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Prudential Supervision
Monday, April 11 2011 | 03:46 PM
Ron D'Vari

There are several forces that might govern a bank’s behavior and keep it from taking reckless risks in lending and investing, possibly endangering the safety of its depositors and investors. First, there is the market: investors who don’t like lending policies can sell the bank’s stock and bonds, causing their prices to fall. Second, there is the oversight of the bank’s management. Third, there is the oversight of the bank’s Board of Directors. Fourth, bank regulators act as watchdogs, seeking to protect the interests of the depositors; this oversight is sometimes called “prudential supervision.”

In the wake of the recent worldwide financial crisis, it appears that the controls exerted on many banks by the market, by management, and by the board, were not enough to prevent gross excesses in bank lending, particularly in the real estate markets.

These problems quickly became those of the government and taxpayers, because of national systems of deposit insurance and the perception that some banks and financial institutions were “too big to fail.”

Consider our own country, where the federal government bailed out commercial banks such as Citibank, Wachovia, JP Morgan/Chase and Bank of America, as well as investment banks and other financial institutions, notably AIG. Similar dilemmas have faced the European Union, including Greece, Italy, Spain, Portugal and Ireland (and others, such as Iceland, which are seeking membership).

These shortcomings have led to calls for more stringent prudential supervision. In the United States, one aspect of the new environment is the far-reaching Dodd-Frank legislation. Internationally, the Basel Accords, promulgated by the Bank for International Settlements, are now entering a proposed third stage (Basel III).

The Dodd-Frank legislation is so far-reaching that banks are still scurrying around trying to understand how to comply. One striking aspect, as emerging in regulations under the 2010 Interagency Guidance Appraisal and Evaluation Guidelines, is that affected financial institutions will need to establish more objectively the value of their illiquid collateral, such as whole loans, real estate owned and derivatives, preferably by third party (arm’s length) evaluators ( disclosure: this is one area where my own firm consults). There has been militant talk by Republican Party spokesmen to roll back key provisions of the legislation, so the legal situation will remain in flux. Tea Party representatives particularly deplore the emerging Consumer Protection Agency.

As to Basel III, the proposed revisions are intended to increase the quantity of quality of banks’ required regulatory capital. More specifically, there will be greater clarity about eligible Tier I and Tier II capital, and the lowest quality category, Tier III, will be eliminated from eligibility. There will be required stress tests, which are hypothetical projections assuming adverse conditions such as economic recession and declines in real estate markets.

Of course, there are real questions about the ability of regulators to anticipate problematic lending, any more than stock investors, managers or boards. At the least, though, such regulators experience different economic incentives from the other players and may be more fearful of the inexpensive borrowing power that is available to depository institutions, multiplying the profit or loss from lending and investing activity.

Ron D'Vari CFA, CEO of NewOak Capital, and Andrew Szabo CFA, Managing Director of NewOak Solutions
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