Stress Test

  The new Basel III standards required banks to hold much more capital and much higher-quality capital. The final requirement for common equity was about three times higher than the existing standard and effectively four times higher for the largest banks. We pushed to force the biggest banks to hold extra capital to offset the extra danger they pose to the global system; this “systemic surcharge” is like a tax on pollution, forcing firms to internalize costs they impose on the world. And the Fed’s new standards for the United States were even tougher than the new international standards. From 2009 through 2012, as a result of the new rules as well as our strategy to recapitalize the system through TARP and the stress test, the eighteen largest U.S. banking institutions doubled their common capital, from $400 billion to $800 billion.

  Stronger New Global Shock Absorbers

  Capital Requirements Under Basel III

  The Basel III reforms dramatically increased the quantity and the quality of capital that banks have to hold, with even stronger requirements for systemically important banks. The reforms also redefined risk-weighted assets, so the full impact of the rules (right bar) effectively requires the biggest banks to hold more than twice as much Tier 1 capital and four times as much of the highest-quality common equity as they were required to hold before the crisis.

  Sources: Bank for International Settlements, Bloomberg, Federal Reserve Board, and company estimates.

  Basel III also introduced the first international leverage restrictions, another way of limiting risk-taking, and U.S. regulators have proposed even stricter limits for the biggest banks. At the same time, Basel III created new liquidity standards that have swiftly helped reduce the banking system’s reliance on short-term funding that can run when confidence withers. Before the crisis, U.S. banks had $1.38 in runnable short-term funding for every dollar in stable retail deposits; by 2012, that figure was down to $0.64. Before the crisis, the fifty largest U.S. banking institutions had about 14 percent of their assets in cash, Treasuries, and other liquid instruments; by 2012, they were up to about 23 percent. The Fed is still working on reforms to prevent disruptions in the tri-party repo markets, but intraday credit, tri-party’s most obvious vulnerability, has decreased 90 percent. This reduces the danger of a reprise of Bank of New York Mellon threatening not to unwind Countrywide’s book.

  Even if Dodd-Frank hadn’t passed, those stronger shock absorbers would have gone a long way toward improving financial stability. And Dodd-Frank gave U.S. regulators the power to enforce their capital and liquidity rules more broadly across the financial system. It also gave them new authorities to identify and monitor systemic risks—in banks, tri-party repo, or whatever turns out to be the next frontier in shadow banking—and to expand the scope of safeguards to confront those risks.

  The law granted some of those powers to a Financial Stability Oversight Council, rather than the Fed, which was a setback for accountability. Treasury chairs the council, but it has little power to compel independent regulators to take coordinated actions for the good of the broader system. Still, Dodd-Frank did ensure that the Fed would have a dominant role supervising the systemically important firms designated by the council, and would take the lead setting capital and liquidity standards in the United States. And I believe the council has served a valuable coordination function, providing a forum for regulators to work together, even though it was partly designed to protect their independent fiefdoms.

  Dodd-Frank also mandated rigorous annual stress tests, making one of our crisis innovations a standing feature of U.S. banking supervision. It will require systemically important firms to prove they have enough capital to survive a severe crisis in order to get approval for dividend payouts, stock buybacks, and other actions that could erode their capital buffers in good times. The Fed’s stress tests are now more exacting and conservative than the original exercise that helped calm the crisis. Its 2013 scenario included loss estimates based on a recession with unemployment rising above 12 percent and GDP plunging at a 6 percent annual rate.

  The bulk of our derivatives reforms also made it into Dodd-Frank. Standardized derivatives must now be submitted to central counterparties, or “clearinghouses,” and traded on open platforms or “exchanges.” Derivatives dealers will face capital requirements, and will have to collect and post mandated margin on derivative transactions. The scaled-back Lincoln amendment prohibits banks from using some non-standardized derivatives, but they can still use derivatives to hedge their risks and their customers’ risks.

  The Consumer Financial Protection Bureau, the most important new U.S. regulatory body since the Environmental Protection Agency, ended up much as we had proposed it, with an even stronger and broader mandate than Elizabeth Warren had envisioned in her original essay. It got the authority to write and enforce consumer rules for much of the financial system, including debt collectors, payday lenders, credit reporting firms, mortgage originators, student loan servicers, and other operators who used to evade scrutiny. Its budget comes from a Fed funding stream that isn’t subject to congressional appropriations, so lawmakers won’t be able to neuter it if they don’t like how it treats their favorite payday lender. The only major disappointment was the carve-out for auto dealers, an unavoidable cost of doing business on Capitol Hill. Otherwise, the CFPB was a tremendous victory for the President over powerful interests who wanted to kill it or weaken it.

  Dodd-Frank became a bit of a Christmas tree, as is typical of major legislation, but most of the ornaments were fine with us. There were quite a few reforms addressing problems that we didn’t think were central to the crisis, but they were mostly sensible reforms. For example, even though the Volcker Rule didn’t end up the way we drew it up, it’s already prompted institutions such as Citi and Bank of America to close their proprietary trading desks and divest of their hedge fund and private equity holdings, a good thing for stability. The law also expanded disclosure of executive compensation at public companies, gave shareholders more “say on pay,” and opened the door to clawing back compensation at firms that have to restate their financials—modest but positive steps toward limiting the Wall Street excesses that infuriated Volcker and so many Americans.

  Several reform proposals that were a bit unwieldy in initial design made it into the bill in more practical form. Minnesota Senator Al Franken’s proposal to have rating agencies randomly assigned to evaluate companies and securities regardless of their capabilities—we called it the Wheel of Fortune plan—was consigned to a study. Instead, Congress took steps to increase transparency and reduce conflicts of interest at the rating agencies; these moves made sense, although they obviously wouldn’t ensure foresight or competence in credit ratings, as we would learn firsthand in 2011.

  We did not support Delaware Senator Ted Kaufman’s effort to impose a limit on the precise size of American banks, but we embraced a House alternative that gave regulators authority to break up banks if they become a grave threat to financial stability. The bill also included our proposal for new limits on bank concentration, which would prevent mergers that concentrate more than 10 percent of the system’s liabilities in any single bank. Today, our largest banks are somewhat larger than they were in 2007, a natural consequence of all the shotgun marriages that took place during the eHarmony stage of the crisis. But they’re still much smaller than foreign banks relative to the size of our economy, and much less concentrated. U.S. banking assets are roughly equivalent to our GDP, while German banks are about three times their GDP, French and Swiss banks are closer to four times GDP, and British banks are about eight times GDP.

  On the firefighting side, Dodd-Frank was more of a mixed bag. We were pleased with the final version of resolution authority, which gave the FDIC the power to place failing systemic firms into receivership and wind them down in an orderly fashion. The cost to the Treasury would be fully repaid by assessments on the industry, making taxpayers whole. The legislation didn’t mandate haircuts for senior creditors, which would have been dis
astrous, and it didn’t create the much-lampooned “bailout fund.” Larger firms were also required to submit “living wills” to their supervisors, emergency protocols proposing how they could be safely dismembered. It’s like leaving a floor plan on file with the fire department, or as we used to say at Treasury, planning your own funeral. More than one hundred financial firms now have blueprints for their breakup in case they run into trouble.

  These changes—along with the new limits on concentration, the stronger shock absorbers across the system, and the “systemic surcharge” imposing higher capital requirements on the largest banks—are quietly reducing the risks of too-big-to-fail. As the FDIC has formalized its rules for resolution authority, the rating agencies have reduced their “ratings uplift” for the unsecured debt of larger banks; they’re no longer considered negligible default risks regardless of their financial condition, because markets are less confident the government would step in to save them if they fail. Today, many small and midsize institutions pay less to borrow than the supposedly too-big-to-fail banks.

  On a less positive note, Dodd-Frank’s elimination of the broader FDIC guarantee authority, together with the loss of the Fed’s power to lend to individual nonbanks, leaves the financial system weaker and more exposed to future panics. Letting systemic firms collapse during a crisis without the ability to prevent the panic from spreading can be devastating. That’s why the fall of Lehman was so horrible. And that’s why Sheila’s willingness to extend the FDIC’s guarantee authority to senior bank debt over Columbus Day 2008 was so important, reducing the flight incentives of nervous creditors. But Sheila was not willing to fight to preserve that authority for her successors amid the anti-bailout fever of the legislative process, and we couldn’t persuade Congress to restore an unpopular power for an agency that didn’t want it.

  The U.S. Banking System Is Small Relative to Our Economy

  Assets of Deposit-Taking Institutions by Country (end-2012)

  U.S. banks have assets equivalent to about 100 percent of U.S. economic output, much lower than advanced nations in Europe and Asia. Among other things, this means that we are much more able to withstand the potential damage caused by the failure of large banks.

  Source: Financial Stability Board.

  Taking away the fire department’s equipment certainly ensures that the equipment won’t be used, but it isn’t much of a strategy for reducing fire damage. When it comes to financial crises, taking away the tools of first responders is a good way to ensure that the next crisis will burn out of control, with greater damage to the economy and greater cost to taxpayers. The more power the government has, the more credibly it can commit to avert catastrophic outcomes; that makes it less likely that it will need to use its power and less likely that catastrophes will occur. Strong firefighting authorities actually make it easier to let firms fail; when you know you have the ability to prevent fires from spreading out of control, you can afford to let them burn for a while.

  U.S. Banks Provide a Relatively Small Share of Credit

  Banking System as a Share of Financial Assets (end-2012)

  Other advanced countries rely on banks to fund a larger share of their financial assets than the U.S. does. This means our financial system is less dependent on banks, and the U.S. economy can generally benefit from alternative sources of credit if the banking system is under pressure. However, in the crisis this became a substantial source of risk, because nonbanks without access to the traditional bank safety net were much more vulnerable to panic.

  Source: Financial Stability Board.

  It almost goes without saying that Congress did not, as Senator Dodd’s aide suggested, “come back in a year or two and fix” the FDIC guarantee authority. But it will have to eventually, in the heat of the next crisis if not before. Even in an emergency, Congress is likely to be slow to restore it, which is why its loss is so dangerous. We saw in 2008 that even after the panic induced by Lehman and the falling dominos that followed, the House rejected TARP and crashed the markets before coming to its senses. Politicians don’t like taking votes that can be caricatured as pro-bailout.

  When I left the Treasury in 2013, I discussed this particular conundrum with one of Larry’s classes at Harvard. He pointed out that the prevailing narrative, on the left and the right, has been that Dodd-Frank has increased moral hazard, ratifying the too-big-to-fail status quo, making future bailouts more likely.

  “Let me get this straight,” Larry said with a grin. “You feel like the biggest problem with Dodd-Frank is not enough emergency bailout authority?”

  Yes, I do. The president is entrusted with extraordinary powers to protect the country from threats to our national security. These powers come with carefully designed constraints, but they allow the president to act quickly in extremis. Congress should give the president and the financial first responders the powers necessary to protect the country from the devastation of financial crises.

  DODD-FRANK LEFT a few other serious problems unaddressed.

  The legislation punted money market fund reforms to the SEC, which has so far failed to produce reforms that could prevent future runs. In 2012, after the SEC’s Mary Schapiro announced that her fellow commissioners had refused to support her reform proposals, I wrote a letter as chairman of the new Financial Stability Oversight Council proposing options for the council to pursue. “Four years after the instability of money market funds contributed to the worst financial crisis since the Great Depression, with the failure of the SEC to act, the Council should now move forward,” I wrote. Mary welcomed the letter to help her push for action at the SEC, which soon began a process to consider reforms. But more than five years after the Reserve Primary Fund broke the buck, money market funds have so far been able to block significant changes to the status quo. This is a glaring vulnerability, and it would be unforgivable to fail to address it before post-crisis amnesia sets in completely.

  We also decided early in the financial reform process that trying to overhaul housing finance in Dodd-Frank would be too heavy a political lift. There was no immediate rush; we knew Fannie and Freddie would be in conservatorship for a while, and that private mortgage lending was too deeply damaged to come back soon. The Consumer Financial Protection Bureau would go on to write some powerful rules to combat mortgage lending abuses, banning incentives that encourage lenders to steer borrowers into unsafe loans, reining in “teaser rates,” “no-doc loans,” and other sketchy underwriting practices, and promoting a fairer foreclosure process. But for now, the U.S. government—through Fannie, Freddie, and the Federal Housing Administration—remains the dominant force in mortgage finance.

  Eventually, Congress will have to make some tough choices about the mortgage market—not just how to reduce the government’s dominant role, but how to balance the trade-off between safety and accessibility. We should require substantial down payments for borrowers, which would make it harder for some families to become homeowners but would help reduce the risk of the terrible collapses we saw in this crisis. Higher down payment requirements would help serve as shock absorbers for the system—much like capital requirements for financial firms or margin requirements for derivatives investors—limiting the risk of excessive booms by limiting highly leveraged borrowing. And while I believe some kind of government guarantee for mortgage finance is necessary to support lending when the private market retreats during severe recessions, the guarantee should be explicit, more limited in scope, and more expensive, with private actors assuming larger losses to reduce the risks for taxpayers. Powerful real estate and financial interests tend to align with progressive consumer advocates to fight measures that could make mortgage lending more conservative and mortgage credit less affordable, so change will be a challenge, but it can’t wait forever.

  Other than the creation of the consumer bureau and the elimination of the OTS, our reforms largely left in place our stunningly fragmented regulatory structure, with three federal bank supervisors, two market regulator
s, five agencies responsible for the Volcker Rule, and ten voting members on the council monitoring systemic risks. This level of bureaucratic balkanization is better than what we had in 2007, but it is not good enough. It is the largest source of complexity and delay in the rulemaking for Dodd-Frank. It limits accountability for outcomes. It will slow the regulatory system’s ability to evolve in response to future market innovations. The President and I considered coming back to this in 2011 and 2012, launching a new fight for a much simpler, more consolidated system, but the politics seemed insurmountable.

  The financial system is safer, but it certainly isn’t perfectly safe. We will have future booms in credit. Markets will find ways around constraints on risk-taking, the way rivers flow around stones. Financial interests will try to use their political clout to weaken constraints over time. Financial innovations tend to outpace financial regulations. Banking is an inherently risky business. And unless Congress can find a way to restore the FDIC’s guarantee authority, the financial system’s first responders will show up to the next crisis with their hands tied.

  In general, though, I thought the President, the regulatory community, and Congress—congressional Democrats, mostly—were remarkably effective in addressing a very complicated problem. I saw plenty of appalling political behavior, and it was kind of stunning to watch members of Congress juggle appeals to populism with the imperatives of fund-raising. There was a lot of preening in public about the evils of finance, with a lot of accommodation in private to financial interests. The dominant advocacy groups on the wings of each party, what Robert Gibbs referred to as “the professional left” and its even more intransigent equivalent on the right, had a remarkably strong grip on the process. But that’s politics. Legislating is the art of the possible. And I didn’t think purism or neatness at the expense of reform was a virtue. A bill that couldn’t pass Congress wouldn’t help fix the system, so we accommodated some cringe-worthy requests.