The two barrels of the FRB’s mighty artillery pointed at big banks are “micro” prudential rules – aimed specifically at risky practices at individual firms – and “macro” rules designed to spot and, then, stop worrisome financial-market trends. A review of the 2006 transcript of FOMC meetings makes clear that, in the run-up to the crisis, the Fed did little more than squirt a water pistol. Neither micro nor macro risks rate a mention at any of the 2006 FOMC sessions. Instead, the Fed thought of little else but its inflation-fighting responsibilities. And perhaps even worse, the central bank’s regulatory axiom was that markets knew more than regulators and, thus, knew best.

We know this not just because several key events that laid the seeds for the crisis were clearly premised on unblinking faith in financiers. Think, for example of the Greenspan opus on OTC derivatives, which defended the FRB’s hands-off policy on grounds that, if derivatives didn’t in fact hedge risk, no one would buy them. But, one of the most interesting quotes in the 2006 transcript points to just how embedded this efficient-market theorem was as the Board’s guiding supervisory principle. Then head of the Federal Reserve Bank of New York and, of course, the lead supervisor for most of the nation’s largest BHCs, Timothy Geithner said in March of 2006 that:

Developments in asset prices and risk premiums over the past several months seem to support this picture of stronger confidence in the growth and inflation outlook because real rates seem to have risen. Equity prices and credit spreads suggest considerable confidence in the prospect for growth. Implied volatilities remain quite low. We don’t know how much of this is fundamental and how much will prove ephemeral.

Mr. Geithner did not go on to question whether this bout of exuberance was not as “irrational” as those Chairman Greenspan famously pooh-poohed a decade before. The 2006 transcripts for this meeting and those thereafter showed that Mr. Geithner’s faith that markets foretold macroprudential risk led the Board to believe that the boom would just go on and on. Apparently, only market-price declines signaled trouble for the FOMC, which more than surprisingly lacked any understanding of the growing leverage, concentration and – yes – microprudential problems that blew up in their lap so soon after Mr. Geithner’s happy talk.

Much commentary on the transcript has focused on how blind the Board was to the emerging housing crisis, a mistake that makes the Fed even more vulnerable to political attack in the wake of last week’s housing-policy white paper. Little noticed, though, is how little a dent consumer-protection made in any of the FOMC’s musings even though the central bank’s responsibilities included governance of key statutes like the Truth-in-Lending Act. Then-Governor Bies is the only one to mention risk associated with products like negative-amortization mortgages, but she does so only to warn about the risk at large mortgage banks that counted unrealized income as revenue under permissive accounting rules. This, she argued, exposed banks to interest-rate risk; nary a word is uttered, though, about what happens to borrowers when the neg-am dance stops.

A lot of FOMC chit-chat was a light-hearted discussion of some of the more dubious sales tactics at home builders. Staff talked about car-plus-house deals and subdivisions with fake furnishings designed to entrap the unwary homebuyer. Nowhere, though, does one read any worry from the Fed about homebuyers put at risk from deceptive marketing. All the FOMC frets about is whether these developer practices affected mortgage interest rates and, thus, the FOMC’s monetary-policy objectives.

The FRB has, of course, now recanted, issuing one after another rule intended to build both a micro- and macroprudential financial fortress. As we’ve noted, we think the sum total of all of these rules raises the specter of complexity risk, resulting in unintended consequences for banks and the macroeconomy. We’ve also suggested that one cure to complexity risk is more transparency – and not just for financial institutions.

Had the FRB complied with the Government-in-the-Sunshine Act and held its regulatory meetings in public, the premises of its policy would have been far more clear. Instead of chuckling about mortgage risk, the Board would have been forced to face it head-on in detailing the thinking behind the few proposals issued at the time to address risks other regulators (e.g., the FDIC and OCC) foretold. We know the Board is busy, but we think it should still find time to go back to the practice of issuing every substantive rule at an open meeting in which the Board of Governors asks questions, the staff answers and the public learns why rules are crafted as they are. We know these meetings were often staged events, but over long years of going to them, we saw frequent sparks of real discussion and even changed opinions. At the least, public pronouncements on regulations lay clear what the Fed is – or isn’t – thinking about, preventing undue market or Congressional confidence in the central bank’s prescience.