The leaders of 11 federal and state agencies will gather Oct. 1 for the first meeting of the Financial Stability Oversight Council, a super-agency set up by the Dodd-Frank Act to get ahead of the next financial crisis.

The doors will be closed, but rest assured improvements in the oversight of the financial services business are already underway.

In interviews, officials of the Federal Reserve Board and the Office of the Comptroller of the Currency — the two agencies most responsible for supervising giant banking companies — readily admitted mistakes and eagerly talked about the improvements they are tackling.

"The holy grail, of course, is to try and see around corners," David K. Wilson, deputy comptroller for credit and market risk, said after describing some of the early warning metrics the agency is working on. "Given what we have just gone through, we are all looking at ourselves and asking how can we do better."

Pat Parkinson, the director of the Fed's division of supervision and regulation, said the Fed is now pulling in specialists from around the agency to help examiners get a more holistic view of the risks facing banking companies.

For example, before a company's performance rating is decided, an entire team — macroeconomists, markets experts and payments pros — serve as a review board, asking the lead examiner questions he might not have considered.

"By bringing this extra perspective to bear," Parkinson said, "we hope the ratings will adjust more promptly and be more forward-looking."

Two key tools the agencies are turning to are horizontal reviews and stress testing.

Instead of examining an individual firm, a horizontal review compares a number of institutions against each other. These give regulators some ammunition with which to convince a bank to change its ways.

The Fed now is using a horizontal review to evaluate how banks determine whether they have enough capital.

"We're testing to see whether we think that internal process has integrity and how does that stack up to what their peers are doing," Parkinson said. "It's very helpful to be able to say, 'You are doing this, and all your peers are doing that.' "

Stress testing, which became famous in 2009 when the government measured the capital adequacy of the largest banking companies, assesses a company's readiness for unexpected events.

To be credible, Wilson said, these tests must be transparent and independent. "Every bank cannot be better than average."

Parkinson noted the tests should take into account the ripple effects that follow disruptions.

The agencies are also devising early warning systems to better measure the speed and direction of change; they do not want to be caught flat-footed by another bubble like that in the residential mortgage market. Wilson said the OCC is relying less on lagging indicators like nonperforming loans to look instead at things like the spreads between single-B debt and Treasuries.

All these innovations will take more people, and the Fed is hiring. But former regulators (read: not Parkinson or Wilson) argue that some employees should be redeployed. In particular they point to "resident examiner" programs. Both agencies have had examiners stationed inside banks and their holding companies for years yet failed to see the financial crisis that hit in 2008. (The Federal Deposit Insurance Corp. is getting into this game; it recently created an Office of Complex Financial Institutions.)

As one former senior regulator put it, "It's too easy for these examiners to go native, to lose their edge and become conduits for the bank. I would drastically cut back on that program and move to more high-impact, precisely targeted examinations of high-risk areas."

These resident programs can become calendar-driven, with areas to be examined mapped out months or even years in advance, which is the antithesis of a nimble supervisory system.

In addition to regulatory innovations, Dodd-Frank required a bunch of new regulations designed to help prevent another crisis.

The Fed will be writing rules on credit exposure as well as concentration and leverage limits. It is to apply "prompt corrective action" — the program of taking increasingly severe steps against a company as its capital falls — to holding companies, too. Companies will be forced to design "living wills," or road maps for unwinding their operations in the event of failure.

So that's what's coming. It will replace a balkanized system that led examiners to look too narrowly at the institutions under their direct supervision. Broad and sophisticated assessments will be made of a firm's capital and liquidity as well as its growth and exposures and its interplay with other financial players.

But two hurdles remain.

First, regulators cannot be content to find problems. They have to have the guts to demand fixes. Dozens of inspector general reviews of failed banks document this pattern of excellent diagnosis followed by soft enforcement.

Next, because financial services is so diverse and dispersed, bank supervisors must learn to work with securities, commodities and insurance regulators.

The Financial Stability Oversight Council may be able to help on both fronts. It could be a forum to shame regulators that fail to follow through, and it should foster cooperation by gathering diverse interests around the same table.

But unless the council opens its meetings to the public, it will be hard to tell what effect it is having.


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