Supervisory Lapses at the Federal Reserve refers to the situations where the Federal Reserve System, also known as the US Central Bank, failed to regulate and monitor financial institutions and other entities under its jurisdiction. These lapses led to various economic and financial crises, which severely impacted the economy of the United States.
Over the years, the Federal Reserve System, as the primary regulator and overseer of the US financial system, has faced criticism for its poor supervisory and regulatory practices. These lapses have contributed to the growth of systemic risks in the financial system, which ultimately led to the 2008 financial crisis.
The Federal Reserve Act of 1913 granted the Federal Reserve System the responsibility to supervise banks, but it did not give the power to regulate non-bank financial institutions such as insurance companies or investment banks. However, after the Financial Crisis of 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, which gave the Federal Reserve expanded regulatory authority over non-bank financial institutions.
Supervisory Lapses at the Federal Reserve have been criticized for lacking effectiveness in identifying and stemming risks in the financial system, particularly the systemic risks. The Fed’s supervisory capabilities have been attributed to staffing and financial resources constraints, poor risk-management practices, and cultural limitations within the organization.
The oversight lapses range from inadequate monitoring of capital requirements, excessive compensation structures, weak controls of firms’ risk activities, inadequate implementation of regulatory measures, and lax enforcement of existing regulations. These loopholes have led to the accumulation of systemic risks, including the subprime mortgage crisis, the housing crisis, the sovereign-debt crisis, and the global financial crisis.
One of the key supervisory lapses identified by experts is the lack of resources that the Federal Reserve allocates to supervision. The supervisory team relies on a small group of examiners, who are often not able to provide adequate coverage to supervised institutions. Furthermore, the Federal Reserve often pays less attention to smaller banks and financial institutions, which can pose a significant risk to the economy, as seen in the case of Washington Mutual.
Another supervisory lapse is the absence of regulatory enforcement. According to critics, the Federal Reserve Supervisory framework is too lenient in enforcing the rules meant to guard the financial system. For instance, during the financial crisis, the Federal Reserve was aware of the pervasive risks posed by the widespread use of adjustable-rate mortgages, yet it continued to allow banks to issue them.
Inadequate risk management practices have also characterized the Federal Reserve System’s supervisory lapses. Despite the existence of regulations intended to limit the risks associated with complex financial products, the Federal Reserve has failed to monitor the extent to which companies adhere to them. This lapse, combined with inadequate understanding of risk by examiners, has created opportunities for financial institutions to exploit loopholes and loosen underwriting standards, leading to the subprime mortgage crisis.
Furthermore, the Federal Reserve’s supervisory framework has faced criticism for lacking a proactive approach that identifies potential risks before they escalate and also lacks transparency in communicating these risks to the public. Additionally, supervisory efforts targeting banks and non-banks have been uncoordinated, resulting in the Fed overseeing some financial products while other government agencies oversee similar ones.
In conclusion, the supervisory lapses at the Federal Reserve have played a role in the economic crisis of the last decade. While various reforms, including the Dodd-Frank Act, have been aimed at addressing these shortcomings, the Federal Reserve must continuously improve its supervisory operations, including allocating adequate resources, strengthening regulatory enforcement, improving risk management practices, and enhancing transparency. These steps will not only guard against the buildup of systemic risks but also protect the economy and ensure stability in the US financial system.
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