The Fed's A-Team Hunts for Signs of Risk

Some of the biggest banks in America, such as JPMorgan Chase (JPM) and PNC Financial Services, want to increase dividends over the next few quarters. When those dividends do go up, it will look like a vote of confidence by bank boards on the sustainability of economic growth and profits. The payouts will also be one of the most carefully screened moves by regulators in modern financial history.

The behind-the-scenes guiding hand of these bank board actions is a little-noticed team of economists, payment systems experts, bank examiners, and quantitative analysts at the Federal Reserve. The group was formed in early 2010 by Chairman Ben Bernanke and Governor Daniel Tarullo to hunt down risks in the financial system before they trigger another crisis.

Almost a year ago, the new Fed team, known as the Large Institution Supervision Coordinating Committee (LISCC)—which staffers pronounce "lis-sick"—helped Bernanke identify and respond to an emerging threat to the global banking system when U.S. money market funds began dumping European bank debt out of fear of a Greek default.

Now, the unit has given the directors of 19 banks, including JPMorgan Chase, PNC, Citigroup (C), and Goldman Sachs (GS), a challenge: Before you hand out cash to shareholders, think about what might happen to you over the next nine quarters if unemployment rises and the economy falters. "The current review of firms' capital plans is another step forward in our approach to supervision of the largest banking organizations," says Tarullo.

If the bankers don't come up with a plan to have enough capital to withstand economic, regulatory, and lending risks, then the regulator is likely to challenge the dividend increases and ask for revisions, according to a set of guidelines issued by the Fed in November. "We came about as close as you can to the Great Depression. Regulators are going to err on the side of caution," says Joel Conn, president of money managers Lakeshore Capital in Birmingham, Ala. The pressure from the Fed may be working. At a Feb. 15 presentation, JPMorgan Chief Financial Officer Douglas Braunstein revealed that the bank's stress scenario for the economy was more severe than the Fed's.

LISCC also wants banks to plan for an array of new regulations that could lower profits. Another LISCC focus is the likelihood that investors in faulty mortgages may force the banks to take them back. Standard & Poor's (MHP) estimates such a maneuver could cost the industry $60 billion.

Before LISCC's creation, the Fed's 12 reserve banks handled much of the day-to-day supervision of big banks and reported back to the Board of Governors in Washington, which sets the rules for bank holding companies. With LISCC, the Fed can tap its deep bench of more than 200 PhDs to figure out how a particular risk might affect the entire financial system or just a single bank.

The intense scrutiny of everything from compensation to stock buybacks shows the depth of the regulatory incursion into tasks normally handled by bank directors. E-mails revealed by the Financial Crisis Inquiry Commission showed the Fed even considered ousting Lehman Brothers Chief Executive Officer Richard Fuld and exercising "influence" over his successor. It's too much, says Wayne Abernathy, executive vice-president of the American Bankers Assn. and former staff director of the Senate Banking Committee under former Senator Phil Gramm (R-Tex.). "What do these guys really bring to the table that the leaders of businesses don't already know or have?" he says. "The answer is: the wrong set of incentives. Their incentive is to take no risk."

On the other side, financial regulators don't have high confidence in bank boards after the crisis revealed they didn't fully plan for events such as the fall in housing prices, says Alan Blinder, a Princeton University professor and former Fed vice-chairman. Regulators "would have loved to have left these issues, especially compensation, to boards if they exercised their responsibility," he says. Bank boards "blew it, big, big-time" during the financial meltdown.

To figure out if banks have enough capital, the Fed has asked the 19 largest banks to come up with at least two scenarios: a "baseline" on how the economy will probably perform and an adverse scenario. The LISCC has deployed Fed economists to come up with its own adverse scenario, laying down an official standard for what could go wrong. The Fed's worst case calls for a 1.5 percent decline in gross domestic product through the end of 2011, according to people familiar with the central bank's thinking.

The unit has also made one of the largest data requests in Fed history outside of normal regulatory reporting, asking for information in a range of areas, including loans and securities portfolios. This will allow the Fed to test any one bank's assumptions about the soundness of its portfolio against analysis of its own. Says Kevin Petrasic, an attorney at the law firm of Paul Hastings in Washington and a former special counsel at the Office of Thrift Supervision: "You have an entire industry that is now on parole."

The bottom line: The Federal Reserve's specially assembled team of risk detectives will pressure the nation's largest banks to raise capital if needed.

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