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Why the Fed Ignored Warnings and Let Banks Pay Shareholders Billions

After paying out $33 billion to shareholders last year, the biggest banks don't have that money to cushion themselves if a new crisis hits.

| Sat Mar. 3, 2012 7:00 AM EST

Instead, the Fed left it to the financial institutions to disclose the results. In March 2011, 11 of the 19 announced that they had been given the go-ahead to buy back shares, pay dividends or get out of TARP. In the first three quarters of 2011, all 19 paid some dividends on either common or preferred stock, and 10 bought back some stock—a total of $33 billion in common and preferred dividends and share buy-backs in the period, according to SNL Financial. That amounted to almost 5 percent of the most important, bedrock type of bank capital held by the 19 institutions as of the end of the third quarter.

But beyond the specifics, the political climate had also shifted by the time of the second stress test. Bankers were emerging from their defensive crouch, emboldened to push back against what they considered excessive regulation. At the same time, the sweeping 2010 financial reform act known as Dodd-Frank gave the Federal Reserve more supervision responsibility. What the Fed had done in a panic in the aftermath of the 2008 crisis was now codified as one of its central legal duties, and as it tried to adapt to its new mission, it suffered internecine battles.

Responsibility for overhauling and improving the Fed's bank regulatory efforts rests with Daniel Tarullo, a 59-year-old former Clinton administration official and academic who became a governor in January 2009. Bankers utter his name in hushed and embittered tones, terrified of his aggressive calls for more oversight and capital. With his white hair and square jaw, he recalls a pro football linebacker from a previous era. Yet, his actions have often fallen short of his tough talk, critics say.

He oversees a sprawling, fragmented institution. Twelve regional reserve banks share bank oversight responsibility with the central board of governors, based in Washington, D.C. The reserve banks have historically taken most of the bank supervision responsibilities, while Washington has concentrated on monetary policy. The individual reserve banks are frenemies, sometimes working together but often suspicious of others' motives and jealous of each other's clout.

"It's like 'Survivor': You make certain alliances, but that doesn't mean you won't cut the throat of the person the next time," says a former Fed supervisor.

The most powerful of the regional banks, the Federal Reserve Bank of New York, rivals the central board in authority and influence. The two institutions often butt heads. The New York Fed is widely seen throughout the rest of the system as overly protective of the two biggest institutions it supervises, JPMorgan Chase and Citigroup. New York returns the view, believing the Richmond Fed to be captured by the biggest bank it oversees, Bank of America, and San Francisco by its charge, Wells Fargo.

Bank supervisors, especially the ones deployed to work physically inside the banks that they oversee, are, like all regulators, vulnerable to capture by the institutions they police. They sometimes identify with and coddle their banks rather than enforce the rules, according to multiple current and former Fed officials.

"You have to work with these people every day. You develop working relationships," says a New York Fed official. "You have to put yourself in their shoes, but you have to make sure they are safe and sound."

Given what its critics call its supervisory neglect, regulatory capture and bureaucratic rivalries, the Fed had a poor understanding of the sector it regulated in the lead-up to the 2008 crisis. "If a supervisor wanted to see [the Fed's] systems, he would have flunked us miserably," recalls a former Federal Reserve banking official. "We would joke about that a lot."

Mandated to overhaul this system, Tarullo centralized supervision—and thus power—in Washington.

"As an academic, I think I came to have a pretty good understanding of the substance of the Fed's regulatory policies," Tarullo tells ProPublica. "But when I got here, I was surprised that the large institution supervisory process wasn't very well coordinated across firms, and really didn't draw on all the economic expertise of the Federal Reserve."

When he arrived, Tarullo found that the supervision and regulation division was beset by personal disagreements and turf battles. He found the unique structure of the Federal Reserve complicated bank supervision and regulation, and such problems persist.

"That's why we created the Large Institution Supervision Coordinating Committee—to make strong coordination and interdisciplinary perspectives permanent features of the supervisory function," he says.

Part of that may be due to his management style. Universally regarded as smart, Tarullo doesn't always look people in the eye. He often leans back in his chair, tilts his head up and addresses the ceiling. The rank-and-file thought he mistrusted them and didn't listen, according to several former Fed employees.

Tarullo and some at the Fed defend his leadership, but critics say his manner could undermine his push for tighter regulation, especially with the Fed's old guard. "Our esteemed leader," was how Patrick Parkinson, a Greenspan acolyte who retired at the end of 2011 as the director of the division of banking supervision and regulation, sarcastically referred to Tarullo, according to a former Fed employee. Parkinson didn't return calls seeking comment.

Tarullo is known for his temper. He has made a few employees cry, according to people familiar with the incidents. At a meeting of the board of governors in late 2009, Tarullo blew up at Coryann Stefansson, a former supervisor who ran the first stress test in front of the entire board. As she contended that the Fed shouldn't push Bank of America to raise more capital, Tarullo surprised people in the stuffy Fed meeting rooms, laden with heavy, dark wood furniture, shouting: "How dare you interrupt me?" a person familiar with the meeting recalls.

Yet, Tarullo gave ground eventually on BofA. In the end, the Fed pushed Bank of America to raise more capital than it initially proposed but less than the FDIC wanted.

The Fed and Tarullo declined comment on the incident.

For his part, Tarullo is cautious about his accomplishments, saying, "I don't want to overstate how much progress has been made, but I do think that with the authority we either had already or have gained from Dodd-Frank, plus the creation of the [large institutions committee] and the requirement of regularized capital planning and oversight, there are at least the makings of something durable."


The first stress test

At the Fed, battle lines over how rigorously to regulate banks were drawn during the first stress test. Officially known as the Supervisory Capital Assessment Program (SCAP, pronounced "Ess-Cap"), the first stress test certainly forced most banks to beef up their capital. But even coming right out of the gravest economic peril since the Great Depression, the Fed gave the banks concessions.

When it first began to test banks against bleak economic scenarios, the Fed took a conservative stance toward bank plans for the future. If a bank was going to sell a business line or other asset to raise capital, it had to complete the transaction before the Fed would count it toward fulfilling the bank's new capital requirements.

One debate was over what are known as "deferred tax assets"—losses that can be written off against future profits. If a bank suffers losses for a prolonged period, it can lose the opportunity to take the write-off, and the asset becomes worthless. Initially, some supervisors pushed for a conservative treatment. Capital is supposed to absorb losses in a crisis. Deferred tax assets, or DTAs, can't do that because they are little more than an accounting concept.

For the stress test, the Fed assumed that banks' profits would suffer a prolonged hit in an economic downturn, reducing or wiping out the value of these assets. But there was an issue with Wells Fargo. Since it hadn't lost money even at the depths of the 2008 crisis, should it be able to get some credit for its deferred tax assets?

Janet Yellen, then-president of the Federal Reserve Bank of San Francisco, supported Wells Fargo. The tough-talking Tarullo came around to her view, according to four people familiar with the negotiation. At the end of 2009, banks were haggling over the details of how to fulfill the capital-raising requirements. The Fed allowed Wells to get some credit for its remaining deferred tax assets. The softer treatment set off cascading effects: Supervisors had to scramble to give Pittsburgh-based PNC Bank similar credit because it, too, had weathered the crisis better than other banks and had a large portion of deferred tax assets on its balance sheet.

"It is common—perhaps too common—for reserve presidents to tend to believe that their firms are invariably better than average," laments a former Fed governor.

"The treatment of Wells' DTAs was fully consistent with a rigorous" stress test, says Yellen, now vice chair of the Fed board of governors, in a statement. She argues that a key issue was that the tax write-offs were imminent, so the risk was minimal that Wells would suffer losses and not be able to use them. "Under Federal Reserve capital regulations, it is appropriate to count DTAs as capital when they are going to be realized in the very near term," she says in her statement. "After looking at the specific characteristics of Wells' DTAs, senior Board staff determined that they qualified as capital" for the first stress test.

PNC and Wells declined to comment.

In a speech on May 6, 2010, the one-year anniversary of the tests, Fed Chairman Bernanke called the first stress test a "watershed event," crediting it with having helped "restore confidence in the banking system and the broader financial system, thereby contributing to the economy's recovery."

By the third quarter of 2011, the top 19 banks that underwent the tests had added hundreds of billions in capital. A crucial measure of their capital is known as Tier 1, and it consists mostly of common stock, reserves and "retained earnings"—income that is not paid to shareholders but instead kept by the company to invest in the business. By the end of the third quarter, the top banks' Tier 1 capital was up to about $740 billion. Using an average weighted to account for the different sizes of the banks, that's 10.1 percent of their assets, compared with a low of 5.4 percent at the end of 2008.

As the banks built more capital, struggles erupted among various government bodies about when and how to let banks pay back TARP money. Most of the banks wanted to pay back the government as quickly as possible, mainly because the bailout money came with intensified oversight and potential restrictions on how much executives could pay themselves. And with the bailouts deeply unpopular with the public, the Treasury also pushed for the banks to pay back the money as quickly as possible so the government could claim the program was successful and hadn't cost the taxpayers much.

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