Bull by the Horns

by Sheila Bair

  After about an hour or so, the line started to thin, and three FDIC staffers—Pattie Lewis, Margaret Foster-Massey, and Mardie Amery—sheepishly approached me, asking if they could sing a song for me. Mardie had written the lyrics to the tune of “My Country, ’Tis of Thee.” It is too precious not to quote in total here:

  ODE TO SHEILA BAIR

  Oh Sheila Bair, ’tis thee

  Who saved the FDIC

  For all these years

  When banks were falling fast

  She hoisted up the mast

  Said we will not repeat the past

  We will persevere

  She made Time magazine

  Forbes ranked her Power Queen

  Of all the world

  She warned of subprime loans

  Listened to bankers’ groans

  Our financial Rosetta Stone

  Her advice was sound

  Now she’ll have family time

  Scott and the kids will find

  She’s lots of fun

  No banks to make her sigh

  With regs they won’t comply

  She’s free just like a butterfly

  Wander where she will

  Thank you for all you’ve done

  You were our number one

  We’re so grateful

  No runs on banks we had

  Your guidance was ironclad

  We’ll miss you but for you, we’re glad

  We wish you the best!

  CHAPTER 26

  How Main Street Can Tame Wall Street

  Financial concepts are not that difficult if you have a little time to study them. The problems that drove the crisis—excess leverage, unbridled speculation, lack of basic consumer safeguards—are really not that hard to understand. Sometimes I think people in the financial sector don’t want you to understand the issues. Of course, if Main Street voters are confused or don’t feel they understand the problems, they are unlikely to exert political influence to correct those problems. That only serves the purposes of the bad actors, who do not want meaningful government protections against their risk taking.

  Below is my list of reforms that I think are the most important to ensuring the stability of our financial system. I’ve divided them into three categories: things that will make our financial institutions work better; things that will make our regulators work better; and things that will make our entire financial system work better.

  In making our financial institutions work better, I have long believed that the most successful regulations are those that create the right economic incentives and let market forces do the rest. That is why I like skin-in-the-game requirements—because they force market participants to put their own money at risk and suffer the consequences if their actions result in financial loss. Resolution authority, higher capital requirements, risk retention—all are examples of regulatory initiatives that are designed to create the certainty of financial loss if an institution’s financial risk taking goes awry. Understanding that they—not taxpayers or consumers—will take losses resulting from their imprudent behavior, financial institutions and those who invest in them will have better incentives to curb their risk taking.

  With resolution authority, Dodd-Frank was designed to make clear to stakeholders—the shareholders and creditors—that they will absorb the attendant losses if the institution they have invested in fails. It also makes clear to boards and management that they will lose their jobs and that those executives materially responsible for the failure will lose their last two years’ worth of compensation. In that way, we created stronger economic incentives for investors as well as boards and executives to monitor and control excessive risk taking in their institutions.

  Similarly, with higher capital requirements, the bank’s owners—for whom the bank’s board and executives work—are forced to put more of their own money at risk, which again will give them more incentives to monitor risk taking. In addition, risk retention requires securitizers to absorb some percentage of the loss each time a loan they have securitized goes bad. Knowing that they will be responsible for future losses, the securitizers will exercise more care in the quality of the loans they securitize.

  Other types of regulations—those that seek to define the kinds of activities that are allowed and not allowed among market participants—are also important but less effective in my view. For instance, a lending standard for banks says that they must make sure the borrower can afford the higher payment when the interest rate goes up on an adjustable-rate mortgage. That is a way of restricting behavior among mortgage lenders.

  However, there will inevitably be a degree of subjectivity in this standard. What is “affordable”? How big can mortgage payments be as a percentage of a borrower’s income? Can the lender take into account likely future salary increases for the borrower in determining whether he or she will be able to afford the higher interest rate? The more regulators try to answer those questions, the more prescriptive the rules become, adding complexity, new opportunities for gaming, and unnecessary constraints on beneficial product innovation. But tell a mortgage lender that whatever lending standard it uses, it will be on the hook for 5 to 10 percent of the losses if the borrower can’t afford his adjusted payments, the lender will have economic incentives to resolve those issues on his own in a way that reduces the likelihood that the borrower will default.

  THINGS THAT WILL MAKE OUR FINANCIAL INSTITUTIONS WORK BETTER

  Raise Capital Requirements

  It is essential that regulators throughout the world fully implement the new Basel III agreements, as well as impose the additional SIFI surcharges for extra capital on the world’s largest banks. If anything, the new Basel standards should be tougher, not weaker. Yet there is relentless industry pressure throughout the globe to dial them back. Main Street needs to weigh in with counterpressure.

  I have spent a lot of time discussing capital requirements in this book. Among responsible people—conservative and liberal, Republican and Democrat—there is widespread recognition that reducing leverage is the best way to stabilize the financial system and lower the risk of failures. From Alan Greenspan to Paul Krugman, from the Wall Street Journal editorial board to the Huffington Post, you will find general agreement that excess leverage fueled the current crisis and higher capital requirements are the key to system stability.

  Industry advocates argue primarily that higher capital standards will unduly constrict credit. They try to scare people by telling them that the rates on their mortgages or credit cards will go up if capital levels are raised. Or they say that higher capital requirements will hurt job creation by impeding the ability of businesses to borrow at reasonable rates.

  Don’t you believe any of it.

  Healthy, well-capitalized banks will always do a better job of lending than weak, overleveraged ones. And when we have the inevitable economic downturns, banks with fat capital cushions will keep lending, while the overleveraged ones will cease lending and pull credit lines. I believe that that is why, when the crisis hit, the smaller banks as a group did a much better job of lending than did the more leveraged large banks. While the smallest banks increased their lending during the crisis, the biggest ones pulled trillions of dollars’ worth of credit lines, and their loan balances declined by more than 10 percent. How many consumers’ credit card lines were pulled? How many corporations and nonprofits couldn’t find financing to buy new office space or expand operations? How many creditworthy entrepreneurs couldn’t obtain credit to start a new business? The credit contraction that brought us the Great Recession was caused by large, overleveraged financial institutions pulling in their horns and going back to their stalls to lick their wounds. The better-capitalized smaller banks stayed in the arena, healthy enough to keep fighting.

  If Congress does revisit financial reform, I hope they will look at strengthening, not weakening, Dodd-Frank on capital standards. With the exception of the Collins Amendment, Dodd-Frank did not strengthen capital requireme
nts but rather deferred to the regulators to set the new standards. It is essential that we maintain the Collins Amendment, which prohibits regulators from letting big banks take on more leverage than is permitted for smaller institutions. The Collins Amendment also requires that bank holding companies—the organizations that own insured banks—have capital levels at least as high as their insured bank. That is the only way to ensure that the safety net provided by deposit insurance is supported by well-capitalized parents that can serve as a source of strength, not weakness, for the FDIC-insured bank you do business with.

  Right now, the regulators are mostly unified on the need to raise capital requirements. However, looking back at the battles I fought before the crisis, when it seemed as though everyone except the FDIC wanted to lower capital requirements, I’m wary that this regulatory resolve will hold. As a consequence, I would like to see Congress impose a simple, hard-and-fast leverage ratio of 8 percent on any financial institution with assets of more than $50 billion. The requirement would apply not only to banks and bank holding companies but also to hedge funds, property insurance companies such as AIG, securities firms such as Lehman Brothers, commercial lenders such as CIT, and private-equity funds. An 8 percent leverage requirement would be consistent with the amount of capital healthy banks maintained up to and during the crisis. It is a simple, easy-to-enforce requirement that would bind the regulators and make all of the United States’ largest financial institutions significantly safer.

  Maintain the Ban on Bailouts

  The FDIC has made great strides in educating the public about the mechanics of resolution authority and how it really will end bailouts for failing institutions. Yet some still try to portray this important part of Dodd-Frank as perpetuating bailouts.

  Nothing could be further from the truth.

  Dodd-Frank expressly prohibits276 the regulators from bailing out a failing institution. It requires that such institutions be placed into either bankruptcy or the FDIC’s bankruptcy-like resolution process. It mandates that shareholders and creditors absorb losses, that boards and directors lose their jobs, and that institutions be broken up and sold off. About the only way a bailout of a failing institution could occur in the future is if Congress itself authorizes it, and I seriously doubt that will happen.

  Those who argue that Dodd-Frank authorizes bailouts frequently point to the provisions that allow the Fed and FDIC to provide systemwide support to healthy institutions in the event of a systemic crisis. I supported those provisions as potentially necessary to keep healthy institutions open and operational when circumstances beyond their control undermine public confidence in the entire system. For instance, a terrorist attack on our financial system or the collapse of the European banking system could cause uninsured depositors or other creditors to temporarily lose confidence in all U.S. financial institutions and withdraw their funds. But recognizing that such programs could be abused as “cover” to help a sick, politically connected institution such as Citi, we pressed for tight controls on the Fed and FDIC providing this type of generally available assistance.

  Ironically, big-bank advocates277 argue that Dodd-Frank does too much to tie the hands of government regulators. Indeed, if anything, the rules on the Fed should be tightened. My deepest fear is that in true Orwellian fashion, industry lobbyists and their congressional allies will try to repeal resolution authority in the name of opposing bailouts, when in reality they will be restoring the precrisis bailout status quo. Here again, Main Street needs to educate itself and oppose efforts to repeal resolution authority. Repeal would simply restore too-big-to-fail policies and reaffirm the competitive advantage large financial institutions have enjoyed over smaller banks, all at the expense of the American taxpayer.

  Some also argue that resolution authority can’t work in practice. They argue that some institutions are too big for the FDIC to resolve. MIT’s Simon Johnson, a coauthor of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, has been of that school. He believes that the megainstitutions should be broken up by Congress now. Though I am sympathetic to that viewpoint, I do not believe Congress has the political will to take that step, and its legal authority to do so would no doubt be challenged if it tried. The Fed and FDIC do have the authority to restructure and downsize big institutions that cannot demonstrate that they will be resolvable in bankruptcy. As I discuss below, they should be prepared to take that step.

  The FDIC staff has produced detailed analyses of how a megainstitution could be seized and broken up in an orderly fashion, essentially by taking control of its holding company. They have presented lengthy briefings to the FDIC’s Systemic Resolution Advisory Committee on the strategies the FDIC would employ to resolve a megabank. All of that information is available on the FDIC’s website. As a result of those briefings, even Simon Johnson acknowledged that “in a complex278 financial system with powerful special interests and myriad global risks. . . the F.D.I.C. is moving closer to a clear statement of the problem and, at a very granular level, what needs to be done. This is progress.”

  The markets also provide tangible proof of progress. The ratings agencies have reduced large banks’ credit ratings, acknowledging that Dodd-Frank has made it much less likely that they will be bailed out in the future. In addition, large banks’ funding costs have increased since Dodd-Frank’s enactment, narrowing the cost advantages they enjoy over smaller institutions. That is a sign that bond investors and others who extend credit to big financial institutions are asking for a higher return. They are starting to understand that Dodd-Frank means what it says: no more bailouts; invest at your own risk. Congress must not roll back the clock.

  Break Up the Megainstitutions

  There have many proposals to break up the largest financial institutions. Some proposals would cap megabanks on the basis of size. Others would restore Glass-Steagall, the Depression-era law repealed by Congress in 1999, that required the complete separation of securities activities from traditional commercial banking. Still others would allow commercial banks to conduct some securities activities such as investment banking, but not brokerage or market making, in a kind of Glass-Steagall-light.279 As of this writing, at least, none of these proposals has any chance of passing Congress.

  My own view is that the problem of too big to fail is really about complexity, not size, and thus “break-up” proposals should focus on simplifying the megabanks so that they can be easily resolved in bankruptcy or the FDIC’s resolution process without resort to taxpayer support. For instance, even though Wells Fargo has assets of $1.3 trillion, I do not worry about the government’s ability to resolve it because it follows a basic business model of taking deposits and making loans, and its operations are almost exclusively in the United States. If Wells did get into trouble (which I don’t expect), it would not be a huge challenge to place its bad loans into a receivership, where losses would be absorbed by its shareholders and unsecured creditors, and transfer its deposits and healthy loans into a “good bank” that could be sold off or recapitalized with new private-sector investment.

  The problem is the complexity that comes with banking organizations trying to be involved in areas as varied as lending, payment processing, asset management, investment banking, brokerage, securities and derivatives market-making, and insurance. Since the repeal of Glass-Steagall, banking organizations have been allowed to enter a wide range of activities that are more volatile, risky, and complex than traditional banking. In addition, as megabanks have grown, both internationally and domestically, they have created thousands of different legal entities, frequently to evade regulatory or tax requirements. This confusing tangle of legal entities operates as a kind of “poison pill” to breaking them up, even though these behemoths could operate more efficiently and safely if they were divided into their component parts. Derivatives activities are a particular problem; the megabanks do not conduct their derivatives activities in a single entity but rather scatter them throughout their organizations. Th
at makes it difficult to know exactly how much money they have at risk in their derivatives transactions and even more difficult to unwind those transactions in the event of a failure. Similarly, international operations can be conducted through the auspices of numerous legal entities, which can be difficult to map to the activities in each country

  Dodd-Frank gave the FDIC and Fed joint authority to order large financial organizations to restructure themselves if they are unable to show that their nonbank operations can be resolved in a bankruptcy without systemic disruptions. In addition, bank regulators have broad authority to require banks and their holding companies to operate in a safe and sound manner. The Fed and FDIC should use these powers to require the largest institutions to restructure themselves into a manageable number of distinct operating subsidiaries, each with their own boards and specialized executive management teams. Their commercial banking operations should be housed in their FDIC-insured banks and their securities, derivatives, and insurance functions should be housed in separate, stand-alone affiliates for each business line. Insured deposits should only be used to support traditional banking operations: lending, payment processing, and trustee functions. Securities, derivatives, and insurance business lines should be walled off and conducted without support from insured deposits.

  Megabanks and others who oppose pushing nontraditional activities outside of insured banks argue that lending can be high risk too if done imprudently. That is true, but there is a longstanding public policy in support of allowing banks to use deposits to support lending, as providing credit to businesses and households is a social good that justifies a government subsidy. Moreover, risks associated with lending are much better understood by bank managers, investors, and examiners. And unlike securities and derivatives, loans are assets held by banks for the long term and thus not subject to short-term, sudden market losses. While there may also be a social economic benefit in more complex derivatives and securities trading (though with many derivatives, I doubt it), there is no consensus that government-backed insured deposits should support them. Thus, financial institutions should be required to attract funding to support these activities from the private investors who will no doubt charge a higher premium than an insured depositor to assume the risks associated with these activities.