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Janet Yellen's big fumble

February 13, 2014: 5:00 AM ET

The new Fed Chair was stumped on a key Volcker Rule question.

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FORTUNE -- Stock markets cheered Janet Yellen's performance in front of the House Financial Services Committee Tuesday, with the S&P 500 up 1.11%. But not everyone was impressed.

One particular exchange bothered Jim Bianco of Bianco Research, who wrote in a note to clients that it appeared Yellen was "painfully flustered" when North Carolina Congressman Patrick McHenry questioned the Fed Chair about recent changes to the controversial Volcker Rule. Check out the clip below, starting at the 2:44 mark:

As you can see, Yellen either doesn't understand McHenry's question or is unfamiliar with recent changes to the Volcker Rule concerning sovereign debt.

The Volcker Rule, a provision of the Dodd-Frank financial reform bill, aims to prevent large banks that fund themselves with federally insured deposits from taking excessive risks through proprietary trading. The original Dodd-Frank legislation only exempted U.S. government debt from these trading restrictions, but the final version of the rule would also allow, in some cases, foreign sovereign debt to be exempt as well.

Here's Bianco:

"Remember Yellen is the head of arguably the most important financial services regulatory body in the world. To be blunt, it is her job to understand why [the] Fed is doing what they are doing and be able to articulate their decisions. Exempting sovereign bonds from capital charges, bonds that have shown a tendency to blow up (see Greece), is a critically important regulatory issue. She cannot sit silently until she is saved by the bell, as was the case today when ... Congressman McHenry ran out of time for his line of questioning."

In a phone interview on Wednesday, McHenry said he was willing to give Yellen the benefit of the doubt, and assume that she didn't understand his question. But she offered an "odd response," he said. He considers the exemption of government securities from the Volcker Rule a "double standard" that exposes the fact that restrictions could negatively affect companies' ability to secure funding. Otherwise, why have an exemption at all? And Yellen's inability to articulate a response on these provisions, which will affect both economic growth and financial stability, "doesn't enhance my view of her," McHenry said.

To be sure, Janet Yellen is a highly qualified economist, and she shouldn't be expected to deliver perfect answers to every question lobbed at her. At the same time, the Federal Reserve has asked Congress and the public to bestow incredible powers and trust in it, just years after it failed to prevent the last crisis. Indeed, Yellen's predecessor Ben Bernanke was always quick to point out that the 2008 crisis was the result of a regulatory failure to perceive and react to risks facing the financial system.

Any federal regulator worth her salt must be aware and thinking about the risks posed by sovereign debt, given the drama that has unfolded in Europe in recent years and the ever-escalating debt levels in countries like the U.S. and Japan. 

In the spirit of the Olympics, Bianco gave Yellen's performance a "7 out of 10 due to the regulatory stumble." Yellen will have a chance on Thursday to raise that score when she testifies before the Senate. Hopefully, she'll do a better job explaining the Fed's attitude toward the Volcker Rule and other financial stability measures.

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