With the banking system going through a period of turmoil, the question of federal regulation will not be going away any time soon. Are market influences enough, or should the government be taking a closer look at how these banks do business.

Treasury Secretary Hank Paulson has proposed the Federal Reserve be given broad powers to regulate the financial industry. He could not have nominated a more incompetent body. The Coast Guard would do a better job.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

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This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

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