Bull by the Horns

by Sheila Bair

  I left the meeting elated. The Hill was already actively engaged in discussions with us about setting up new resolution tools to handle large, interconnected financial institutions when they got into trouble. The president’s personal commitment of support would all but guarantee that it got done.

  On March 19137, Chris Dodd publicly proposed empowering the FDIC with expanded resolution authority. Citing the Fed’s regulatory failures in consumer protection and supervising bank holding companies, he went even further and said that the Congress should take away the Fed’s power to regulate big, systemic entities and give it to the FDIC.

  Dodd’s House counterpart, Barney Frank, the chairman of the House Financial Services Committee, had also been in contact with us about new resolution authority. The Fed staff had been talking with him too, and they were pushing hard for the Fed to get the authority. They had already given138 him draft language—as “technical assistance,” which, of course, gave the Fed most of the power.

  On March 25139, nine days after the White House meeting, Tim went public with a Treasury proposal for new resolution tools. They were a far cry from what we had in mind. Though it created new resolution tools that were “modeled” on the FDIC’s, it also gave the government huge latitude to keep doing bailouts. The Treasury secretary and FDIC, acting on recommendations by the Fed, could decide to put an institution into our bankruptcy-like process, or the government could provide “financial assistance measures,” which included all of the bailout measures we had used during the crisis. What’s more, instead of funding resolution activities through assessments on financial institutions in advance—the FDIC model—the bill had the Treasury Department funding the measures using taxpayer dollars, with any losses paid by assessments on the industry later over time. That approach would—once again—make taxpayers the first line of defense if a large financial institution failed and would also have the perverse effect of imposing the ultimate burden of loss on the surviving institutions. The failed firm would pay nothing.

  At least the proposal had us directly involved in the decision making and in charge of the resolution process, but, based on past experience, I was afraid that when it got down to a crunch, the Fed and Treasury would try to avoid a resolution and instead opt for a bailout and put severe pressure on the FDIC to go along. I wanted a requirement that all failing financial institutions would have to be put into our resolution process, where their shareholders and creditors, not the taxpayers, would have to absorb the losses.

  We held our fire and worked behind the scenes with Treasury staff and Chairman Frank’s office to try to make sure that the Treasury draft legislation would end bailouts, with no loopholes. The Fed and OCC were fighting us and each other. All the agencies were jockeying for the new resolution power, and that included me. But not because I was trying to feather my own nest; I had no intention of serving past the expiration of my five-year term. I wanted the FDIC to be in control of the resolution process not only because we had the greatest expertise in dealing with failed financial institutions but, most important, because by culture, I knew, the FDIC would be the most resistant to bailouts.

  After resolving failed banks for eight decades, the FDIC had prescribed rules for handling them, which we followed religiously. The process we used was the same for all institutions and their creditors. We provided extensive public information about our resolutions, we were audited annually by the GAO, and we received a lot of tough-love oversight from our inspector general’s office—by far the largest and most robust among the banking agencies. We watched every dime because we couldn’t print money like the Fed, nor could we tap taxpayers or issue public debt, as could the Treasury (and we didn’t want to). Everything we did was paid for by assessments on the industry. I wanted a statutory framework that, long after I was gone, would prevent a repeat of the ad hoc responses the government had used in 2008 and was still using in 2009, even after the crisis had passed. Those responses had resulted in overly generous bailout programs, favoritism for institutions such as Citigroup, and, worst of all, a reaffirmation of market perceptions that investing in big financial firms was safe because the government wouldn’t let them go down. Giving the new resolution power to the FDIC would be the best way to make sure that we wouldn’t see a repeat of the bailouts.

  Amid all of the agency scrambling, Chairman Frank asked me to meet with him privately on April 20. It was a unique opportunity. I’ve always liked and respected Barney Frank. He’s been repeatedly bashed for his support of Fannie and Freddie, and he’s acknowledged making mistakes on GSE policy, but I think the criticisms have been overblown. Overall, Frank’s legislative record has been impressive, and he has taken some courageous positions over the years. For instance, he was one of the few in Congress brave enough to take on Wall Street and mortgage brokers by pushing for strong national lending standards in the early 2000s. He is the preeminent expert in Congress on financial policy, and, notwithstanding his liberal reputation, I’ve always found him to be pretty middle of the road. He’s a brilliant, short, frumpy, Jewish, gay guy who succeeded in the rough-and-tumble world of Massachusetts politics by being emotionally as tough as nails. He’s never been one to want to spend quality, personal one-on-one time with professional colleagues. I was honored to be meeting with him privately.

  Whenever I had met with Frank before, I had sat in a straight-back chair facing him across his desk. He usually liked to keep his distance when meeting with people. However, that time, as I entered his office, he came around from his desk, shook my hand—also rare—and took a seat next to mine. I thought he wanted to talk about resolution authority, so I launched into our priorities of banning bailouts and making sure that the FDIC’s process applied consistently and evenly to all. I also pitched him hard on giving the FDIC the power to assess big financial institutions to build a prepaid fund that could be tapped to provide working capital. He was receptive to all those points, but what he really wanted to talk about was the need for a new systemic risk regulator and who that should be.

  Dodd had already gone public in wanting to take supervision of large holding companies away from the Fed. Frank hadn’t proposed stripping the Fed of its current powers, but he was also disinclined to give the Fed any new authority. As we talked through the issues, I told him I thought he needed to differentiate between the agency that supervised the large, systemic entities—that is, the agency responsible for examining those institutions and enforcing safety and soundness standards against them—from the entity that would have the power to say which institutions were systemic and write rules that would address systemic risk. For the supervisory function, I thought that the Fed, with all its shortcomings, was the best equipped. The SEC was not a safety and soundness regulator, and it had allowed the large investment banks to take on far too much leverage. The SEC’s strength and core mission were to protect securities investors, not to prevent large-bank failures. I felt that the OCC was too narrowly focused on protecting its large banks instead of regulating them. Though I felt the Fed also had its issues with regulatory capture, given its role as a central bank, it had another important function that gave it greater separation from the behemoths.

  I think I surprised him when I told him that I didn’t want the FDIC to be the systemic regulator. Having both resolution authority and supervisory powers over large financial institutions was, I feared, too much for the agency to bite off. As a check against the Fed’s laxity, however, I suggested that he give the FDIC backup authority for large institutions that would help us keep the Fed honest. If one of the big guys got into trouble again, the FDIC could come in itself if it didn’t feel the Fed was adequately addressing the problems. Clearly the Fed had its shortcomings as a regulator. Citigroup was Exhibit A. So having the FDIC looking at the banks with a second set of eyes was, I thought, a good idea and would also give the FDIC direct legal authority to address problems with management where warranted—authority that we had lacked with Citigroup.

  We then t
urned to the question of how nonbank systemic entities should be designated. That was a huge issue. It was one thing for a financial institution to decide voluntarily that it wanted to own an insured bank and be a bank holding company, with all of the regulatory requirements that entailed. It was quite another thing for the government to order a financial institution to be regulated by the Fed. Someone had to have that authority; otherwise we would not be able to fix the problem of regulatory arbitrage that had led up to the crisis. Bear Stearns, Lehman, Merrill Lynch, and AIG had all escaped tighter capital and regulatory standards by operating as “shadow banks.” I suggested that an independent council of regulators, chaired by a presidentially appointed head, be formed to make that kind of systemic determination. I also suggested that the council have the ability to write rules to address risks that spanned individual regulators’ jurisdictions. For instance, the oversight of money market funds was clearly a matter that concerned both bank regulators and the SEC. Finally, the council should be able to step in with its own rules when an individual regulator was not doing its job. For instance, as I envisioned it, in the early 2000s, the council would have been able to step in and write mortgage-lending standards when the Fed failed to act. It would also have had the power to set higher capital standards for securities firms in 2004 and 2005 as those firms started taking on so much leverage after the SEC relaxed its capital requirements.

  Frank liked my idea of a systemic risk council and said he would bring it up with the Treasury and the Fed, which he did. Both the Treasury and the Fed initially resisted the idea. The Fed wanted to have all of the power over both designating and regulating systemic institutions, and it certainly didn’t want a new council with authority to write its own rules to address systemic risks when the Fed failed to act. Tim, who still had a strong allegiance to the Fed from his seven years as president of the NY Fed, was of a similar view. But the reality was that even if Frank had wanted to give the Fed those major new powers, he probably didn’t have the votes to do so. The members of his committee were still quite angry about the Fed’s regulatory failures leading up to the crisis, and there was a growing popular resentment against the Fed and its role in the bailouts. The political winds were in favor of stripping the Fed of power, not giving it more.

  Once Tim heard that I had met with Frank, he reached out to me. He didn’t like the council idea, but I told him I could not support giving the Fed unfettered new powers. For decades it had been at the forefront of the deregulatory movement that had given us the crisis. We needed a council to be a check on it. I reiterated that I would not support resolution authority that allowed the government to bail out mismanaged institutions such as Citi and AIG. I told him that I could support legislation that gave the FDIC and the Fed the power, in periods of severe market distress, to provide systemwide support through lending and debt guarantee programs that were generally available to all healthy institutions—no special favors for anyone. But if an institution was failing, it could not use those programs and would have to be put into resolution.

  Though I could support systemwide programs for healthy institutions in times of crisis, I also wanted an extremely high bar for the government to provide this type of systemwide support. Supermajorities of the FDIC board and Federal Reserve Board should be required, as well as the approval of the Treasury secretary and president. I was appalled at the trillions of dollars the Fed had seemingly willy-nilly lent, directly or indirectly, to scores of large banks, hedge funds, and asset managers, as well as foreign institutions. There were virtually no requirements that it publish an explanation of why the programs were needed, how eligibility was determined, and, most important, who was profiting and by how much. It was completely off on its own. Indeed, it would not be until late 2011 that it would fully disclose the true extent of the lending programs that it had launched during the crisis, and that was only after it was forced to do so by the courts in response to a lawsuit filed by Bloomberg News.

  I thought I was making some progress with Tim and was trying to meet him halfway by agreeing to systemic support programs while insisting on a ban for individual bank bailouts. Unfortunately, instead of relying on the many excellent career staff at Treasury, Tim had recruited Patrick Parkinson from the Fed to develop a white paper that would provide the president’s blueprint for reform. I was surprised by his choice. I had known Pat for years; he was a great guy, smart, thoughtful, and sincere. But as a career Fed staffer, he was very close to Chairman Greenspan and was known for his antiregulatory views. During the Greenspan years, he had been Will Rogers in reverse when it came to regulation: he’d never met one he liked. He’d had a role in opposing CFTC Chairman Brooksley Born’s attempts to regulate the derivatives markets. And he was a Fed partisan. Whether consciously or not, his loyalties were there. Soon the process of writing the white paper devolved into backroom Fed and Treasury discussions. Tim and Pat stopped sharing drafts of the white paper. Tim would simply hold meetings and discuss concepts in the abstract. He said he was worried about press leaks (a favorite excuse at both the Treasury and the Fed when they didn’t want to share information).

  Throughout the spring and early summer of 2009, we continued our multiple-track discussions with the Treasury Department and the Hill. The Senate was particularly interested in new resolution authority. Two of the Senate’s smartest members, Mark Warner, a savvy Democrat from Virginia, and Robert Corker, a down-home Tennessee Republican, contacted us about helping with a bill to give the FDIC new resolution powers. Chairman Dodd scheduled a hearing on the need to end too big to fail, asking me and Minneapolis Federal Reserve Bank President Gary Stern, a long time TBTF critic, to testify. (It should be noted that the NY Fed was the only Fed regional bank with much enthusiasm for big-bank bailouts. Other regional bank heads, including Stern, Dallas’s Richard Fisher, Richmond’s Jeff Lacker, and Kansas City’s Thomas Hoenig, have been staunch critics.) But the best public platform I had to advance the need for resolution authority was at the Economic Club of New York on April 27. I knew that unless I could convince at least some in the New York financial community to support resolution authority, we would never get it. The opposition of the weak, bailed-out banks would be too strong. So I laid out all of my arguments but made my strongest pitch based on basic economic and capitalist principles: “Everybody should have140 the freedom to fail in a market economy. Without that freedom, capitalism doesn’t work. In the longer term, a legal mechanism to resolve systemically important firms would result in a more efficient alignment of capital with better managed institutions. Ultimately, this would benefit those better managed institutions and make the financial system and the economy stronger.”

  Some of the better-managed banks, such as JPMorgan Chase, did end up supporting resolution authority. We also received strong support from smaller banks. In April, Camden Fine, the president and CEO of the Independent Community Bankers of America (ICBA), wrote a letter to Secretary Geithner vigorously endorsing giving the FDIC the ability to resolve large nonbank entities—and for good reason. Why should the little banks be subject to that harsh process but not the big guys?

  We were also starting to make some headway on the council. SEC Chairman Mary Schapiro had endorsed the idea. Rahm Emanuel invited me to lunch on May 27, and we discussed the concept in detail. Indeed, I gave him several suggestions on how regulatory authorities might be realigned in a way that would be fair to all of the agencies but make the U.S. regulatory system more streamlined and efficient. But I also made141 an important concession: I told him I could live with the Treasury secretary chairing the council, instead of an independently appointed head.

  Tactically, that was the right move. With the prospect of chairing the council, Tim’s views on it started to change. In early June, Tim acknowledged in Senate testimony that in reference to the Fed, “I don’t believe142 it’s necessary or desirable for us to concentrate all authority for dealing with future risks to the system in one agency.” Dodd and Frank were also clearly s
ympathetic to the council and were pushing it behind the scenes. The Fed was becoming increasingly isolated in its resistance. But the trade-off in letting Treasury head the council was that it compromised the independence of the financial regulatory process. Treasury was a part of the administration and was bound to promote the president and his policies. Financial regulators were supposed to be independent of those considerations. In my public statements, I would continue to speak out in favor of an independently appointed chairman, but I did not make it a priority. (The final legislation ended up creating a council headed by the Treasury secretary.)

  Frankly, I had my hands full trying to steer the reform efforts on resolution authority. Treasury and the Fed were still pushing for regulators to have maximum flexibility to do future bailouts. That was amazing to me. They seemed impervious to the public outrage and cynicism caused by the bailouts. I think the White House truly wanted to end bailouts, but it was relying on Tim and Pat Parkinson to put together the technical proposal.

  On June 12, the heads of all the major agencies received an invitation from Larry Summers’s office to attend a meeting with the president on June 17 ahead of an announcement later that day of the administration’s reform measures. We were not given a copy of the final white paper until shortly before the meeting, so my staff and I had little time to review it. Much to my surprise (and contrary to the express representations that had been made to my staff), instead of ending bailouts, the white paper essentially ratified them as legitimate and empowered the secretary of the Treasury to carry them out unilaterally in the future. The white paper removed the FDIC from any meaningful role in the resolution of a large bank, except if asked by the secretary of the Treasury. It was the bailout advocates’ dream. Now even the FDIC—the only agency that had tried to curb the bailout excesses and impose some meaningful structural and management changes on mismanaged institutions—would be disempowered. As my chief legal counsel, Mike Krimminger, stated in his analysis: