Business lender CIT Group's troubles are raising questions about the Federal Reserve's ability to pinpoint a firm's problems and put it back on the right track.

Less than seven months ago, the Fed approved a request by CIT, a lender to nearly 1 million small and mid-sized businesses, to become a bank holding company, giving it access to taxpayer funds under the Treasury's Troubled Asset Relief Program, known as TARP. The approval also made CIT subject to more regulation by the central bank.

Based on information provided by CIT and its primary regulators, the Fed judged in December that the lender's capital, management and future prospects qualified it as a bank holding company.

Now, CIT's inability to borrow cheaply has put it on the brink of bankruptcy, save for a last-minute emergency financing deal arranged by bondholders.

The U.S. Treasury Department acknowledged last week that it will likely lose the entire $2.3 billion it pumped into CIT, which would be the first loss suffered under the government's $700 billion financial rescue program.

The Fed's failure to force a restructuring at CIT is unlikely to sit well with Republicans and Democrats alike who are already uneasy about a proposal by President Barack Obama to expand the Fed's regulatory powers to put the U.S. central bank in charge of monitoring large, interconnected firms whose failure would threaten financial stability.

Representative Spencer Bachus, the top Republican on the House of Representatives Financial Services Committee, said on Tuesday the Fed had historically done a poor job in identifying and addressing systemic risk.

A prime example of this is troubled lender CIT, the Alabama congressman said. This inability to assess risk once again threatens to undermine a fragile economy and erase the taxpayer funds provided to CIT under TARP.

A Fed spokesman said he could not comment on supervisory matters involving individual institutions.

FDIC SAW PROBLEMS BREWING

When the Fed granted CIT's request, red flags were already flying. Just weeks after the request was approved, the Federal Deposit Insurance Corp opted not to clear CIT for its debt guarantee program because it thought the lender's problems went a lot deeper than short-term liquidity.

The agency was concerned with CIT's higher risk lending, escalating bad loans, and limited capacity for new lending.

Last week, the New York Federal Reserve Bank completed a preliminary stress test of CIT, concluding the lender needs $4 billion of regulatory capital, CIT said on Tuesday.

Maybe it is that in the valley of the blind the one-eyed woman is queen, but you have to give some credit to the FDIC, said William Black, an economics and law professor at the University of Missouri-Kansas City.

This again shows that the Fed is really not good at identifying risk. That is basic level regulation: you look at what's coming due. That is what the FDIC did.

But Randy Marshall, a managing director at risk and business consultancy Protiviti, said that while detractors could tout CIT as an example of why the Fed should not be given greater supervisory powers, it was important to note that financial conditions were deteriorating rapidly in December.

It was difficult to guess right every time about which firms would continue to be well-capitalized, Marshall said.

In its December statement approving CIT's request to become a bank holding company, the Fed said considerations relating to the financial and managerial resources and future prospects of the organizations involved are consistent with approval.

In the same statement, however, the Fed appeared to acknowledge some concerns, saying CIT was working on strengthening its risk-management systems.

In normal circumstances CIT Group would never have been approved, a former Fed official said. But there are times when a system can deal with a shock and times when it can't. The Fed, in a way, was already acting as a systemic regulator.

Faced with frozen markets after the failure of Lehman Brothers, the Fed expedited CIT's request to seek safety as a bank holding company. American Express and GMAC also found shelter under the government umbrella.

Given where we were in fall 2008 and given that the market was essentially stalling, there was no alternative, said Christian Weller, a senior fellow at the liberal Washington think-tank Center for American Progress. You had to accept the notion that there would be some lost investments.

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