by Calculated Risk on 6/29/2009 12:28:00 PM

Boston Fed President Eric Rosengren spoke this morning on The Roles and Responsibilities of a Systemic Regulator

One of my complaints five years ago was that lending standards were too lax (or non-existent), leverage was increasing rapidly, and lenders were clearly making loans that would probably not be repaid.

Rosengren addresses this issue:

Frequently, examiners spend significant time analyzing the adequacy of reserves, given asset quality. Reserve levels are calculated based on accounting standards that focus on incurred losses at the bank, rather than expected or unexpected losses. The incurred-loss model can sometimes be at odds with a more risk-based view that is more forward looking. By focusing on reserves in the manner defined by accounting rules, examiners are looking at history rather than focusing on whether banks have adequately provided for future losses. During periods when asset prices are rising rapidly and when nonperforming loans tend to be low, this construct can result in lower estimates for incurred losses and thus lower reserves – while at the same time, earnings and capital will likely be growing.

Periods when earnings are strong and nonperforming loans are low are likely the times that a macroprudential supervisor would need to be particularly vigilant. Rising asset prices are often accompanied by increases in leverage, as financial institutions provide financing for sectors of the economy that are growing rapidly. This growth frequently occurs with lessened attention to underwriting standards, a greater willingness to finance long-run positions with short-term liabilities, and a greater concentration of loans in areas that have grown rapidly. So – unlike the focus on incurred losses and accounting reserves of traditional safety and soundness supervision – a systemic regulator would need to be focused on forward-looking estimates of potential losses that could cause contagious failures of financial institutions.
bold emphasis added

UPDATE: Lama notes that Rosengren is incorrect about accounting just looking at "history", and reminds me of the guest piece he wrote in 2008: The Pig and The Balance Sheet

And Rosengren concludes:

A systemic regulator or macroprudential supervisor would need not only the ability to monitor systemically important institutions, but also the ability to change behavior if firms are financing a boom by increasing leverage and liquidity risk. It follows that legislation that aims to design an effective systemic regulator needs to provide the regulator with the authority to make such changes. Understanding the activities of systemically important firms would require a clear picture of their leverage, their liquidity, and their risk management. Furthermore, to be truly effective in “leaning against the wind,” such a regulator would need the ability to prevent the build-up of excessive leverage or liquidity risk.

However Rosengren doesn't address how the macroprudential supervisor would identify excessive leverage or liquidity risk. During every bubble there are always people in position of authority arguing everything is fine. As an example, here is what then Treasury Secretary Snow said on June 28, 2005 (has it really been 4 years?):

Snow tried to alleviate concerns that climbing nationwide housing prices could ultimately lead to an asset bubble that will burst at some point.

"I think in some markets housing prices have risen out of alignment with underlying earnings," Snow said. But also answering the question whether there was a housing bubble in the United States his answer was a flat-out "no."

He was flat-out wrong. And that was almost at the peak of the bubble (in activity).

I think we need to clearly understand how we identify - in real time - these macroeconomic and systemic risks.