming him here. I would not be surprised if, by the standards of big bank supervisors, he was not particularly bad in terms of regulatory capture. I wouldn’t even be surprised if he was one of the best. That’s the problem.

The problem, as everyone who is familiar with bank supervision knows, is that there is a cultural disinclination to challenge banks on their behaviour. Supervisors have an excess of caution, a tendency to hide behind committee decisions and a reluctance to give orders to supervised institutions. And there’s a clear reason for this — career risk.

The incentives facing a career supervisor have the kind of risk distribution that Nassim Taleb could tell you about — they are long-tailed and asymmetric. If you do something, you are vulnerable to being criticised for doing so. And in a job where bonuses are relatively small and success comes only with promotion, being criticised is your major income risk. If you do nothing, however, most times you will not be criticised unless the bank in question actually collapses, and how often does that happen?

What’s the root of this problem? I once signed the Official Secrets Act when I worked for the Bank of England, but I don’t think I’m breaking it by saying that the biggest problem is that senior management of bank supervisors don’t have the supervisors’ backs. I’ll say that again and put it in a subheading because it’s the main point here.

Senior management don’t have the line supervisors’ backs.

Consider this. If you were an advertiser in a national newspaper, and you didn’t like something a journalist wrote about your company, and you decided to complain to the newspaper’s owner and demand that the journalist be sacked or moved off covering you, you would expect a mouthful of maritime language in response. Even in the rare cases where you managed to put enough pressure on to get your way, everyone involved would know that they were doing something rare and unethical. There is a norm in newspaper journalism that you if you want to complain to a journalist, you do it to her, or in extremis, to her editor. And particularly, that complaining to the boss is a big no-no and it’s an equally big no-no for the corporate management to second-guess the editorial staff.

That is the opposite of what happens in bank supervision. Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors. If you’re a bank CEO, then calling Tim Geithner for a chat — that ought to be OK. Calling Tim Geithner to complain about how your supervisor is treating you — that ought to be a third-rail, relationship-destroying, potential career ender of a call.

And it isn’t, and the cultural consequences of that are as damaging as they’re predictable. Central banks have incredibly powerful internal cultures, which is why they tend to grind down any attempt to bring in outsiders, and they quickly get rid of the ones who can’t be quickly assimilated to their own risk-averse behaviour. In many ways the way that people look on the “revolving door” in regulation is wrong — the problem is every bit as much to do with the “lifers” who would never consider an outside offer as it is to do with the staff who have one eye on a job at the place they’re supervising.

With supreme irony, the New York Fed is holding a conference on “Bank Ethics And Culture” on October 20. Most of it is on the standard stuff, related to the drawing of payoff diagrams, scratching one’s chin and talking about “risk-taking incentives” and then coming up with another proposal to regulate other people’s bonuses (I’m familiar with this literature — I think I might have been the first guy to do one of these articles, in 1996). But when it comes to taking a look in the mirror at their own culture, as their statement on the Segarra case makes clear, they don't want to know. There’s a session on “Enforcement” scheduled for the afternoon of the 20th, and there’s still time to make it meaningful.

Bull Market

A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

Thanks to Mark Buchanan, felix salmon, and Alexis Goldstein

    Dan Davies

    Written by

    Senior Research Advisor, Frontline Analysts

    Bull Market

    A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

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