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Fed's approach to regulation left banks exposed to crisis

The hands-off approach also was a matter of philosophy. Rather than scrutinize banks directly, the Fed decided to push them to appoint internal risk managers who imposed their own checks and balances. Regulators focused on watching the watchmen. Bernanke's predecessor, Alan Greenspan, said that banking was becoming too complicated for regulators to keep up. As he put it bluntly in 1994, self-regulation was increasingly necessary "largely because government regulators cannot do that job."

Greenspan revisited the theme in a 2000 speech, saying, "The speed of transactions and the growing complexities of these instruments have required federal and state examiners to focus supervision more on risk-management procedures than on actual portfolios."

Some experts say the reliance on others clouded the central bank's ability to see the trouble brewing on the balance sheets of large banks. Others argue that the Fed had a clear view of the problems; it simply underestimated the risk. Either way, the approach had dire consequences.

By 2006, National City had become primarily a subprime mortgage lender, federal data show. Even as the Fed continued to regard National City as healthy, the company's executives were increasingly divided, with some warning that National City needed to pull back. The following year, the bank sold its subprime lending operation to Merrill Lynch, but by then it was too late to get rid of the loans. As defaults rose, so did losses, and the bank could no longer persuade investors to lend it the money it needed to survive.

In fall 2008, regulators arranged for the company to be sold for a pittance to its Pittsburgh rival PNC.

A warning ignored

In January 2005, National City's chief economist had delivered a prescient warning to the Fed's board of governors: An increasingly overvalued housing market posed a threat to the broader economy, not to mention his own bank and others deeply involved in writing mortgages.

The message wasn't well received. One board member expressed particular skepticism -- Ben Bernanke.

"Where do you think it will be the worst?" Bernanke asked, according to people who attended the meeting, one in a series of sessions the Fed holds with economists.

"I would have to say California," said the economist, Richard Dekaser.

"They have been saying that about California since I bought my first house in 1979," Bernanke replied.

This time the warnings were correct, and the collapse of the California real estate market would bring down the nation's fourth-largest bank, the largest casualty of the financial crisis.

Dekaser and Bernanke declined to comment on the exchange.

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