Getting A Handle On Complex Financial Institutions

Getting A Handle On Complex Financial Institutions WORD ON THE STREET: There is no single issue more important to the stability of our financial system than the regulatory regime applicable to large financial institutions. I would hope that, by now, there is general recognition of the role certain large, mismanaged institutions played in the lead-up to the financial crisis, and the subsequent need for massive governmental assistance to contain the damage caused by their behavior.

The disproportionate failure rate of large, so-called systemic entities stands in stark contrast to the relative stability of smaller, community banks – of which less than 5% have failed. As our economy continues to reel from the financial crisis, with high unemployment and millions losing their homes, we cannot afford a repeat of the regulatory and market failures that allowed this debacle to occur.

There is nothing inherently wrong with size. In many business areas, large institutions can achieve significant economies and public benefits. However, size should be driven by market forces, not implied government subsidies.

Capital allocation should be determined by investors pursuing sound, innovative business models that promise sustainable returns based on acceptable risk tolerances. It should not be based on highly leveraged bets that promise privatization of benefits but socialization of losses if those bets fail.

With the implied government support provided to Fannie Mae, Freddie Mac, and so-called ‘too big to fail’ financial institutions, the smart money fed the beasts, and the smart money proved to be right. As failures mounted, the government blinked and opened up its checkbook. Creditors and trading partners were made whole. Many executives and board members survived.

In most cases, the government didn't even wipe out shareholders before taking exposure. Implied government subsidies of large financial institutions not only produce an unstable financial system, but they also skew allocation of capital away from other, more stable business sectors. Beginning in the mid-1990s, the assets of financial firms grew much more rapidly than ‘real economy’ assets, with financial firm assets peaking in 2007. Most of this growth was concentrated in the 30 largest institutions.

From 2000 to 2008, leverage increased dramatically among large U.S. investment banks and large European and U.K. institutions. Fortunately, for U.S. commercial banks, leverage remained flat – primarily because the Federal Deposit Insurance Corp. (FDIC) successfully blocked implementation of the Basel II advanced approaches for setting bank capital.

These trends in growth and leverage were not accompanied by increases in traditional lending to support the non-financial sector. Rather, portfolio lending fell significantly, as many large financial institutions found trading assets to be much easier and more profitable than going through the hard work of developing and applying sound underwriting standards for the loans these large financial institutions planned to keep on their books. Regulators, for the most part, did not try to constrain these trends, but left the market largely to regulate itself.

In some cases – for instance, with the repeal of Glass-Steagall and passage of the Commodity Futures Modernization Act – Congress explicitly told the regulators ‘hands off.’ As free markets became free-for-all markets, compensation rose, skyrocketing past wages paid to equally skilled employees in other fields. This enticed many of our best and brightest to forego careers in areas like engineering and technology to heed the siren song of quick, easy money from an overheated, over-leveraged financial industry.

In recognition of the harmful effects of too-big-to-fail policies, a central feature of the Dodd-Frank Act is the creation of a resolution framework. Which, going forward, will impose losses and accountability on shareholders, creditors, boards, and executives when mismanaged institutions fail. Under Title II of Dodd-Frank, the government can now resolve systemic bank holding companies and nonbank entities using the same time-tested tools the FDIC has used to resolve failing banks for decades. Such tools were not available during the 2008 crisis.

Many industry advocates continue to argue that higher capital requirements will inhibit lending. It is true that equity capital is marginally more expensive than debt. This is due, in part, to the ‘too big to fail’ doctrine, as well as the favored tax treatment of debt over equity.

But this is not a reason to allow them to keep leveraging up. It is a fallacy to think that thinly capitalized institutions will do a better job of lending. Throughout the crisis, better-capitalized community banks maintained stronger loan balances than their large bank competitors.

A large financial institution nearing insolvency will quickly pull credit lines and cease lending to maintain capital. This is why we had such a severe recession. On the other hand, a well-capitalized bank will keep functioning even when the inevitable business cycle turns downward. There may be a small, incremental increase in the cost of credit from higher capital levels in good times, but the benefit of stability in bad times more than outweighs those costs.

If there is any question as to why we need strongly capitalized banks, look no further than Europe, where lax capital regulation has resulted in a highly leveraged banking system that is poorly positioned to absorb losses associated with its sovereign debt crisis. I know some American bank CEOs have complained about the higher capital standards – and they are right – in part. Capital regulation is much tougher here, and I hope it's going to get even tougher.

But do we want the European banking system? That system is now so fragile it is doubtful that even the strongest banks could raise significant new capital from non-government sources. The choices in Europe are not pretty. They can let a good portion of their banking system fail, or they can commit to massive financial assistance through a combination of European Central Bank bond buying and loans and guarantees from the International Monetary Fund and stronger Eurozone countries. Frankly, I don't know which is worse.

Liquidity is another area that needs more attention from regulators, both in the U.S. and internationally. In the years leading up to the crisis, financial institutions became more and more reliant on cheap, short-term credit, which they used to fund longer-term, illiquid mortgage-related assets. Much of this credit was provided by money market mutual funds.

As the market began to lose confidence in the values of those assets, creditors refused to keep extending credit that caused widespread funding shortages. Money-market mutual funds, in particular, took flight at the first sign of trouble to keep from ‘breaking the buck.’

Though financial institutions have made significant progress in extending the average maturities of their liabilities, this has been driven, in part, by market conditions. We need to put strong rules in place on the liability side of the balance sheet to prevent a recurrence of the liquidity failures of 2008. For instance, we need to dramatically toughen the types of collateral than can be used to secure repos and other short-term loans.

We should also think about caps on the amount of short-term debt that financial institutions can use to fund their balance sheets, as well as the establishment of minimum requirements for the issuance of long-term debt. And finally, money-market mutual funds should be required to use a floating net asset value, which should substantially reduce this highly volatile source of short-term funding.

A final preventative measure I would like to discuss is the Volcker Rule. The basic construct of the Volcker Rule is one that I strongly support: FDIC-insured banks and their affiliates should make money by providing credit intermediation and related services to their customers, not by speculating on market movements with the firm's funds.

However, to some extent, this basic construct is at odds with Congress' 1999 repeal of Glass-Steagall, which allowed insured banks to affiliate with securities firms. And let's be honest – making money off of market movements is one of the things that securities firms have long done. Acknowledging these competing policy priorities, Congress recognized exceptions from the Volcker Rule for traditional securities activities, such as market making and investment banking. But the line between these exceptions and prohibited proprietary trading is unclear.

I fear that the recently proposed regulation to implement the Volcker Rule is extraordinarily complex and tries too hard to slice and dice these exceptions in a way that could arguably permit high-risk proprietary trading in an insured bank while restricting legitimate market-making activities in securities affiliates. I believe that the regulators should think hard about starting over again with a simple rule based on the underlying economics of the transaction, not on its label or accounting treatment.

If it makes money from the customer paying fees, interest and commissions, it passes. If its profitability or loss is based on market movements, it fails. And the inevitable gray areas associated with market making and investment banking should be forced outside of the insured bank and be supported by higher capital, given the greater risk profile of those activities.

In addition, the new rules should require executives and boards to be personally accountable for monitoring and compliance. Bank leadership needs to make it clear to employees that they are supposed to make money by providing good customer service, not by speculating with the firm's funds.

Complex rules are easy to game and difficult to enforce. We have too much complexity in the financial system already. If regulators can't make this work, then maybe we should return to Glass-Steagall in all of its 32-page simplicity.

Much work remains to be done to rein in the types of activities undertaken by large financial institutions that caused our 2008 financial crisis. However, through robust implementation of a credible resolution mechanism, strong capital and liquidity requirements, and curbs on proprietary trading, we can once again make our financial system the envy of the world and an engine of growth for the real economy.

Sheila Bair is former chairwoman of the Federal Deposit Insurance Corp. This article is adapted and edited from recent testimony delivered before the Senate Committee on Banking, Housing and Urban Affairs' Financial Institutions and Consumer Protection Subcommittee. The full testimony is available online.


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