By Steven K. Beckner

NEW YORK (MNI) – Cleveland Federal Reserve Bank President Sandra
Pianalto Wednesday stressed the need for consolidated supervision of
financial institutions and the need for the Fed to stay involved in that
supervision.

Pianalto, in remarks prepared for a conference sponsored by the
Levy Economics Institute, advocated a tiered system of supervision based
on the size and systemic risk weighting of banks.

Pianalto, a voting member of the Fed’s policymaking Federal Open
Market Committee, did not talk about the economy or monetary policy. But
she said that the Fed’s regulatory role provides crucial input to her
and her colleagues as they strive to analyze economic and financial
conditions and set interest rates.

Before the financial crisis, Pianalto suggested supervision of
larger bank holding companies and their subsidiaries was inadequate.

“As the various supervisors focused on the risks originated and
faced by the particular part of the company for which they were
responsible, it was sometimes difficult for bank holding company
supervisors to identify the aggregate risk in the enterprise, and to do
so in a timely way,” she said.

“For example, think about the liquidity required for a particular
entity in a holding company versus the liquidity needs of the overall
enterprise,” she illustrated. “A liquidity level that may appear
adequate for the needs of a specific entity — the bank subsidiary,
let’s say — may not meet the needs of the consolidated organization.
Within the corporate structure, both bank and nonbank entities require
funding to remain active.”

Pianalto said “consolidated supervision would provide for the
ability to identify the aggregate liquidity requirements and to develop
a comprehensive supervisory plan that addresses the risks to the entire
organization.”

Since the crisis, she said the Fed has taken steps to “sharpen our
focus on enterprise-wide risk supervision.”

But she said legislation is needed to “remove some of the
constraints we currently face to obtain information from, and address
unsafe and unsound practices in, the subsidiaries of bank holding
companies.”

“In other words, we should move toward consolidated supervision to
ensure that the aggregate risks of the entire firm are identified in a
timely way and that appropriate supervisory action can be taken,
regardless of where that risk originates in the organization,” she said.

Pianalto warned that “without consolidated supervisory authority,
oversight gaps will continue, making it difficult to identify
cross-entity risks within a bank holding company and to take appropriate
action to mitigate those risks.”

Pianalto echoed many of her Fed colleagues in calling for an “end
to the ‘too big to fail’ problem.”

“To achieve this goal, banking supervisors must be able to identify
which firms are systemically important, and why,” she said. “While the
size of a specific financial firm is an important factor, it is only one
of several factors that should be considered. Other important factors
that need to be considered are contagion, correlation, concentration,
and context.”

By “contagion” she meant the “‘too interconnected to fail’ problem.
If an institution is connected to many other institutions and firms —
through loans, deposits, and insurance contracts, for example — all of
those firms may collapse if the first firm fails.”

“Correlation can be thought of as the ‘too many to let fail’
problem,” she said. “Institutions may engage in the same risky behavior
as many other institutions, and the failure of one institution may
result in the closure of all those institutions engaged in that same
practice.”

“Concentration can be thought of as the ‘too dominant to fail’
problem,” she continued. “In these situations, an institution has a
market concentration sufficiently large that its failure could
materially disrupt or lock up the market.”

Pianalto said “context” refers to the “too much attention to fail”
problem. “Because of market conditions and other conditions that exist
at the time, the closure of a particular institution may cause panic and
result in the impairment of other firms.”

Pianalto said identifying “systemically important” institutions
just according to size is “too simplistic.” Between the largest banks
and the community banks, she said there is “a middle tier of financial
firms that poses a greater risk to the financial system than community
banks and thus requires a higher degree of supervisory attention.”

So she advocated “a multi-tier approach to thinking about our
financial industry” and a three-tiered regulatory framework which she
called “tiered parity.” She said there should be three categories of
banks: “systemically important,” “moderately complex,” and “noncomplex.”

Under her proposed supervisory system, Pianalto said “the
regulations and the approach to supervision for each tier would
correspond to the degree of risk posed to the financial system by the
firms within each tier.”

She said “any institution that is identified as systemically
important would be subject to stricter supervisory requirements, such as
capital and liquidity standards, as well as close supervision of its
risk taking, risk management, and financial condition.” And they would
be required to develop a “living will” that would provide for “planned
and orderly unwinding if necessary.”

As for the second tier of “moderately complex financial firms,”
she said regulations “would be revised and customized to consider the
risks they collectively pose to the financial system. Supervisors would
conduct focused reviews of all the firms in this group at the same time
to determine the degree of risk they pose and to ensure the consistent
application of supervisory action, where warranted.”

With Congress considering financial reform legislation that would
limit and redefine the Fed’s supervisory role, Pianalto said the crisis
demonstrated why “the Federal Reserve should continue to supervise
banking organizations of all sizes and should take on an expanded role
in supervising systemically important financial institutions.”

“Retaining our role in the supervision of banks of all sizes is
vital,” she added.

Pianalto said “the knowledge, expertise, and direct access to
information that come from our supervision and lending responsibilities
contributed to our effectiveness in monetary policy.”

“During the darkest moments of the crisis, this knowledge,
expertise, and direct access to information were critical and could not
have been developed at a moment’s notice,” she continued. “even today,
the intelligence I gather from my banking supervisors is extraordinarily
useful to me as a monetary policymaker in helping to identify factors
that may pose risks to my economic outlook.”

Pianalto added that, in turn, “the knowledge that the Federal
Reserve has about the economy and financial markets enhances our
effectiveness as a financial supervisor.”

“This wide range of expertise also makes the Federal Reserve
uniquely suited to supervise large, complex financial organizations and
to address risks to the stability of the financial system,” she said.
“No other agency has, or could easily develop, the degree and nature of
expertise that the Federal Reserve brings to the supervision of banking
organizations of all sizes and the identification and analysis of
systemic risks.”

** Market News International New York Newsroom: 212-669-6430 **

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