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Regulatory Complexity

2012 Financial Markets Conference

April 2012

An interview with Sheila Bair, senior adviser, Pew Charitable Trusts and former chairman, Federal Deposit Insurance Corporation (FDIC)

Dave Altig: Hi, I'm Dave Altig. I'm the research director at the Atlanta Fed and I'm here with Sheila Bair, former chair of the Federal Deposit Insurance Corporation and currently a senior adviser at The Pew Charitable Trusts. Welcome, Chairman Bair.

Sheila Bair: Thank you.

Altig: So, you're going to give the keynote address tonight at our Financial Market Conference here. Can you give us the cliff notes version of your remarks?

Bair: Well, it's a bit of a play on your theme, the devil's in the details. My theme is the devil is the detail. I'm going to talk a bit about regulatory complexity and how I think it can be addressed. I think it's becoming a growing issue and it manifests itself in a lot of different areas and talk a bit about the type of regulation. My personal view is the regulations that reinforce economic incentives, have them work for you, can be simpler than highly prescriptive regulations that try to define exceptional behaviors. And you need both, obviously, but I think when you can rely as much as you can on economic incentives, that's important. I think the Fed has pursued that certainly with their higher prudential standards, higher capital standards, resolution authority is all about, you know, requiring some skin in the game and some adverse economic consequences if risk taking is too severe.

Altig: So there're a couple of issues in there, the Dodd-Frank legislation.

Bair: Right.

Altig: I don't think anyone has accused it of being…

Bair: …too simple. (laughs)

Altig: Too simple. So, I mean, in terms of your principle of wanting to keep things as simple and noncomplex as possible, how does Dodd-Frank stack up?

Bair: Well, it is, and you know, and I think people need to understand that the regulators have a very challenging task because there are a lot of complexities in that bill. I support it, I'm glad we have it, we are a lot better having it than not having it, but clearly it was an imperfect legislative process that produced it and there was a lot of give and take. We didn't have the discipline of a bipartisan committee process, which I think really hurt. So, there are constraints on the regulators and there is the Volcker Rule, typically the most cited example of regulations very complex, but a lot of those exceptions are in the statute. They were not creations of the regulators and so there are some constraints there I grant you, but I do think there is still some latitude and flexibility to use simpler approaches, to use more enforceable principles-based approaches even within the confines of Dodd-Frank.

Altig: So you mentioned the resolution authority and the resolution procedures in the bill. Are you of the opinion that those procedures are sufficient to the task of addressing the crisis like we saw the last time around?

Bair: That's a good question. Well, I do. I think that part of the bill, actually, I don't think is excessively complex. I mean, I think Title II really is a bankruptcy process with a couple of important improvements for financial institutions. And the FDIC process for insured banks is essentially a bankruptcy process with some changes to suit the unique situation of financial institutions. So derivatives obviously, you can require derivatives counterparties to continue to perform. In bankruptcy they have the immediate right to pull their positions out. They're exempt from what's called the automatic stay, so unlike other creditors that are stuck, derivatives counterparties can retreat, and that really is one of the things that created a lot of the systemic problems after the Lehman failure bankruptcy. So, we can require derivatives counterparties to continue to perform. I still say "we," they, now the FDIC can as resolution authority. There is also the ability to provide temporary liquidity support to keep the franchise operational. You know, financial institutions, all its assets are liquid, if you can't continue to fund your assets you are in big trouble and you lose the franchise very quickly, and again we saw that with Lehman. Eighty percent loss rates because there was just no funding, immediate seamless funding available. So that says something else that the Title II resolution process can do that you can't do in bankruptcy.

The most important thing probably is the ability to advance plan, to work with the Federal Reserve board as a holding company, regulator, and I assume will be the primary regulator in virtually any of these situations if they occur. To go into an institution early, to start planning, to require living wills, which basically is the road map to how they can be resolved in an orderly way. And to work with the international regulators—as you know these institutions don't fail overnight, even with Lehman there were many, many months of deterioration before it finally went down and you can usually see it coming. I think this myth that all of a sudden there's a failure that nobody was expecting, that generally does not happen. So there usually is preparation time as an institution deteriorates, and the FDIC as another regulator can work with these foreign regulators to plan in advance and to agree in advance how foreign operations will be dealt with. So I do think the tools are there that you need now to resolve these even very large institutions in a way that, like bankruptcy, imposes losses on shareholders and unsecured creditors, not taxpayers, and that's the way it should be.

Altig: So the operation of this resolution procedure, particularly the last part that you mentioned, having some maybe prior negotiation with systemically important institutions does require that we know up-front what the systemically important institutions are. I guess right now, they're sort of defined by size, somewhat by complexity, I guess, but size. Do you think we have sort of the right metrics in place and the right understanding of what these institutions are?

Bair: Well, I think that's another really good question. I would say first just to go back and clarify one thing. The Title II preparation process, I don't think, is a negotiation process—it is what it is. I think it's a very harsh process and can give, with management when they see their banks deteriorating, when they know that Title II can be at the end of the road for them if they don't right their own ship, I think it can be a very powerful tool to get them to go out and raise capital, sell themselves, or whatever, but there's no negotiation. There's no negotiation with an FDIC bank when it fails and I don't see that there would be one for Title II as well.  In terms of designating nonbank systemic entities, I was very glad to see that the F Stock finalized the rule. I think their first cut is very quantitative and objective and I think that was good, I think that gives a greater market certainty at least to those who are likely not going to be viewed as potentially systemic. I think the metrics they used in terms of leverage and the amount of CDS [credit default swap] protection written on the institution, excessive reliance on short-term funding, you know, amount of outstanding debt, I found that those were all good triggers, simple triggers that the market can understand and are not really gameable. Back to my earlier theme of simplicity, so I like that.

 When you get into the more intense scrutiny, it is going to become more qualitative and less quantitative, but nonetheless, I think you will be able to determine with some pretty definitive guidance who will be systemic and who will not be. And for me it always comes down to whether if they fail and go into a bankruptcy, is this going to have broader ramifications for our economy? Is this going to cause more widespread systemic damage to our economy and our financial system? And the onus will really be on the institution to make that demonstration, but I think it's very important that they do make that demonstration because, getting back to Title II and the FDIC's new powers, the FDIC's worst nightmare is to have an institution that's deteriorating and assuming that it is going to go into bankruptcy, so there's no preparation or getting involved and then all of a sudden, "Oh gee, well, we figured out it's systemic after all." So I think identifying those ones that are potentially systemic early on with quantifiable metrics, which they ruled as going in there, and really drilling down and saying OK, what's going to happen to you if you go into bankruptcy? Satisfy us that, you know, this can be handled in a way that's not going to create problems. I think that's really, for me, the key decision that needs to be made, and I don't think it's going to be a difficult one to make.

Altig: So, tackling the simplicity issue from a slightly different angle, the Dallas Fed's annual report this year basically took the position that Dodd-Frank did not really crack the "too big to fail" problem. Largely because, if I understand the argument right, they're just basically saying the institutions are still too complex and they need to be simplified, and we need to do something up-front to get to simpler banking structures.

Bair: Simpler banking, well, I'm all for that. Yeah, although I think that, you know, I hear a lot of questioning from two very distinct vantage points about whether resolution authority will work. And on one side I hear it from I think kind of behind the scenes from some of the "too big to fail" banks, kind of like the status quo, right? So they've lost some of their bump-up and their rating, and they don't want to lose any more, and their funding costs are going to go up, and maybe they don't really want the market to believe that this could happen to them. And then I think you have others who I'm more sympathetic to, who just like to break the banks up, think they're too big, too complex, can't understand them, let's get rid of them. So there again, if they can be resolved successfully, then that undercuts that argument as well.

So I do think that there is a way. The FDIC has developed a framework by taking control of the holding company, and you can keep the operating subsidiaries under the holding company operational through funding and keep them open. And that way you can maintain your overseas operations, too and avoid some adverse consequences with automatic default clauses, acceleration clauses by keeping those foreign institutions open. I think in the short term that framework can work. Longer term, I'm very much with the Dallas Fed. At least they need to be simplified. Make them structure themselves so their business lines are distinctly aligned with their legal entities.

Right now, you know, they've got thousands of legal entities, one particular business line could be 500 different legal entities that support that business line, it's ridiculous. So they do need to simplify these structures—they need to—so that they can be easier to break up if they get into problems, and I think this will help shareholders, too. These places—they're too big to manage. I mean, I think even, and you look at the share values of the megabanks and with the exception of JPMorgan Chase, they trade significantly below tangible book value. Even JPMorgan Chase, which I think is viewed as a well-managed bank of the megabanks, the best managed, their share valuations don't come anywhere close to the very best managed regional banks, like U.S. Bancorp. So there's a complexity discount. These shareholders cannot really see or understand what's going on and they're very, very even for the best management, they are very, very difficult to manage, and I think you see that in their share prices. So if you don't break them up, at least create distinct operating subsidiaries, perhaps at their own intermediate boards, so you can see what's going on inside of these and they can be spun off and broken off easily if they get into trouble. I think that would be huge, and I think actually the Fed and the FDIC do have that power through the living will process to eventually get there. So I encourage the Dallas Fed on that level.

Altig: To shift gears just a little bit, one of the tools of the recovery in financial markets in banking in particular, if you will, has been the stress test process. I guess you're not completely satisfied with the way the last round went?

Bair: Yeah, well, I always try to be constructive and there are some things I really liked. I liked the fact it was a true stress scenario. The Fed made institution-specific information available. I think that was really a huge milestone and I think it puts out important market information, and we're all better for it. The banks are better for it. You can always do better; I see this stress test as an evolving process, so you know me, I always like to chime in with my suggestions for improvements, but I do think in particular that they need to look at…if you're looking at a stressed environment as we saw in 2008, the market looks at leverage ratios, they don't trust the risk space capital. Maybe if you never get Basel cleaned up, you know, they'll be more trustworthy, but that's going to be a long time coming, and so I think putting as much emphasis, equal emphasis at least on where their leverage ratios are in a stressed environment before approving capital distributions, I think is really important. And I do think it's important to credit the Fed. They are not allowing, as I understand it, the level of capital distributions, even the ones that they approved. The banks are still building their capital bases, so they're not depleting capital, but they're not building as fast as they might otherwise, and so I do think the Fed needs to be careful with that. 

It's amazing to me how much money went out the door in dividends in 2007 and even early 2008 by banks that were quite sick, so it's great. I think people, in fairness to the Fed, don't recognize what a profound change this is in the regulatory role, in the Fed's role, of really hands-on management of these dividend payouts and so it is difficult, I do understand that, but I hope next year perhaps they'll put a little more attention to the leverage ratios especially.

Altig: So speaking of the Basel process, the other prong beyond capital-related regulations is of course liquidity-related regulations. Do you think that we're moving fast enough toward the implementation of those sorts of standards?

Bair: Well, I do think the liquidity agreements that were made in Basel, I think there is an observation period, and I think that was appropriate because some of the outcomes you were seeing in just getting data from the banks, it was counterintuitive in terms of who we were seeing had the most stable liquidity and the ones who didn't. I think a lot of that is because it skewed in favor of the investment banks, which of course during the crisis we saw had highly volatile balance sheets, but that's because they keep a lot of liquid assets on their balance sheet. That's their model. You know a bread-and-butter bank that most of their assets are loans; those are not liquid, so on the liquidity ratios maybe you're not going to come out so well. So, I do think maybe the liquidity standards that are contemplated in Basel III need some more careful thought.

I do think, though, there are some other things. I think Chairman Bernanke, I believe yesterday, has spoken against excessive reliance on wholesale funding, that there's not been enough progress on that. I just filed a comment letter with a couple of other academics on the Fed's heightened prudential standards, 165 and 166 rule-makings, to suggest that they require that holding companies have at least 30 percent of their capital structure be either equity, subdebt, or term unsecured debt. I think that will provide more stable funding. It would also help make sure there was plenty of loss absorption if you get into a Title II resolution situation. So I think in the near term there's still a lot of things—and money market funds, too, are another, that's coming at it from the provider end as opposed to the institutional user end, but nonetheless, I think addressing money markets that does, I think, create an unnatural amount of very short-term flighty funding that we certainly saw created a lot of problems during the crisis.

Altig: So at the end of the day, capital is the answer.

Bair: Capital is important, liquidity is…capital is the most important because liquidity generally, the banks that have liquidity, or financial institutions, I shouldn't say banks, because a lot of these are not banks. The financial institutions that have liquidity problems, generally, the markets [are] perceiving a capital issue. So if you take care of the capital, the liquidity will stabilize a lot. If you do get in a situation where everybody's just scared, then, you know, the government had to come in with measures before and might have to do so again, but in those situations the banks that have stable funding, either long-term debt, insured deposits, or at the best a combination of those, are really the ones that can survive. Wells Fargo did not really have a liquidity crisis. JPMorgan Chase did not have a liquidity crisis.

So I think the banks are viewed as stronger that have cleaner assets and have strong capital bases are the ones that are going to weather liquidity events better, and so I would always put the first focus on that but reducing the reliance on short-term funding. And that's been a progression. It didn't used to be like this. You know, 15 years ago you didn't see this kind of heavy reliance on short-term funding. This is one area where I'd like to get back to the old days.

Altig: So one of the themes of the day was an expressed concern by maybe half of the crowd that the fix for regulatory lapses, if you will, or weaknesses, are going to create another sort of shadow set of institutions or instruments or whatever it might be and we're going to be perpetually fighting yesterday's war. Do you have thoughts about that?

Bair: Well, I think Dodd-Frank does address that. I think finalizing the rule to be able to designate other institutions that are nonbanks as systemic, I think is important.  I think having a consumer agency regulating everybody now, banks and nonbanks, I think helps address the problems at the retail level. With shadow, you know, these horrible mortgages that were being originated and some of the banks were doing that, but most of them were not. Those were nonbank mortgage originators. It really had no regulation, so I do think there're some tools there. But it is something you need to be very cognizant of and again I think, you know, having, listen—I'd be happy to just have a hard-and-fast leverage capital standard applied to any financial institution with more than $50 billion in assets. I would love to see something like that. I think, you know, having some across-the-board standards would be very important because leverage is really, if you have to put your finger on one thing that really created problems, it was excess leverage and most of that was outside of insured banks and so, but you had banks getting in trouble because they're lending it to highly leveraged institutions where the leverage is just going into the shadows. So having a leverage requirement that applies to everyone I think, of any kind of significant size, would make a lot of sense.

Altig: I'll ask you a question that we get asked a lot as we go out because, like you were in your previous life, we spend a lot of time with community banks that often ask do we feel there's a future for community banks and what does it look like, and has all the attention on SIFIs [systemically important financial institutions], for example, going to create an unlevel playing field of sorts?

Bair: Well, I think that's a real issue and again, I think that does relate to the complexity issue we talked about earlier because complexuals are harder for smaller banks, right? They don't have big compliance to have to go and wade through these rules and try to figure out how/what they're supposed to be doing. So I like the idea of a two-tiered regulatory structure. I think banks below $10 billion, certainly below $1 billion, are very different than the multitrillion-dollar money institutions. And they take deposits, they make loans. Sometimes they make bad loans. Sometimes they take high-rate broker deposits. They can make mistakes even in that space, but it's a lot simpler to understand. And so, you know, they don't have these esoteric instruments on their balance sheet; they don't have these huge servicing operations. I worry about servicing a lot. I think I'd like to see community banks get into more mortgage lending again and I do worry that, you know, they've just got a small portfolio of loans they're servicing themselves, all this bureaucracy that we're now putting in place around servicing—some of it much needed, some of it maybe not—could really hurt them. So I think it's up to the regulators to be aware of that, to be cognizant of that, have two-tiered structures or just exceptions, which Dodd-Frank did in a number of areas, when appropriate, because we need community banks. The small businesses need community banks, places like my hometown, Independence, Kansas, they need community banks. There are a lot of small institutions where it's just not cost-efficient or worthwhile of the large institutions to open up branches. And I think communities also like, you know a homegrown bank, too, someone they know and have long-standing relationships with. So, it's an important part of our banking culture and I think there's a good economic reason to have community banks, and again, like everything it should be market driven, but regulators should make sure that they're not driving, you know, through regulatory burdens that are not necessary in community banks, that they're driving consolidation in that space.

Altig: So I'll ask you one more, a bit of a personal question. So you were the head of the FDIC in some really challenging times. I guess they were interesting, too.

Bair: Yeah, they were.

Altig: When you think back, it may be too early yet, but when you think back on that time, is there something that sort of pops into your head that boy, I think we really got that one right?

Bair: Yeah. So I think the stabilization measures were unfortunately necessary. I didn't like them, I'm not proud of them. But I think at that time they were within the realm of the alternatives we had, they were the right thing to do. I do think the debt guarantee programs along with the transaction account guarantee, which stabilized… we were seeing insured deposit stock, and I'm very proud of that, but we were seeing a lot of volatility with uninsured deposits and they were going to the "too big to fail" banks, and that was creating a lot of stress with community banks and I'm glad we did do that. It's probably time to think about phasing that out, but at the time I think it was the right thing to do. So and I think we worked together. We had our disagreements but we did work together and we did meet each other halfway and decided and moved forward and acted quickly when that was needed. So I do think those steps we took in 2008, I regret having to do them, I'm not proud of it, I wish we hadn't had to do it, but again, within the realm of all the available alternatives, I think we made the right choices and it worked. It did stabilize the system.

Altig: Chairman Bair, thank you very much.

Bair: Thanks.