A huge regulatory gap condoned by the Fed

Fed Chairman Ben Bernanke testified before the Senate Banking Committee earlier today on the many challenges the U.S. economy now faces. He had a few thoughts to share about the government's most troublesome ward, failed insurer AIG.

I think if there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.

AIG exploited a huge gap in the regulatory system. There was no oversight of the financial-products division. This was a hedge fund basically that was attached to a large and stable insurance company.

They made huge numbers of irresponsible bets. They took huge losses. There was no regulatory oversight because there was a gap in the system. We were then forced - we had no choice but to stabilize the system - because of the implications that the failure would have had on the broad economic system.

Yes, there was a huge gap in the system. There is little disagreement on that fact. But, interestingly, it wasn't viewed as a "gap" at the time.

In fact, no one seemed to mind all that much that giant insurance companies were creating trillions of dollars worth of unregulated liabilities, particularly the Federal Reserve.

That is, until the wheels started falling off.

It takes only a few minutes to cull, from the Fed's website, these gems:

Remarks by Chairman Alan Greenspan
Before the Council on Foreign Relations, Washington, D.C.
November 19, 2002

International Financial Risk Management

Today I would like to share with you some of the evolving international financial issues that have so engaged us at the Federal Reserve over the past year. I, particularly, have been focusing on innovations in the management of risk and some of the implications of those innovations for our global economic and financial system.
...
The market for credit derivatives has grown in prominence not only because of its ability to disperse risk but also because of the information it contributes to enhanced risk management by banks and other financial intermediaries. Credit default swaps, for example, are priced to reflect the probability of the net loss from the default of an ever-broadening array of borrowers, both financial and nonfinancial.

As the market for credit default swaps expands and deepens, the collective knowledge held by market participants is exactly reflected in the prices of these derivative instruments. They offer significant supplementary information about credit risk to a bank's loan officer, for example, who heretofore had to rely mainly on in-house credit analysis. To be sure, loan officers have always looked to the market prices of the stocks and bonds of a potential borrower for guidance, but none directly answered the key question for any prospective loan: What is the probable net loss in a given time frame? Credit default swaps, of course, do just that and presumably in the process embody all relevant market prices of the financial instruments issued by potential borrowers.

So far, it looks like the net loss is about $150 billion over the last six months.

And, when the housing bubble was almost fully inflated, these thoughts a few years later.

Remarks by Chairman Alan Greenspan
Risk Transfer and Financial Stability
To the Federal Reserve Bank of Chicago's Forty-first Annual
Conference on Bank Structure, Chicago, Illinois (via satellite)
May 5, 2005

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers. But some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks' efforts to lay off risk using credit derivatives may be creating concentrations of risk outside the banking system that could prove a threat to financial stability.
...
While available data cannot resolve these issues, a study conducted last year by the Joint Forum, which was based on interviews with market participants, does shed some light. The study concluded that notional values had significantly overstated the amount of credit risk that had been transferred outside the banking system to that point and that the amount of risk transfer was quite modest relative to the total amount of credit risk that exists in the financial system. The study found no evidence of "hidden concentrations" of credit risk.
...
Some other concerns about the transfer of credit risk outside the banking system seem to be based on questionable assumptions. Some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk. But those unregulated and less heavily regulated entities generally are subject to more-effective market discipline than banks. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities.

There really wasn't a gap - as in some sort of an omission in regulatory oversight...

It was a conscious decision by the central bank and others charged with regulating financial markets to allow these credit derivatives to be a self-regulating.

ooo