A few weeks ago, the Federal Reserve told a number of large banks that it was going to start going deal by deal to look for troubled loans. It was the equivalent of a parent telling their child to stop goofing off and do their homework. You don’t want me to come up there.
The move followed more than a year of haranguing by the U.S. central bank and the lender chief regulator about the increasingly risky loans banks were making, mostly to overly indebted companies, at least by the Fed’s measures. In early 2013, former Fed board member Jeremy Stein warned about a bubble in lending. In September, the Fed told banks that if they continued to make high-risk loans, the central bank might force them to hold more capital. Earlier this year, the Fed officially warned the banks that it looked like some of their lending was not conforming to standards set in March 2013.
And then, nothing happened. The risky loans that the Fed was worried about continued to multiply.
So, earlier this month, the Fed told a number of banks that it was switching from requiring a yearly report on lending to a monthly one. The Fed also pledged to go through every loan the banks made to find the bad ones.
And on Monday, the Fed tried another scolding approach. It rounded up a number of top bankers, including Morgan Stanley (MS) CEO James Gorman. The meeting was held behind closed doors. But that didn’t stop the Fed from releasing some tough-sounding speeches supposedly delivered at the session. William Dudley, head of the New York Fed, apparently said that banks needed to curb risky lending and fix their ethical problems or face the possibility of being broken up.
Will the latest talking-to work? Probably not.
So far, the Fed has been all talk and not much action. Despite the tough words, Monday’s meeting was, according to one attendee who spoke to The Wall Street Journal, “collegial, probably a little too collegial.” The Fed fed bankers chicken and salmon for lunch. Sounds lovely.
The deal-by-deal review is probably an empty threat as well. First of all, the Fed doesn’t have nearly enough manpower to evaluate every loan a bank makes, not even if it just focuses on the big ones. Second, going loan by loan doesn’t make a lot of sense anyway. Individually, most bank loans don’t seem bad. And there are plenty of borrowers that banks turn away. There is a whole group of hedge funds that specializes in making loans to businesses that can’t get access to capital, or at least funding at good prices, from banks. The loans that banks do make come with high interest rates to justify the risk. And right now, plenty of investors are clamoring to get in on those loans, buying into leveraged bond deals.
The problem isn’t the individual loans. Banks run into problems when all those only-sort-of-risky-looking loans add up to a big mess. When all those loans go bad together, you have a problem.
Banks have bankers who evaluate each loan. It’s the big picture that banks often miss, and that’s what regulators are supposed to be looking at.
The Fed has been criticized for its lax oversight of the banks, most notably in a report by NPR and ProPublica on the firing of a New York Fed examiner who had wanted to get tough on Goldman (GS). More evidence of the NY Fed’s poor examination skills came in a report last week from the Fed’s inspector general on JPMorgan’s London Whale trading incident. The report said that, despite warnings, investigators at the New York Fed failed to take a closer look at JPMorgan’s (JPM) risky trading.
The Fed has the unenviable task of keeping a tight leash on the banks all while encouraging them to lend. The whole point of keeping interest rates at near zero is to boost lending to get the economy moving again. The Fed has done a terrible job of toeing the line between being a cheerleader for lending and the big banks, and keeping an eye on them. And when you know you are not really going to punish anyone, raising your voice and praying that it works becomes your next best option.