Geithner and the Hubris of Financial Services Regulation

The Washington Post has a fascinating profile of Treasury Secretary Tim Geitner’s tenure as financial regulator. The missteps of the Treasury Department in managing the bailout of the financial services industry might well result in Geithner’s firing in 2010, but he would really be the fall guy for a failed regulatory perspective and approach embraced by the Obama Administration. My colleague Anthony Randazzo has been chronicling the missteps for several months now.

The relevant part of the Post article, I believe, is its discussion of Geithner’s tenure as President of the New York Federal Reserve Bank. The New York FED is a central player in financial industry regulation and policy implementaton, and Geithner was steward of the ship during the period the financial services volcano was building toward eruption. Not surprisingly, like just about everyone else in the mainstream, he missed it.

Yet as Geithner and the New York Fed worked to solve narrow mechanical issues in the derivatives market, they missed clear signs of a catastrophe in the making. When the housing market collapsed, derivatives stoked the fires that ignited inside some of the biggest banking companies. The firms’ failure to assess an array of risks they were taking has emerged as a key element in the multitrillion-dollar meltdown of the global financial system.

Although Geithner repeatedly raised concerns about the failure of banks to understand their risks, including those taken through derivatives, he and the Federal Reserve system did not act with enough force to blunt the troubles that ensued. That was largely because he and other regulators relied too much on assurances from senior banking executives that their firms were safe and sound, according to interviews and a review of documents by The Washington Post and the nonprofit journalism organization ProPublica.

But, is this fair? The article is a good journalistic account, but it also relies on the old tactic of judging decisions using 20/20 hindsight. Should Geithner have been expected to recognize the emergent financial crisis when virtually everyone else missed it?

While Geithner and the New York FED analysts believed that the banks were not able to really evaluate risk in their portfolios, it’s not at all clear that the FED was in a better position than banks to make these judgement calls. And, in the end, they are judgement calls.

The following passage from the Post article on “credit derivatives,” one of the culprits in today’s finacial services collapse, is interesting in this respect:

“The development of credit derivatives,” Greenspan said in a May 2005 speech, “has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively.”

Geithner often cited the merits of credit derivatives as well, saying in a May 2006 speech at New York University that they “probably improve the overall efficiency and resiliency of financial markets.”
By then, some financial institutions already were worried about the subprime mortgages underlying exotic securities. AIG’s Financial Products unit, one of the largest issuers of credit-default swaps, stopped offering that insurance. Even so, few understood the magnitude of the looming disaster.

“What nobody knew was that credit derivatives had moved from a risk diversification and risk management vehicle to the world’s biggest gambling casino,” said H. Rodgin Cohen, a New York attorney for large financial companies such as J.P. Morgan Chase and Wachovia.

The problem we now face is that the federal government is substituting political accountability for market accountability. In retrospect, the banks could not adequately value the risk in their portfolios. Most of these products were relatively new. Most analysts believed the economy was in a steady state of virtually permanent growth. The solution, however, is not to expunge risk, but to create better ways for that risk to be properly evaluated. That’s what the financial services industry is struggling with now.


That same year [2006] he [Geithner] initiated a Fed-wide review of how well the financial giants were able to measure their ability to survive the stresses of a market downturn. William Rutledge, the New York Fed’s executive vice president for bank supervision, said the reviews turned up several weaknesses. They found that banking companies were pretty good at measuring the risks to specific parts of their businesses but had little understanding of the dangers to the institution as a whole. The firms also failed to account for the kind of worst-case scenarios that would later cripple several banking giants.

In the current political climate, politicians are looking for a scape goat. It’s easy to pick on Geithner, and deflect real debate and discussion with accusations of the “cozy relationships” between regulators and Wall Street.

In truth, unfortunately, we are living through a massive market correction that is being hobbled by further regulatory manipulations by the federal government. Geithner’s tenure as Treasury Secretary is more illustrative of the problems we face when government tries to do too much and, in the process, ignores the complexity and inevitability of these corrections. The belief that government can anticipate, correct, and manage the financial services industry back to health is, in fact, a fatal conceit that should have been learned from Geithner’s experience at the New York FED.