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It wasn’t only the bankers to whom Dodd-Frank caused anxiety. Geithner was worried about how it would work in a crisis. He feared that the formalized process of resolution centered on the FDIC would hobble the crisis response. But that put a premium on crisis prevention, and that points to the truly significant change brought about by Dodd-Frank. It perpetuated and institutionalized the stress-testing regime begun in the spring of 2009, and as such it was one of the pioneers of a new type of governance known as macroprudential regulation.56 This required banks to be assessed not simply in terms of their business models but with regard to their impact on macroeconomic stability. Conversely, macroeconomic scenarios were evaluated in terms of their impact on the key banks. Henceforth, the risk of financial crisis was no longer a matter for ad hoc intervention in emerging market economies, as it had been in the 1990s. It was to be a permanent preoccupation of governments across the G20. The Financial Stability Council created by Dodd-Frank gave the Fed and the Treasury and the other regulators a standing platform from which to develop this new form of oversight and control. As the government regulators became ever more sophisticated in their understanding of modern finance, the banks built gigantic compliance teams to interact on a daily basis with the regulatory authorities. It was in the interaction between the two that the truly crucial work was done of defining the rules for the three parameters that mattered most for financial stability: capital, leverage and liquidity. It was a deeply incestuous relationship rife with conflicts of interest. For American conservatives it was the moment in which high-minded corporate liberalism shaded into a self-dealing of liberal corporatism.57 And this went beyond the sociology of bureaucratic interaction and the revolving door that connected regulators, law firms and banks. To see how tightly this logic of entanglement worked, one needed only to go back to the original stress tests of May 2009.
It was clear that accrediting the stability of a core group of systemically important banks conferred a privilege on them. It would reduce their funding costs and that was indeed the point. But this takes the focus of the exercise on capital raising at face value and pays insufficient attention to the details of the tests. If the aim was to restore the financial health of the banks, issuing new shares was not the only option. In fact, of the estimated losses of $600 billion predicted in the 2009 stress-test scenario, 60 percent would be covered by “resources other than capital.” An explanatory note attached to the relevant table explained that the main source of these additional “resources” would be “pre-provision net revenue.”58 Pre-provision net revenue (PPNR) is defined as net income from interest and noninterest sources minus noninterest expenses. It is not the same as profit because it does not make allowance for loss provisions, but it is a close relation. For the foreseeable future one of the main concerns of Fed and Treasury policy was to ensure that America’s top nineteen banks would earn a sufficiently ample portion of PPNR. The stakes were high. The banks that did not generate enough PPNR would not survive a stress test and would need to go to market or make calls on the TARP fund.
Through the stress tests the Treasury had sidestepped calls for nationalization and the “resolution” of Citigroup. Instead, in the interests of financial stability and minimizing the drain on the TARP fund, the Treasury and the Fed were in effect making it a government objective to restore bank revenue to healthy levels. The logic was inescapable. If financial stability, along with inflation control and employment, was now a key objective of economic policy, then bank profits were one of the key intermediate variables. More profit meant more strength on bank balance sheets and more stability. As part of the stress-testing regime, the Fed compiled statistics on PPNR and developed models with which to predict its likely development according to various macroeconomic scenarios.59
But the entanglement did not stop there. It was only logical, having targeted banks’ profits, that the regulators should also have a say in what the banks did with them.60 As a Fed press release spelled out two years later in November 2011 as part of its Comprehensive Capital Analysis and Review:
“[T]he Federal Reserve annually will evaluate institutions’ capital adequacy, internal capital adequacy assessment processes, and their plans to make capital distributions, such as dividend payments or stock repurchases. The Federal Reserve will approve dividend increases or other capital distributions only for companies whose capital plans are approved by supervisors and are able to demonstrate sufficient financial strength to operate as successful financial intermediaries under stressed macroeconomic and financial market scenarios, even after making the desired capital distributions.”61
Obama and Geithner might have blocked the push toward nationalization, but in a truly ironic historical twist, less than twenty years after the defeat of communism, in the wake of the deepest crisis global capitalism had experienced since the 1930s, the bastions of American finance would be required to negotiate government-approved “capital plans” before paying dividends to shareholders. The imperative of guarding systemic stability required nothing less. It was a dramatic act of intrusive regulation in a sector that had once prided itself as the bulldozer of market freedom. And it was clear from the outset that whatever changes America adopted could not stop at its borders. They would have to be flanked by global measures: first, to ensure that America did not suffer competitive disadvantage; and second, to ensure that dangerous practices were not simply offshored. The G20 finance ministers had resolved during their critical meetings in October 2008 that no systemically important institutions would be allowed to fail. Now the question was how they would be regulated. The Americans had made a start. The wider frame would be set by the Basel Committee.
V
The urgency with which change was begun was striking. To get from the banking crises of the early 1970s to the first Basel regulations in 1988 had taken fourteen years of lackluster negotiations. The formal process of revision that turned Basel I into Basel II began in 1999. Eight years later, as the crisis struck, the new standards had still not been fully implemented. Basel III started off at an altogether different pace. The first call to action came from the G20 in November 2008. A new global Financial Stability Board chaired by the head of the Italian central bank, Mario Draghi, convened in the summer. Draghi had trained alongside Bernanke at MIT in the 1970s and was a fluent exponent of the new hybrid of finance and macroeconomics. By September 2009 technical discussions were ongoing. Within weeks, rumors began to circulate that the Basel Committee, in the manner of the US stress tests, had identified thirty financial groups as “systemically important” at a global level.62 They would be subject to tougher capital standards and required to draft living wills that would map out in advance how they would be wound up should it come to the worst. The G20 gave the new regulations its imprimatur at the November 2010 Seoul meeting. The first list of the twenty-nine systemically important financial institutions subject to the full Basel III regime was published in November 2011.
Global Systemically Important Financial Institutions: Assets and Tier 1 Capital (end fo 2012)
Source: A. Rostom and M. J. Kim, “Watch Out for SIFIs—One Size Won’t Fit All,” World Bank (blog), July 1, 2013, http://blogs.worldbank.org/psd/watch-out-sifis-one-size-wont-fit-all. Data: The Banker, July 2012, and bank annual reports.
In the wake of the crisis, these twenty-nine institutions, with their headquarters in the United States, Europe, Japan and China, held total assets of $46 trillion. They thus accounted for roughly 22 percent of all financial assets worldwide. Henceforth, they would be subject to a special regime of oversight, not just at the national level through stress tests but at a global level too. Given the mechanics of the 2008 crisis, Basel III focused on new areas of regulation. To give them resilience in the face of a “run on repo,” all SIFI would be required to hold sufficient high-quality liquid assets that could be sold or repoed to cover thirty days of net outflows from their businesses. In addition, to constrain maturity
mismatch, banks had to demonstrate that they had sufficient stable long-term funding to match their book of long-term loans. What the Basel III regulations aimed to ensure was that banks could not find themselves in the situation of a Northern Rock, with a giant balance sheet of long-term mortgages funded by unstable short-term wholesale funding. In due course these would emerge as the controversial cutting-edge regulations of Basel III. But in the first phase of the battle over the new regulations it would be the classic issue of capital that was to the fore.
In the aftermath of the crisis, many reform-minded economists were calling for a huge step up in capital.63 Economists Anat Admati and Martin Hellwig spearheaded a call for banks to be required to hold capital up to 20–30 percent of their balance sheet, the kind of capital ratio that was typical of other businesses and hedge funds. This would have given them huge solidity. And it would have justified much lower rates of return. For the same reason, it was vigorously resisted by the global banks, which had no desire to be turned into boring providers of financial utilities. Leading the charge was the Institute of International Finance. Its members included the entire global banking world, American, European and Asian. Its managing director, Charles Dallara, was a veteran sovereign debt negotiator who had overseen the early steps in Tim Geithner’s career at the US Treasury in the 1980s. The assertive chairman of the group was Josef Ackermann, the Swiss CEO of Deutsche Bank. They argued that aggressive recapitalization would slow down lending and thus economic growth. According to the IIF’s in-house econometric models, a 2 percent increase in capital requirements for the G-SIFI would cut GDP in the United States, Japan and Europe by 3 percent and would reduce annual growth by as much as 0.6 percent. With the recovery struggling to achieve growth of 1 or 2 percent, that was an ominous forecast.64 It was a tendentious and hypothetical argument that the advocates of capital raising were forced to counter with their own even more elaborate econometrics.
Amid the war of the economic models in Basel, Sheila Bair made herself into the spokesperson for raising capital. The Swiss regulators were pushing in a similar direction. After the near collapse of UBS and the huge losses at Credit Suisse, they clearly understood that they could not afford to have either of their megabanks fail.65 The rest of the US delegation did not go so far as Bair. The compromise that resulted was a substantial change but by no means radical. The new rules specified 7 percent as the basic minimum requirement for Tier 1 common equity in relation to risk-weighted assets for all banks. However, systemically important banks were required to hold higher amounts, depending on their size and impact on the world economy. Between November 2014 and January 2019, the twenty-nine selected institutions would be required to raise their capital in relation to risk-weighted assets to between 8 and 12.5 percent, depending on their degree of systemic importance.66 A further 3.5 percent could be added in the form, for instance, of convertible bonds that at moments of stress transformed from bonds to equity. Crucially, unlike under Basel II, leverage was measured two ways. The basic standard was set with regard to risk-weighted assets, which banks could calculate according to arcane in-house formulae. But as a cruder test of solidity, risk-weighted leverage would be checked against a simple ratio of total bank assets to loss-absorbing capital. This was not to fall below a 3 percent “leverage ratio” of equity to assets. This left Bair and her fellow campaigners indignant. In the United States, by way of the Collins Amendment and the standard set by the FDIC, the bar was raised higher. But if more was not done at Basel, it had less to do with the American delegation than with opposition from Europe.
Since the crisis, Berlin and Paris had been talking tough about Anglo-Saxon finance and the EU Commission had finally woken up to the need to create a financial firefighting capacity. The Larosière committee on financial regulation reported in February 2009.67 It recommended an entirely new structure of Europe-wide banking supervision that by 2011 would result in the formation of four new agencies: the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), as well as a European Systemic Risk Board to oversee macroprudential regulation. In organizational terms it was far more comprehensive than anything attempted by Dodd-Frank. But though the Larosière group acknowledged that giant cross-border banks posed huge problems for national supervisors and though the committee recognized that the federal structures of the United States gave it a distinct advantage in crisis management, it recommended no more than ad hoc burden-sharing agreements and rejected the idea of a common deposit insurance scheme. The vision it offered was of the coordination and harmonization of national measures, not a banking union.68 Meanwhile, for all the effort put into creating new supervisory agencies, on the question of bank business models and recapitalization, Europe’s progress was painfully slow.69
With the United States setting the pace, in May 2009 the Committee of European Banking Supervisors announced that it would be conducting a scenario-planning exercise with Europe’s banks. But the committee insisted that these were “not a stress test to identify individual banks” and that “the outcomes [would remain] confidential.”70 There was reason to fear the results of a more searching investigation. With banks desperate to avoid the stigma of official assistance, the hundreds of billions in public funds that had been allocated across Europe in October 2008 to fund recapitalization had remained largely untapped. Meanwhile, rock-bottom prices for bank shares made it expensive to raise capital through the markets. As a result, already in April 2009, in its first devastating summation of the financial crisis, the IMF estimated that the United States was significantly ahead in the game of bank recapitalization.71 According to the Fund, Europe’s banks faced at least another trillion dollars in write-downs by 2010 on top of the losses they had already recognized. That was twice as much as was still outstanding in the United States. In local reports from across Europe, even more alarming numbers were circulating. In April 2009 Süddeutsche Zeitung got hold of a leaked paper from Germany’s bank regulator BaFin that seemed to suggest that there were 816 billion euros of assets on the books of Germany’s banks that were either toxic or unsellable under current conditions.72 In the summer of 2009 Germany introduced new legislation to launch bad banks to absorb this toxic debt. But once again the funds were not taken up. European actions were facilitative, not mandatory. All told, the IMF estimated that to restore something like stability, the European banks would need between $500 billion and $1.25 trillion, either in new capital or in accumulated and retained profits. But far from actively pursuing new funds, over the years that followed, the European banks lagged far behind their American peers.
Racing to Recapitalize: US and EU Bank Equity Issuance (annualized figures as % of total assets)
Source: D. Schoenmaker and T. Peek, “The State of the Banking Sector in Europe,” OECD Economics Department Working Papers 1102 (2014), figure 8, http://dx.doi.org/10.1787/5k3ttg7n4r32-en.
This striking graph, which shows how aggressively America’s banks raised capital relative to their European peers, serves as a fitting conclusion to the first phase of the crisis. TARP, followed by the stress tests, the Dodd-Frank regime and capital planning, put the American banking system on a forced road to recovery. It foreclosed more radical options. The banks remained too big to fail. Far from downsizing or breaking them up, by 2013, J.P. Morgan, Goldman Sachs, Bank of America, Citigroup, Wells Fargo and Morgan Stanley were 37 percent larger than they were in 2008.73 The resources of the state were put one-sidedly at the service of management and shareholders. But if the aim was to get America’s banks out of the emergency ward, it worked. As Geithner insisted, the ultimate test of his policy of stabilization was the financial health of the banks, and on that score the record was pretty unambiguous. Between 2009 and 2012 the eighteen largest US banks increased their common capital from $400 billion to $800 billion. They reduced their ratio of risky wholesale funding from $1.38 per dollar
of FDIC-insured retail deposits to $0.64. At the same time, they raised the share of their assets in cash, Treasurys and highly liquid instruments from 14 to 23 percent.74 The elite closure and cooperation that the Treasury and the Fed had finally managed to orchestrate in October 2008 was doing its job.
By contrast, the lack of comprehensive recapitalization of Europe’s wounded banking system was an omission that marks one of the fundamental turning points in the crisis. With the help of low-interest loans from Trichet’s ECB, many banks resorted to the makeshift of pumping up their profits by buying higher-yielding government debt. But the failure to build new capital would leave the European banks in no position to absorb any further shocks. While the United States began to stabilize, in Europe the banking crisis of 2008 would merge a year later with a new crisis: a panic in the eurozone public debt market. The connecting thread between the crisis of subprime and the crisis of the eurozone was the fragility of Europe’s bank balance sheets. Back to back, the combination of the two crises would mark one of the most significant inflections in European economic history since 1945. It would shake Europe’s politics to its foundations. It would open a stark divide within the Atlantic economy between Europe and America, and it would pose a profound challenge to transatlantic relations.