by Sheila Bair
Why did the votes break along these lines? Different people have different theories. Capital regulation has always been a more central part of bank supervision in the United States (thanks to the FDIC), Canada, and the United Kingdom than in Europe. The French, German, and Japanese governments have closer ties to their banks than even we do (if you can believe that) and are not so averse to backing them if they get into trouble. Their regulators are also closer to their politicians, in contrast to the United States, Canada, and other countries, where the laws try to insulate regulators from political influence. In addition, smaller European countries, such as Switzerland and the Netherlands, do not have large enough economies or budgets to bail out all of their megabanks, even if they wanted to. In Switzerland, for instance, total Swiss bank assets are six times as large as that country’s GDP. So too-big-to-fail policies actually give a competitive advantage to banks domiciled in the larger economies, whose governments can credibly back them, if necessary. (The calculus has changed somewhat with the European sovereign debt crisis, as that crisis has called into question even France’s ability to bail out its banks, given their high degrees of leverage and large holdings of distressed sovereign debt.)
Nout had hoped to have all the issues resolved at the Basel Committee’s July meeting. The process he followed was to have the staff representatives of Basel Committee members meet first and hash out the technical recommendations. Those would then be presented to the agency heads, or principals, who met under the acronym GHOS, which stood for Governors [of central banks] and Heads of Supervision. Nout chaired the Basel Committee discussion, and Jean-Claude Trichet, the head of the European Central Bank (ECB), chaired the GHOS, with Nout as his cochair. After GHOS members approved the recommendations, they went to the G20 finance ministers for ratification. The G20 process was somewhat pro forma. The finance ministers deferred to the GHOS once that body achieved consensus. Nout had encouraged G20 ratification as a way to “lock in” the work of the Basel Committee and GHOS. The finance ministers had requested that the Basel Committee complete its work on capital in time for their next meeting, to take place in South Korea in November. That was his deadline for getting all of the reforms wrapped up.
The Basel Committee and GHOS meetings were held in a modern-looking, circular structure whose architecture was a metaphor for the roundabout way in which decisions were made. Throughout five years of attending Basel Committee and GHOS meetings, I found many of them to be as productive as watching fresh paint dry on a wall. Being voluntary organizations, the Basel Committee and GHOS chose to decide by consensus, not majority vote. That meant that meetings were typically dominated by those who opposed reforms. Reform opponents would typically filibuster—that is, talk endlessly to wear other members down—and the best at this, by far, were the Germans, led by Franz-Christoph Zeitler, a senior official at Germany’s central bank, the Bundesbank, and Jochen Sanio, Germany’s top banking regulator. Franz and Jochen could drone on for hours, and if we tried to accommodate them with some type of compromise, they would raise the ante and drone on some more. Sanio was more reasonable than Zeitler, but they were both pretty difficult. Their tactics were reminiscent of those used by segregationists on the Senate floor to try to block civil rights legislation. The Senate had responded by instituting a cloture rule, which meant that with 60 votes, the Senate could end debate and bring a bill to a vote. Unfortunately, the Basel Committee and GHOS had no cloture rule.
My deputy, Jason Cave, was our staff representative to the Basel Committee. He worked with Pat Parkinson, who represented the Fed, and Kevin Bailey from the OCC. The Fed representative was supposed to be the head of the U.S. delegation, but Pat hardly ever spoke up. He talked a good game when he met with us, but when it came to engaging the French and Germans during the Basel Committee discussions, he was reticent. Pat’s a smart guy and articulate when he needs to be, so it made me wonder how committed he was to capital reform. That was frustrating to Jason, as protocol dictated that the Fed spoke for the U.S. delegation. Jason still jumped into the discussions when he felt he needed to, but Pat’s silence weakened the force of his arguments.
I had a similar problem at the GHOS meetings. Ben hardly ever said anything. I think one issue was that of stature. As the head of the world’s largest central bank, he didn’t want to get down into the fray, which I understood. But he also had Bill Dudley and Dan Tarullo with him, who spoke with frustrating rarity. I didn’t know if they were just intimidated by mixing it up with the French and Germans or whether I was being gamed and they didn’t really want reform. We would meet among ourselves, ostensibly to work out a unified U.S. position, and the Fed would make concessions to us for higher standards to reach agreement. But it rarely wanted to commit the position to writing in a letter circulated to other Basel Committee members, as was a common practice with other countries. And when we got into the Basel Committee and GHOS meetings, they wouldn’t vigorously defend the positions we had so painstakingly negotiated.
Fortunately, others were speaking up, even when the Fed remained silent.
I certainly wasn’t afraid to vocalize my views. By 2010, though I can’t say I was popular with the other GHOS members, they respected what we had accomplished at the FDIC during the crisis and feared the influence I had with the media. Moreover, Nout and Stefan welcomed my advocacy. As the chairman and staff director, they were supposed to play the role of moderator and consensus builder. If the capital hawks on the GHOS didn’t speak up to counter the French and Germans, it made their job of getting agreement on strong reforms all the more difficult.
More important, other influential GHOS members were now weighing in, and by far the most forceful and eloquent was Mervyn King, the head of the Bank of England. Mervyn was a cherub-faced, frumpily dressed economist who had spent most of his career at the Bank of England. He prided himself on being a public servant and had no patience with rich, ostentatious bankers. He was as unmaterialistic as one could get. He was notorious for wearing clothes until they were threadbare. I remember once running into him at the Blue Mosque in Istanbul while we were there attending a G30 meeting. Visitors to the mosque were required to take their shoes off before entering, and I really tried hard not to stare at a huge hole in Mervyn’s left sock, out of which his big toe protruded prominently. Mervyn had a razor-sharp intellect and wit to match. No one had a better command of the English language or ability to shape arguments using that language to punch opponents squarely between the eyes. Adair Turner, Mervyn’s colleague who headed the Financial Services Authority (later moved to the Bank of England), was also quite articulate. Together they were quite a “dynamic duo” in advocating for higher capital requirements.
Another strong champion of tougher capital standards on the GHOS was Philipp Hildebrand228, a career banker who headed the Swiss National Bank. Hildebrand—impeccably dressed and movie-star handsome—was a contrasting bookend to King. He was just as forceful and effective in advocating for stronger capital requirements, but unlike Mervyn’s, his position came as much from necessity as principle. If one of the giant Swiss banks went down, it would likely take the entire Swiss government with it. Phil knew that his Swiss banks needed more capital and was already raising their requirements unilaterally. But that could put Swiss banks at a disadvantage to their French and German competitors. It was essential to the interests of his banks and his government that there be an international agreement forcing all banks to raise more capital. Hildebrand’s colleague Daniel Zuberbühler, Switzerland’s top bank regulator, was also quite strong on capital and an authoritative voice during the meetings on the need for tougher standards.
To increase the ranks of pro-reform advocates, Nout did something very clever: just prior to the July 2010 meeting, he opened up the Basel Committee/GHOS membership to all G20 countries, which raised our membership to twenty-seven nations. That meant that the leaders of major developing countries, including China and India, were now at the table. Those officials, with their nasc
ent banking systems, tended to be cautious and conservative when it came to capital. Their banks typically held significantly higher levels of capital than the overleveraged European banks, and they tended to use simpler, more concrete measures of capital adequacy than the easy-to-game Basel II standards. Virtually all of the new members supported Nout’s and Stefan’s reform agenda. That meant that the French, Germans, and Japanese would be in a much smaller minority if they continued their resistance to reform.
The GHOS meetings were conducted in a cavernous, windowless fluorescent-lit room, with each nation’s representatives sitting around a huge oval-shaped conference table. The room was completely soundproof, as insulated from the outside world as the decisions the GHOS made. Perhaps to put me in my place, the seating order for the U.S. delegation always had me at the end, next to the representative from the OCC. I really didn’t mind, because being at the end of the U.S. lineup seated me next to the U.K. delegation, led by Mervyn, who was just as strong, if not stronger, on capital than I was. We would sometimes whisper and pass notes and almost always reinforce each other’s policy positions. Between the U.K. and Swiss delegations, most of the arguments that needed to be said were said. I just wish more of them had come from the U.S. delegation.
Fortunately, the longer Dan Tarullo served on the GHOS, the more confident he became in speaking up. As I came to know and work with Dan, I became convinced that he really did want meaningful reform of capital regulation, even if he had to take on the big banks to do it. He was known for having a bit of an ego, and I think he didn’t like hearing me take an active role in some of the discussions. In truth, I wanted him and Ben to speak up, as the arguments would mean more coming from the Fed than the FDIC. I started playing a little game to give Dan an extra prod. In front of each of our seats was a small button to press to turn on our microphone when we wanted to speak. It illuminated a red light that signaled we wanted to talk. Whenever I heard the French or Germans making an outrageous argument, I would make a noticeable gesture of moving my hand slowly toward my button. Dan would catch me out of the corner of his eye and almost always jump in first.
During the July 2010 meetings of the Basel Committee and GHOS, after a year and a half of work, we made significant decisions on several important issues. They included issues related to how much capital banks have to hold against the risk that their trading partners might default on their obligations and how much cash and other highly liquid assets they must hold to withstand creditor runs. Most important from the FDIC’s perspective, we reached agreement to eliminate the use of hybrid debt as capital. Many countries allowed debtlike instruments to count as capital for banking organizations, even though they have no loss-absorbing capacity. The Collins Amendment had already taken care of most of this problem in the United States, but it was important to achieve agreement among all international regulators so that other countries followed suit. Indeed, I think the fact that the U.S. Congress had already ended the use of hybrid debt as capital put pressure on the GHOS to do the same. It showed that legislative bodies were ready to enact on needed reforms if the regulators and central bankers didn’t act on their own.
At last we reached agreement on an international leverage ratio. It was an important victory, even if the standard was far lower than I wanted it to be.
The meeting that day was a far cry from the bruising I had taken in Mérida four years earlier. This time I had allies, including Mervyn and Phil, as well as irrefutable research on the value of a leverage ratio from the Basel Committee staff. The research showed that banks that reported strong risk-based ratios but weak leverage ratios were the most likely to get into trouble during a crisis. On the other hand, banks that reported strong leverage ratios were the least likely to get into trouble. It put the lie to the notion that regulators could rely solely on risk-based capital standards to ensure capital adequacy. Risk-based ratios were poor predictors of how healthy a bank was.
European banks were clearly gaming the Basel II framework to lower the risk weighting of their assets to ridiculous levels. Subsequent research by private financial analysts has borne this out. One research report showed229 that the majority of European banks were saying that their assets were getting safer even during the global recession, when delinquencies and defaults on loans and other assets were spiking up! As of the end of 2010, European banks risk weighted their assets at about half the level of U.S. banks.
Though the French and Germans eventually acquiesced in a leverage ratio, they successfully argued for a low number. We ended up with a paltry 3 percent, though we also agreed on a methodology to include some off-balance-sheet risks. Thus, even though the 3 percent is short of the 5 percent U.S. standard that we pushed for, it includes certain risks associated with derivatives and other off-balance-sheet items that are not captured by the U.S. rule. As I will discuss later, the leverage ratio, both in the U.S. and internationally, needs to be higher. But the 3 percent was an important start, and even at that level, the Basel Committee staff estimated that more than 40 percent of the world’s largest banks (most of them in Europe) would have to raise capital to meet it.
The irony is that if the Europeans had agreed to a leverage ratio in 2006, when I first proposed it, they would not have run into many of the problems they now face with their sovereign debt crisis. The Basel II framework allowed banks to hold most sovereign debt at a zero risk weight. That meant, for instance, that the banks could load up on high-yielding distressed sovereign debt from Portugal, Spain, and Italy without holding any capital against those investments. So what did the European banks do? They amassed some $3 trillion worth of sovereign debt and are now stuck with it. The European banking systems’ massive holdings have impeded efforts to restructure the debt to provide some fiscal relief to distressed countries. The banks, with their low levels of capitalization, don’t have sufficient capital to absorb losses from a meaningful restructuring of the debt.
Though important agreements were finalized at the July meeting, the hotly contested question of the new risk-based capital ratio was punted until the next round of meetings in September. Nout and Stefan continued to wrestle with resistance from the French, Germans, and Japanese, and the industry kept up its relentless media campaign, with the self-serving argument that higher capital standards would hurt the economic recovery. In August, I published an op-ed in the Financial Times putting the lie to those arguments. “If we fail230 to follow through in strengthening bank capital,” I argued, “we risk wasting the capital we already have and exposing the global economy to the onerous and indefensible costs of another financial crisis.” We kept communicating with them and the Fed over the course of the next three months. At last they told us that they thought we could get agreement on a 7 percent standard as the baseline, with an additional surcharge on SIFIs.
The 7 percent was, again, disappointing but still a huge improvement over the laughable 2 percent standard already in place. Moreover, according to Nout and Stefan, we would either agree to the 7 percent or have no agreement, in which case the issue would be bucked to the G20 finance ministers. That was a group of politically appointed officials, not independent regulators and central bankers, and we feared that if the G20 finance ministers decided the ratio, it would be even lower than the 7 percent. Or worse, the finance ministers would not decide, leaving us with the status quo.
We and the Fed agreed that we would enter the September meeting strongly advocating for the 8 percent, but we were also prepared to fall back to 7 percent if that would get everyone on board, including the Germans, who had partially dissented from the decisions we had made in July. I told the Fed I could live with the 7 percent only if there were a firm, public, written commitment from the GHOS that we would also develop and impose a higher surcharge on the SIFIs. Ben and Dan were in complete agreement on that point. We also agreed to push for a shorter transition period. Again to appease the French, Germans, and Japanese, Nout was suggesting that banks would not have to comply with the new standard
until 2020!
Our strategy set, we prepared to leave for Basel.
However, on Friday, September 10, two days before the GHOS meeting, I got a call from Tim strongly urging me to insist on an 8 percent requirement, even if it meant not achieving agreement at the GHOS meeting. He suggested that the impact of the higher 8 percent standard could be blunted by easing restrictions on dividends and bonuses once the buffer was breached. This sounded to me like having a meaningless standard; banks would have no incentive to maintain the buffer if there were no negative consequences in breaching it. I thanked him for the call but told him I had already committed to the Fed to support the 7 percent with the understanding that there would be a SIFI surcharge. I then called Ben and recounted the conversation. (He had received a similar communication from Tim.)
I was perplexed and not sure what Tim’s true agenda was. In late July, he had seemed to be moving toward weaker standards. An FDIC staff member had attended one of his meetings for me on July 23. (I had been unable to attend the meeting because of preexisting commitments in New York.) Her report of the meeting231 had been alarming. She said that Geithner had been challenging the agencies on the 8 percent baseline standard, suggesting that it be lowered to 6 percent. According to her memo, Geithner received some support from John Dugan, who noted that “the impact is huge for some firms” (which I took to mean Citi and BofA), but the Fed had held firm at 8 percent.
Then, on August 6232, I met with Tim privately in his office during one of our regular monthly meetings. It was a miserable meeting, probably the low point in our strained working relationship. He was agitated over Senator Dodd pushing me to head the new consumer agency. Without my knowledge or consent, Dodd had gone public, saying I was his preferred candidate and that he could get me confirmed in “two days.” Tim ranted that “no one” could get confirmed; then he started pushing me on who should replace me at the FDIC, even though the end of my tenure was still a year away. I was so shaken by the meeting that I memorialized it in a memo to the file immediately afterward, writing that he had “lobbied me intensely233 on lower numbers for the Basel III calibration, knowing full well that our healthy banks will be just fine with a high numbers, but of course Citi and BofA will get killed. Why do we keep making banking policy to accommodate weak institutions? Keep hoping our relationship will improve, but this was a new low.”