Bull by the Horns

by Sheila Bair

  Sue Bies was a former banker and had been the Fed’s point person on Basel II for several years. Of all the regulators, she was clearly the most determined. But John Dugan was also pushing hard. Both argued that Basel II was more sophisticated than the current rules, relying, as it did, on the complex models banks used to predict the probability and severity of future losses. I think they truly believed that the capital reductions under Basel II were justified based on their confidence in the ability of the large banks to manage risk adequately. That confidence, of course, later proved to be woefully misplaced. Their other main argument was that we needed to move forward to maintain the competitiveness of the U.S. financial system. In other words, Europe was letting its banks operate with lower capital, and we needed to let ours do so as well.

  Both Dugan and Bies said that they wanted all four bank regulatory agencies to adopt the same set of bank capital rules. (In the summer and fall of 2006, OTS Director John Reich was still on the fence about Basel. Later, he would join the Fed and OCC.) But they also intimated that the OCC and Fed would be willing to proceed independently of the FDIC if there was no interagency agreement. That was a serious threat to the FDIC position. As the primary regulators of the major financial institutions, the Fed and OCC had the raw legal authority to ignore our concerns and implement Basel II for their banks on their own. If they did so, they would not be obliged to include any of the safeguards the FDIC wanted against capital reductions.

  Given the FDIC’s waning leverage, I reluctantly agreed to issue15 a proposed rule for comment implementing the advanced approaches but insisted that certain conditions previously negotiated by the FDIC and Vice Chairman Gruenberg be included. One was a three-year transition period that capped the amount of capital reduction for any individual bank at 5 percent per year, though the caps would come off after the third year. Another was a permanent 10 percent cap on the amount of total capital that could decline among all banks using the advanced approaches.

  Even with those safeguards, our staff analysis showed16 that the big U.S. banks would be able to lower their capital levels significantly. Citigroup’s capital release would have been $2.5 billion. Bank of America could have released $14.6 billion. Washington Mutual, a major West Coast mortgage lender and the OTS’s biggest charter, could have released $2.3 billion. All of those institutions would later fail or run into serious trouble. Without the FDIC safeguards, those capital reductions would have been even higher. Indeed, our studies showed17 that the total capital held by big banks would decline by 22 percent, with a median decline of 31 percent among individual institutions.

  We were on the ropes but still swinging, so I decided that there was no defense like an offense. I was scheduled to go to my first meeting of the Basel Committee in Mérida, Mexico, in October 2006. The chairman of the Basel Committee, Nout Wellink, who headed the central bank of the Netherlands, had paid a courtesy call on me in Washington that summer. During the meeting, he had said he would be open to considering an international leverage ratio to address declining capital levels in Europe under Basel II. Nout was a gentlemanly career central banker who (quietly) shared many of my concerns about Basel II, and I was flattered that he had made a point of visiting me to encourage discussion of an international leverage ratio. The Basel II accord—and the capital reductions it entailed—were particularly worrisome for smaller countries such as the Netherlands, which was home to very large banking institutions whose assets far exceeded their country’s GDP. The failure of one of those behemoths could bring the whole country down. On the other hand, politically, Nout could not break from other EU nations, and the larger countries—Germany and France in particular—had no problem in letting their big banks take on a lot of leverage. To his credit, Nout saw even then the problems that were developing in Europe over Basel II implementation, and he wanted to try to head them off.

  How would a leverage ratio have helped the situation?

  Basel II set capital standards based on the perceived riskiness of a bank’s assets. The leverage ratio, on the other hand, is a simple measure of bank capital to the value of total assets. So if a bank has $1 trillion in assets—be they mortgages, credit card debt, derivatives, or government securities—and the required ratio is 5 percent, capital has to equal $50 billion. That $50 billion is a floor below which the amount of capital cannot fall, even if the bank says its assets are very low risk. It prevents banks from gaming the risk weighting of assets and also helps prevent wide fluctuations in bank capital through economic cycles. The United States has had a leverage ratio for insured banks for decades, and it has proven to be a good tool against excess leverage. (It saved our bacon during the crisis.) Canada and Australia also use leverage ratios.

  I thought an international leverage ratio was a “capital” idea and enthusiastically embraced Nout’s overture. We notified the other U.S. regulators that I would be bringing it up in Mérida. They were not pleased. I told them I thought that an international leverage ratio was the best way to stem capital declines in Europe. If we were worried about international competitiveness, we should be trying to increase capital in Europe, not decrease it here. I thought we at least had an understanding that they wouldn’t try to undermine me, particularly since Nout was sympathetic.

  However, shortly before the Mérida meeting, I had a conference call with Nout. He warned me that the Germans, French, and EU were up in arms about my proposing an international leverage ratio and that he wouldn’t be able to support me. He also told me that he suspected the other U.S. regulators were encouraging the opposition. He specifically mentioned that John Dugan was letting Basel Committee members know that the other U.S. regulators did not support my initiative. That was amazing to me. After putting a gun to my head to implement a capital accord that they knew would lead to significant capital reductions at U.S. banks, the Fed and OCC weren’t even willing to stand aside and let us take a shot at getting something going with an international leverage ratio. Undeterred, I told Nout that I still wanted to bring it up.

  I will never forget walking into the large, brightly lit conference room at the Mérida hotel where we were staying on October 4, 2006. With me I had Jason Cave, who had armed me with compelling arguments surrounding the problem of declining capital and variations among nations implementing Basel II. It was roasting hot in Mérida, and I wore a sleeveless linen dress. I had underestimated the Mexicans’ penchant for air-conditioning. It was freezing in the room, and of course everyone else was dressed in long-sleeved business suits. With every ounce of physical control I had, I kept my body from shivering, terrified that my international colleagues would view the slightest tremor not as a reaction to the sixty-degree temperature but as fear and nervousness in confronting them. I knew I was going to be alone, but what I had to say needed to be said. If they were going to continue to forge ahead with the lunacy that was Basel II, I was going to at least make it uncomfortable for them.

  So I laid it all out. I talked about the importance of capital to financial stability, I talked about the risks of leaving capital adequacy too much to banks’ discretion, I talked about the risks of low capital in periods of economic distress, I talked about the dangers of a “race to the bottom” in capital standards and all of the studies that had been conducted showing that the advanced approaches under Basel II would lead to jaw-dropping capital reductions.

  Nout was right. They didn’t take it well. Danièle Nouy, the head banking regulator from France, led the assault, basically asking who did I think I was, trying to undermine an international agreement that had been years in the making? (Looking back, I think a major obstacle to international regulators’ acknowledging the problems with Basel II was that they had spent so much time on it that they did not want to admit they had made a mistake and all those years of effort had been a waste.) But Danièle’s remarks were tame compared to those of Patrick Pearson, the representative from the European Union, who used the meeting as a platform to launch into an anti-U.S. diatribe. Germany a
lso weighed in (though I think strategically they had wanted Danièle to take the lead so the assault would not appear to be gender-biased). I was disappointed that Daniel Zuberbühler of Switzerland also piled on, suggesting that the leverage ratio was a “stone age” measure. (Daniel later recanted and became a supporter of an international leverage ratio. He showed a lot of courage in changing his position, and his support was pivotal when the Basel Committee finally approved a leverage ratio in 2010.) My fellow U.S. regulators remained stone silent.

  I returned to my hotel room that evening, saddened and frustrated by how the meeting had gone and deeply disappointed that my U.S. colleagues were undermining my efforts. I had clearly made myself unpopular at that first meeting and wasn’t sure what I had achieved in return. But I took solace in the fact that I did what I thought was right. Fortunately, my son, Preston, who had accompanied me on the trip, greeted me back at the hotel with enthusiastic stories about a tour he had taken of the rain forest that day. Listening to his vivid descriptions of the exotic birds and plants he had seen on the tour helped me put the unpleasant meeting out of my mind for a few hours. Even though it was expensive for our family to cover their travel costs, I tried to take one of my kids with me whenever I traveled, and Preston, already a seasoned traveler at thirteen, was always up for a trip.

  As bad as the Mérida meeting was, I did get one thing out of it. Nout was able to engineer agreement on a “stock-taking” exercise to review how Basel II was being implemented, its impact on capital levels, variations among banks in the capital treatment of the same or similar assets, and whether “supplemental capital measures” (a euphemism for the leverage ratio) were warranted. The study at least kept the issue alive, albeit on the back burner. Nout and I had breakfast the next morning with Klaas Knot, Nout’s successor as the president of the Dutch central bank, where we hammered out the language describing this review. Later that day, I mentioned the agreement in a speech I gave18 to an international regulatory group on the need for a global leverage ratio. Nout told me later that a number of Basel Committee members had reacted very angrily to my speech.

  A few days after the Mérida meeting, there was a scathing article in The Economist that I suspected had been leaked by the Germans. The article essentially said that I was trying to derail “a seven-year mission to make the world’s banks more efficient,” suggested that I was a “Luddite,” and called the Mérida meeting a “frank exchange of views.” That was my first experience with press leaks coming out of the Basel Committee. It was a complete blindside. We called The Economist and complained vigorously about its failure to contact us and get our perspective. Later, The Economist would come our way in understanding the folly of Basel II. As the media would eventually turn against them, Basel II proponents would accuse us of leaking to the press, though we never did. Our policy was not to initiate any discussion of the Basel meetings. We would respond to leaks by others only to make sure our perspective was heard. Ironically, I think that helped us with the media. Reporters live for leaks, but I don’t think they respect those who try to manipulate them with selective divulgence of sensitive information. We never played that game but would respond with only corrections when reporters called with misinformation leaked by others. That policy served us well throughout the crisis.

  Meanwhile, in the United States, political pressure was mounting to let the major commercial banks and thrifts start implementing Basel II. In June 2004, the Securities and Exchange Commission (SEC) had given investment banks the authority to start using Basel II as an alternative to the traditional net capital rules that had imposed hard-and-fast capital requirements on those institutions. Predictably, the Basel II rules were permitting the investment banks to take on significantly more leverage, prompting outcries from the commercial banks and thrifts that that too was putting them at a competitive disadvantage. That action by the SEC19 was later widely credited as leading investment banks to take on excess leverage, which in turn contributed to the downfall of the investment houses Bear Stearns, Lehman Brothers, and Merrill Lynch. SEC Commissioner Harvey Goldschmid prophetically stated at the time, “If anything goes wrong20, it’s going to be an awfully big mess.”

  In addition, New York Senator Charles Schumer and New York City Mayor Michael Bloomberg commissioned a high-profile study by McKinsey & Company, a major New York–based consulting firm, on financial regulation and the competitiveness of the U.S. financial system. The study consisted primarily of a survey of big-bank CEOs. Not surprisingly, their report, issued in January 2007, gave a ringing endorsement to full implementation of the Basel II capital accord as well as transitioning to European-style principles-based regulation. (Not so prominent in the report was the fact that McKinsey & Company provided the models and consulting services that big banks could use to implement the Basel II advanced approaches.)

  The McKinsey report was followed by a letter from Senators Schumer and Mike Crapo (R–Idaho) in mid-March to the four banking regulators, calling upon us to write a “harmonized, balanced” rule to implement Basel II that would put U.S. banks onto a “more equal footing” with international competitors. Amazingly, the letter criticized the safeguards the FDIC had insisted upon, including the 10 percent cap on capital reductions, as “redundant” and argued that limitations on capital reductions should be imposed only during the transition period. We also started receiving subtle inquiries from the Treasury Department about where things stood on Basel II implementation. Treasury officials did not weigh in on the substance of the debate but made clear that they wanted an agreement to move forward.

  Undeterred, I continued to speak out against Basel II and on June 25, 2007, delivered a major speech to a conference of bank risk managers in Paris. By that point, delinquencies and defaults on subprime mortgages were rising significantly. I pointed out that the Basel II approach assumed low mortgage default rates because historically that had been the case. Indeed, studies that the FDIC and other regulators had conducted of Basel II’s impact showed that the amount of capital banks would hold against mortgages would decrease by a whopping 64 percent, with some banks seeing a 90 percent reduction. Did we really want to see such precipitous drops in capital just as the housing market was turning and delinquencies and defaults were spiking up?

  The speech drew a sharp rebuke from Senator Schumer. On June 28, he sent a letter to me, stating “I believe your determination to keep complex, financial institutions tethered to the outdated Basel I standards actually jeopardizes the safety, soundness, efficiency, and competitiveness of our markets” and further that “I do not agree that more capital is always better, particularly where banks create strong systems to internalize their risks.” The letter concluded with an open invitation to call him, which I did. We ended up having a short meeting; in a bit of irony, his office asked that I meet him at the headquarters of the Democratic Senatorial Campaign Committee, the fund-raising arm of Senate Democrats, which he then chaired. Accompanied by Eric Spitler, my senior legislative aide, I met Schumer in the lobby of the campaign committee and walked to the Capitol as he was late for another meeting. I had to walk fast to keep up with him, while breathlessly explaining that we needed to maintain caps on capital reductions until we had a better understanding of how the accord could impact financial stability. He waved us off at the bottom of the Capitol steps. Eric and I dejectedly walked back to our car. I knew I might be making an enemy of Schumer, a powerful member of the Senate Banking Committee, and that worried me. But I couldn’t back down. If I did, the big banks we insured would seize the opportunity to take on more leverage, further destabilizing a financial system that was already showing signs of stress.

  Negotiations among the four banking regulators continued. Though John Reich initially had been in the middle and sympathetic to some of the FDIC’s positions, he began to ally with the other regulators once the head of the largest thrift that he regulated, Washington Mutual, started weighing in. (WaMu, a major player in high-risk mortgage lending, later fa
iled.) Even with the safeguards we had built into the rule, WaMu would have experienced a capital reduction of $2.4 billion under Basel II. Without the caps, its capital reductions would have been even higher. WaMu CEO Kerry Killinger was actively lobbying us on the issue.

  Fortunately, the cavalry arrived in the form of Senate Banking Committee Chairman Christopher Dodd (D–Conn.) and ranking Republican member Richard Shelby (R–Ala.). During a July 19, 2007, oversight hearing with Federal Reserve Board Chairman Ben Bernanke, both of those senators asked highly pointed questions regarding the Basel II accord and its likely impact on capital levels. Dodd repeatedly emphasized that he felt it was important for all the regulators to agree on the same standard, which was of tremendous help given Fed and OCC threats to go their own way if we kept holding out. Shelby pressed hard on the prospect of capital reductions and how that would impact financial stability. He reminded Chairman Bernanke of all the poorly capitalized savings and loans that had failed during the S&L crisis and cautioned that he didn’t want problems landing in the lap of Congress in the future.

  That helped.

  Shortly after the hearing, I received a call from Ben suggesting that he come to my office to see if the two of us could hammer out an agreement.

  At 4:30 on the afternoon of July 19, I sat down at my computer with Ben standing at my side, and we hammered out a compromise. It was my first experience working directly with Ben, and it portended positive future dealings. Unlike others in the regulatory community—whose first tactic was always to try to strong-arm us—Ben would listen to our concerns and try to find ways to address them.