Former NY Fed bank examiner Carmen Segarra has once again shined a bright light on the gap between the narrative and reality of bank supervision.  The narrative says Fed led bank supervision and regulation can prevent a financial crisis.  The reality is Fed led bank supervision and regulation is not fit for that purpose.

Ms. Segarra laid out her case.

I am not surprised by what Ms. Segarra observes.  The financial system has been systemically broken since the Committee to Save the Banks decided to save the banks.  This decision deliberately broke the system.  Over-promising what bank supervision and regulation can accomplish is just one aspect of the broken system they promoted.

Based on her comments, Ms. Segarra believed in the narrative the Committee to Save the Banks promoted about bank supervision.  As a result, she was slapped in the face when she discovered the gap between the narrative and reality.

Where Ms. Segarra thought changes were going to be made, I would have been shocked if the Fed had made a dramatic change in how it handles bank supervision and regulation.

Why?

Because Rule One of bank supervision is bank examiners never approve or disapprove of a potential investment (derivative, security or loan).  By definition, Rule One makes bank supervision and regulation unfit for the purpose of preventing a financial crisis.

Why do bank examiners follow Rule One then?

If bank examiners approved or disapproved of each potential investment, it would be the examiners who were allocating capital to the economy and not the bankers.  For better or worse, it is believed the bankers do a better job of allocating capital to the economy than bank examiners would do.

Also, if the bank examiners were the ones who allocated capital, then taxpayers would be on the hook for bailing out every bank that fails.  Why?  Because bank failure is the fault of the bank examiners and not the bankers.  Rule One was adopted to avoid this.

So then what do bank examiners do?

Ultimately, all of bank examination comes down to protecting the deposit insurance fund (and by extension, the taxpayers) from losses.  Bank examiners kick the tires and try to uncover any exposures that might trigger sizable losses.  [They also do a lot of ticking off the boxes to be sure the banks are complying with various legal requirements.  However, this is all parking ticket level stuff as oppose to the real crimes like market rigging and fraud the bankers engaged in during the run-up to the financial crisis.]

But what about all those bank capital and liquidity regulations banks are suppose to comply with?  Surely, they can prevent a financial crisis.  Under the theory PhD Economists subscribe to, yes they can.  In reality, no they cannot.

Why?

Financial panics and bank runs are the direct result of the solvency of the opaque banks being called into doubt.  The lack of disclosure means there are no facts with which to dispel the doubt.  Hence, it is better to run and try to get your money back rather than hope the banks are actually solvent.

Regular readers know I have long advocated for stripping the Fed of its bank supervision and regulation responsibilities.  There are a number of reasons for this ranging from regulatory capture to reinforcing market discipline.  The excuse the Fed needs this responsibility to support its lender of last resort role hasn’t been valid since deposit insurance was adopted.  Deposit insurance guarantees the Fed’s loans will be repaid regardless of how insolvent a bank might be.

For those who would like to argue with the content of this post, it reflects my unique career path.  First, I was trained as a bank examiner while working at the Fed in DC.  Second, I worked for a Too Big to Fail bank that managed to lose the equivalent of 50% of its book capital on an interest rate bet.  Third, as the global expert on financial transparency, I have written extensively on opacity, bank runs and financial system design.