April 11 (Bloomberg) -- Federal Reserve Bank of Kansas City President Esther George said regulators must eliminate too-big-to-fail policies that bail out large financial institutions during times of crisis.
“The most critical issue in addressing TBTF concerns is having policy makers with the resolve to follow through,” George said a speech today in New York. The U.S. must “correct the misaligned incentives and the improper expansion of federal safety net protections that encouraged and enabled institutions to take excessive risks.”
To achieve those goals, George said that regulators must not “view stress tests, other forms of quantitative analysis and models used by macroprudential supervisors as being a substitute or replacement for examiners and onsite supervision.”
The Fed said last month that 15 of the 19 largest U.S. banks could maintain adequate capital levels even in a severe recession scenario that assumes they continue to pay dividends and buy back stock.
The results of the so-called stress tests showed that nearly three years of economic expansion have helped U.S. banks raise profits, rebuild capital, and increase liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008 nearly toppled the financial system.
“The breakdown we have seen in models-based approaches suggests that we should not develop a false sense of security from the stress tests and other new supervisory tools we are now putting in place,” George said.
“While these tools can be useful additions to supervision, we must recognize the very important and unique role that examiners have in supervision and their ability to bring a strong sense of reality and caution to the oversight of the financial system,” she said.
The Fed started the most recent test and review of banks’ forward-looking capital strategy in November, saying they should have “credible plans” to meet tougher standards required by new regulations and to continue lending even in period of financial stress.
“Policy makers and regulators can face substantial pressure to back off from implementing tighter oversight, especially if such oversight interferes with financial institutions going back to their usual operating parameters,” George said. “Signs of this are already occurring with the efforts by financial institutions and others to weaken or delay stronger capital standards and other provisions of the Dodd- Frank Act.”
U.S. stocks ended a five-day decline as Alcoa Inc. opened the earnings season with an unexpected first-quarter profit. The Standard & Poor’s 500 Index advanced 0.9 percent to 1,370.33 at 9:53 a.m. in New York, halting a five-day slump, as Alcoa rallied 7.1 percent.
George was the Kansas City Fed’s No. 2 official under Thomas Hoenig, who retired last year. She joined the Fed in 1982, spent much of her career in bank supervision and became first vice president in 2009.
From 2001 to 2009, she was senior vice president in charge of the Division of Supervision and Risk Management, overseeing regulation of the Kansas City Fed district’s 170 state-chartered member banks and almost 1,000 bank and financial holding companies. She worked in Washington in 2009 as acting director of bank supervision for the entire Fed system.
“The critical and defining question for us is how to break this pattern of growing safety nets and escalating crises, while restoring much-needed market discipline to the financial system,” George said at the 21st Annual Hyman P. Minsky Conference organized by the Levy Economics Institute of Bard College.
“Ending TBTF is the only sure way to curtail the expansion of public safety nets and break the pattern of repeated and ever-escalating financial crises,” she said.
Copyright 2014 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.