Federal Reserve documents 33 page

IN THE SENATE, Dodd never achieved his grand bipartisan bargain. He tried various tactics after Shelby’s sharply critical statement in mid-November. He formed bipartisan teams of committee members to work out compromises on particular issues, with modest progress. When he and Shelby reached an impasse, he worked with Corker, a middle-ranking Republican on his committee. Still, Dodd couldn’t strike a comprehensive deal, and when it finally came time, on March 22, to send the bill to the Senate floor, every Republican on his committee voted no. But his persistent efforts to reach across the aisle would pay off later in the spring. The full Senate approved regulatory reform legislation, 59–39, on May 20, with four Republican senators joining in support. The Senate bill, like the House bill, retained our supervisory authority over all bank holding companies and state-chartered member banks, thanks to an amendment on the Senate floor from Amy Klobuchar of Minnesota and Kay Bailey Hutchison of Texas (a friend and onetime political opponent of Richard Fisher’s), as well as lobbying from Camden Fine’s community banking trade group. Dodd also forged an agreement with Bernie Sanders, as a substitute for “audit the Fed,” that increased disclosures and provided for a onetime review of the Fed’s governance and crisis-era programs.

The next step, in June, was a conference between selected House members and senators to work out differences between the House and Senate bills. Each chamber adopted the resulting compromise, and

President Obama signed the bill into law on July 21, 2010. I attended the signing ceremony in the Ronald Reagan building, a massive office complex a few blocks from the White House. I felt satisfied. The bill, which in the end hewed fairly closely to the administration proposal, was hardly perfect, but it was nevertheless a substantial accomplishment. By coincidence, that afternoon, I testified before Dodd’s committee, delivering the chairman’s usual twice-a-year report to Congress. The final legislation, I said, went a long way toward achieving its overarching goal: “reducing the likelihood of future financial crises and strengthening the capacity of financial regulators to respond to risks that may emerge.”

Dodd soberly noted that it would take months and years for the Fed and other agencies to write the regulations to implement the law, known formally as the Dodd-Frank Wall Street Reform and Consumer Protection Act. “Much work remains to be done,” I agreed. Indeed, by one estimate, the law required the agencies to write 243 new regulations, conduct 67 onetime studies, and write 22 new periodic reports— all of which had to be done by staff while they carried out their normal duties. Many of the rules were “multi-agency,” meaning that as many as five or six agencies were required to reach agreement on them.

It seemed to me that the final legislation had struck sensible compromises on most of the contentious issues. Closing an important gap in oversight, the Fed would become the regulator of systemically important financial institutions—bank holding companies but also nonbanks such as the Wall Street investment firms and huge insurance companies like AIG. We would be required to devise tougher capital and other standards for firms in that category, but we would not choose which firms would be designated as systemically important. That job fell to a new body, the Financial Stability Oversight Council, made up of the heads of the many federal financial regulatory agencies (including the Fed) and chaired by the Treasury secretary, as the administration had proposed.†

An amendment from Senator Susan Collins of Maine ensured, among other things, that tougher capital standards would be applied not just to U.S. institutions but also to foreign-owned banks operating in the United States. This measure angered some foreign bankers and their regulators. Before Dodd-Frank, the Fed had relied on the parent companies abroad to provide financial support if a U.S. subsidiary ran into problems. But, as demonstrated by the heavy borrowing from the Fed by foreign-owned institutions during the crisis, U.S. subsidiaries of foreign banks needed to be able to stand on their own. The Board would go on to pass tough rules that force U.S. subsidiaries of foreign banks to meet requirements similar to those imposed on domestic banks.

The final bill, like the administration’s original proposal, left the regulatory bureaucracy relatively intact. However, it did eliminate the Office of Thrift Supervision and create a Consumer Financial Protection Bureau. The deal that Barney Frank and Camden Fine had struck, shielding smaller banks from regular exams by the bureau, survived. The new regulator was called a “bureau,” not an “agency,” because, at the suggestion of Bob Corker, it became technically part of the Federal Reserve. That was in name only. The bureau was to be headed by a director who would be appointed by the president and confirmed by the Senate, and who consequently would act independently of the Fed. The Fed would have

no power to hire, fire, or direct any of its employees; no power to delay or disapprove its rules; and no power to intervene in any of its examinations or proceedings. We were required, however, to pay its operating expenses indefinitely ($563 million in 2014). The unusual arrangement relieved the agency of having to go to Congress every year for approval of its budget. The bottom line for taxpayers was the same, though. Every dollar spent on the bureau’s operations meant that the Federal Reserve returned one dollar less in net revenue to the Treasury.

The administration recruited Elizabeth Warren, who had proposed the new agency in 2007, to set it up and get it running. But implacable opposition from Republicans meant she would never be nominated to head it. She came to see me to discuss the transfer of staff and other resources from the Fed. We had a good conversation, and she seemed pleased with the cooperation that the Fed was providing. Her instincts were too populist for us to see eye to eye on policy, however, and when she became a senator from Massachusetts she would sharply and frequently criticize the Fed.

One of the most important reforms of the Dodd-Frank Act was the new authority to unwind failing, systemically important financial firms. Under the “orderly liquidation authority,” the Treasury secretary, after consulting with the president and obtaining the approval of the Federal Reserve and FDIC boards, could turn over a collapsing firm to the FDIC. The FDIC could operate the firm and make good on its obligations to secured creditors (such as repo counterparties). The FDIC also could repudiate contracts, such as the AIG bonus contracts, and impose losses on unsecured creditors. The failing firm’s senior executives would be fired, and shareholders would stand last in line to recover their investment. The FDIC could borrow any funds needed for winding down a big firm from the Treasury, but if it incurred losses, they would be recovered by levying an assessment on large financial firms. To help make the FDIC’s job easier, big financial firms would file plans, dubbed “living wills,” showing how they could be dismantled without destabilizing the financial system.

With the new orderly liquidation authority in place, the Fed would lose its ability to use the “unusual and exigent” clause, Section 13(3), to rescue individual institutions such as AIG and Bear Stearns. It was one authority I was happy to lose. We would still be able to use 13(3) to create emergency lending programs with broad eligibility, such as our lending program for securities dealers or the facility to support money market funds, although we’d have to obtain the Treasury secretary’s permission first. I didn’t consider that much of a concession, since I couldn’t imagine a major financial crisis in which the Fed and the Treasury would not work closely.

Some aspects of the final legislation may have diminished our ability to respond to future financial panics, though. Under the compromise that Bernie Sanders worked out with Chris Dodd, we would have to publish the identities of future discount window borrowers—but with a two-year lag. We would begin doing that in September 2012. Lagged disclosure is a lot better than immediate disclosure, but the new disclosure requirements may still increase the stigma of borrowing from the Fed in a panic. The legislation also restricted the FDIC’s authority to guarantee bank debt, as the agency had announced on the

day after Columbus Day 2008. Now the FDIC would need congressional approval in addition to the concurrence of the Fed and the Treasury secretary—not an easy hurdle to clear, as we saw with the TARP vote. And the FDIC no longer could invoke the systemic risk exception for specific firms that had allowed it during the crisis to help stabilize Citigroup.

Other provisions affecting the Federal Reserve turned out, from our perspective, far better than the original proposals. Per the agreement between Dodd and Sanders, we would continue to be shielded from ongoing and potentially politically motivated GAO reviews of monetary policy decisions (no “audit the Fed”). But the legislation required two onetime GAO reviews—one of our lending during the crisis and the other of the Fed’s unique governance system created a century ago by the original Federal Reserve Act. The review of our crisis lending, released in July 2011, would find that our programs were effectively designed and operated, and that all our loans had been repaid. The governance review focused on the nine-member Reserve Bank private-sector boards, which by law included bankers and others with financial industry experience. To avoid conflicts of interest, we had long had policies that prevented the Reserve Bank directors from involving themselves in bank supervisory and emergency lending decisions. The GAO would find that our policies were followed but would suggest we make them publicly available on Fed websites. Three of the directors on each Reserve Bank board are still, by law, chosen by bankers to represent the banks in the district. To prevent the appearance that bankers were choosing their own regulator, Dodd-Frank barred those three directors from taking part in the selection of Reserve Bank presidents, confining that duty to the remaining six directors.

As the administration had proposed originally, the final legislation tightened derivatives regulation and pushed more derivatives trading into the sunlight by requiring greater use of exchanges. The final law reached beyond the administration’s original proposal with the addition of what became known as the Volcker rule, after its originator, former Fed chairman Paul Volcker. Paul, who once claimed that ATMs were the only worthwhile financial innovation in his time, believed that banks’ trading in securities markets on their own account distracted them from their primary business of making loans. Moreover, he believed, it led them to take excessive risks, with losses ultimately ending up at the door of the taxpayer. His rule, endorsed by President Obama in January 2010, banned banking companies from short-term trading of many securities, derivatives, and commodity futures and options. It provided exceptions for trading government securities, for using derivatives to hedge (or reduce) a banking company’s risks, and for trading on behalf of customers. In a sense, the Volcker rule was an effort to partially reinstate the Depression-era Glass-Steagall provision that had separated commercial and investment banking.

The Dodd-Frank Act left some unfinished business: The status of Fannie Mae and Freddie Mac remained unresolved, for instance, and the act did not address the vulnerability of money market funds and the repo market to runs. Nevertheless, the law does much good and stands as a remarkable accomplishment.

I believe that the many administration officials, lawmakers, and regulatory policymakers—and their

staffs—who poured a year and a half of prodigious work into the legislation had been guided, knowingly or not, by a simultaneously high-minded and pragmatic sentiment that Woodrow Wilson voiced before he launched the effort that would establish the Federal Reserve System. “We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step by step we shall make it what it should be,” Wilson said in his first inaugural address. Wilson’s words continued to make good sense a century later.

* An interesting earlier historical example of “stigma” occurred after the names of banks receiving loans from the Reconstruction Finance Corporation were published in newspapers in late August 1932. Economic historians judge that the RFC had some success in reducing bank failures during its first seven months in operation (February –August 1932) but that its effectiveness greatly diminished after loan recipients were identified.

† The name was changed from the administration’s June 2009 proposal, which would have named the body the Financial Services Oversight Council.

CHAPTER 21

QE2: False Dawn

On February 3, 2010, six days after the Senate voted to confirm me to a second four-year term, I stood, with my right hand raised and Anna at my side, on a landing overlooking the Eccles Building’s spacious atrium. Vice Chairman Don Kohn, my good friend and close colleague throughout the crisis, administered the oath of office. Board members, visitors, and hundreds of Board employees gathered on the ground floor, along the second-floor railing ringing the atrium, and on the broad marble steps of the staircases on either side.

“America and the world owe you a debt of gratitude,” I told the staff. “We moved rapidly, forcefully, and creatively to confront the deepest financial crisis since the Great Depression and help prevent a looming economic collapse.”

My gratitude was heartfelt. Our response to the crisis had been a team effort. But I was not declaring victory that day, not with more than fifteen million Americans unable to find work and millions more in danger of losing their homes. “We must continue to do all that we can to ensure that our policies are helping to guide the country’s return to prosperity,” I said.

The economy had begun to grow again during the summer of 2009, ending a year-and-a-half-long recession—the longest since the 1929–1933 downturn that marked the first leg of the Great Depression. The initial estimate for the last three months of 2009 showed output expanding rapidly. The growth, however, had not yet translated into a significant improvement in the job market. The unemployment rate, which had peaked at a twenty-six-year high of 10.2 percent in October, stood at 10 percent by the end of the year.* The situation called to mind the jobless recovery that had followed the 2001 recession. I wondered if we were seeing a replay.

Still, our lending programs and securities purchases—along with the Obama administration’s fiscal stimulus and the bank stress tests—appeared to be having their intended effect. Financial conditions were improving, a bellwether for the broader economy. Stocks had substantially rebounded, funding markets functioned more normally, and the banking system—though by no means completely healthy—appeared to have stabilized. At least as far as the financial system was concerned, it was time to start unwinding our emergency measures.

We had taken the first step in June 2009, when the Board reduced the bank loans offered in the biweekly discount window auctions from $300 billion to $250 billion. By March 2010, we would phase out the auctions completely. We were also in the midst of normalizing the terms of our regular discount window lending to banks. By March, the typical maturity on the loans, which had been extended for up to ninety days during the crisis, would be back to overnight. And, with less reason to encourage banks to borrow from us, we would soon increase the interest rate on discount window loans by a quarter of a percentage point.

Lending under all but one of our various 13(3) facilities, including those aimed at stabilizing money market funds, the commercial paper market, and securities firms, had ended on February 1, as had the currency swap agreements with other central banks. Our only remaining special lending facility was the TALF. After June 30, 2010, it, too, would cease new lending. All told, the TALF lent $71 billion—below the program’s original $200 billion limit and far below the expansion to $1 trillion in February 2009. Even so, it supported the origination of nearly 3 million auto loans, more than 1 million student loans, nearly 900,000 loans to small businesses, 150,000 other business loans, and millions of credit card loans.

I felt good about what we had accomplished with these programs. Less well known and certainly less controversial than the Bear Stearns and AIG rescues, our lending facilities had been essential in controlling the panic. And, although we made thousands of loans to a wide range of borrowers, every penny was repaid, with interest—and the Fed, and thus the taxpayers, profited by billions of dollars. Much more importantly, these programs prevented the financial system from seizing up and helped to keep credit flowing. Walter Bagehot would have been pleased.

Although FOMC members, hawks and doves alike, agreed it was time to wind down our emergency lending programs, they differed on when to begin rolling back our accommodative monetary policy. At the end of March, we would complete the securities purchases that we had promised a year earlier. We now held $2 trillion in Treasury securities, Fannie, Freddie, and Ginnie mortgage-backed securities, and Fannie and Freddie debt, up from $760 billion before we expanded QE1 in March 2009. In the meantime, we had kept the funds rate near zero and continued to predict, in our statement, that it would remain exceptionally low “for an extended period.” The hawks, led by Kansas City Fed president Tom Hoenig (who had a vote in 2010), worried that this easy policy would eventually have bad side effects—if not higher inflation, then perhaps the return of excessive risk taking in financial markets. They pressed the Committee to think about how we might exit from our unusual policies.

With unemployment still near its peak and inflation quite low, I thought we were a long way from tightening policy. Two historical episodes—one seventy years old and one relatively recent—influenced my thinking. The first was the recession of 1937–1938, the so-called recession within the Depression. Expansionary monetary and fiscal policies had put the economy on the path of recovery after Franklin Roosevelt took office in 1933. But excessive fear of future inflation led, in 1937, to the tightening of both monetary and fiscal policy, despite the fact that unemployment was still high. Tax increases and a contraction in the money supply (caused in part by Fed policy) hurled the economy, which was still fragile, back into a steep decline. More recently, the Bank of Japan, eager to move away from zero interest rates, had tightened policy in 2000 and again in 2007. Each time, the move had proved premature and the bank was forced to reverse itself. Still, in the interest of good planning, I thought it made sense for the FOMC to discuss and agree on the mechanics of normalizing policy. And making clear that we had a workable strategy for tightening policy when the time came might ease the concerns of both the hawks inside the Fed and our external critics.

Barney Frank also thought that a public airing of exit issues would help. He invited me to testify on February 10 before his House Financial Services Committee. I wasn’t enthusiastic, especially since I had the regular semiannual Monetary Policy Report testimony just two weeks later. I also was scheduled, the prior weekend, to attend a meeting of the G-7 finance ministers and central bank governors in Iqaluit, Canada, which would cut into my prep time. But testifying was easier than saying no to Barney.

Iqaluit, a city of about seven thousand, is the capital of the territory of Nunavut, in northern Canada, about two hundred miles below the Arctic Circle. Surrounded by snow and ice, it is accessible only by air in the winter. The austere setting seemed apt, given the policy goals of Canadian finance minister Jim Flaherty, the host, and some of his European counterparts. Now that the most chaotic phase of the crisis was over, they—like the FOMC hawks and some U.S. lawmakers—argued for less expansionary fiscal and monetary policies. Tim Geithner and I pushed back. We were skeptical that the progress so far was sufficient to warrant a change in course.

Our discussions in Iqaluit were punctuated by dogsled rides (I declined, but Mervyn King tried it) and a chance to see the inside of a real igloo and eat raw seal meat. (I went into the igloo but passed on the seal meat.) The weather held up nicely for our near-Arctic travel but then disrupted our return to Washington. While we were away, a major blizzard, later dubbed Snowmageddon, dumped two feet of snow on Washington and buried much of the mid-Atlantic region. Washington’s airports closed and we spent an unplanned night in Boston before returning home.

Government offices were shut, but I wanted to prep for Barney’s hearing on Wednesday. On Tuesday morning, staff members dressed in jeans, sweaters, and flannel shirts met with me in the Anteroom, a small but elegant conference room ringed with portraits of past chairmen. We reviewed questions I might be asked. Other staff members joined by conference call. As it turned out, federal offices did not reopen until Friday and the hearing was postponed until March. We posted my statement on the Board’s website

anyway. It explained how we would go about raising interest rates at the appropriate time if our balance sheet was still much larger than normal at that point, which seemed likely.

Prior to the crisis, the Fed affected the federal funds rate by changing the supply of bank reserves. In particular, to raise the funds rate, we would sell some of our securities. The payments we received would reduce bank reserves and leave banks with greater need to borrow on the interbank market. More borrowing by banks would in turn push up the federal funds rate, the interest rate on interbank loans. But our securities purchases under QE1 had flooded the banking system with reserves, to the point that most banks now had little reason to borrow from each other. With virtually no demand for short-term loans between banks, the funds rate had fallen close to zero. In this situation, moderate reductions in the supply of reserves would be unlikely to affect banks’ borrowing needs and thus influence the federal funds rate. In short, the Fed’s traditional method for affecting short-term interest rates in its pursuit of maximum employment and price stability would no longer work.

We needed new methods to raise interest rates when the time came, even if our balance sheet remained large. An important new tool had come as part of the TARP legislation, when Congress had given us the power to pay interest on banks’ reserve accounts at the Fed. We had set that rate at 1/4 percent. If we wanted to tighten policy, we could increase it. Since banks would be unwilling to lend to each other or anyone else at a rate below what they could earn by holding reserves at the Fed, raising the interest rate paid on reserve accounts should raise the funds rate as well as other short-term rates.

To supplement that tool, we had also tested methods for draining reserves from the banking system without necessarily selling our securities. One of several methods was offering banks higher-yielding term deposits with longer maturities. A bank’s reserve account at the Fed is similar to a consumer’s checking account at a commercial bank. Like a consumer with a checking account, a bank can withdraw funds in its reserve account on demand. The term deposits we would offer could be thought of as analogous to certificates of deposit, or CDs. Like money held in a CD, reserves held as term deposits couldn’t be used day to day, and this would effectively reduce the supply of available reserves in the banking system. Fewer available reserves should mean a higher funds rate. Another tool involved financing our securities holdings by borrowing from securities dealers and other nonbank lenders rather than through the creation of bank reserves. Again, fewer available reserves in the banking system should cause the funds rate to rise.

Of course, we could always tighten monetary policy simply by selling some of our securities, thereby unwinding the effects of quantitative easing. I was willing to consider selling our securities eventually, if the sales were very gradual and announced well in advance. But I saw this as a way of normalizing our balance sheet in the longer term, not as the primary tool for tightening policy. I worried that Fed securities sales would lead to volatile and hard-to-predict movements in interest rates, making them a less precise tool for managing financial conditions.

Our new methods were works in progress, but I had already seen enough to feel confident that

tightening policy would pose no technical obstacles, even if our securities holdings remained much larger than before the crisis. I wanted both legislators and market participants to understand that. I also wanted them to understand that developing these exit tools did not mean we were contemplating an actual tightening of monetary policy anytime soon.

Besides their usual concerns about inflation, the FOMC hawks also worried that low rates might encourage investors, frustrated by low returns, to take excessive risks, possibly fueling new asset bubbles. I took that issue very seriously. After all that we had been through, I wanted to be sure that we were doing everything we could to maintain financial stability. And, as I had long argued, I believed that the first line of defense against speculative excesses should be regulatory and supervisory policies.

We had already heightened our scrutiny of the largest, most complex banks and our attention to risks in the financial system as a whole. Over 2010, we further increased our surveillance of the financial system —including parts we didn’t regulate. Multidisciplinary teams produced analyses and reports, ranging from statistical studies to compilations of market chatter, and regularly briefed the Board and the FOMC. After the passage of the Dodd-Frank Act in July 2010, we created an umbrella organization within the Board—the Office of Financial Stability Policy and Research—to oversee and coordinate the staff’s work. I chose Nellie Liang, an experienced and savvy financial economist who had helped lead the stress tests of large banks in 2009, as its first director. To a much greater extent than before the crisis, the FOMC had begun to pay attention to potential financial stability risks as it discussed monetary policy.

These new efforts to promote financial stability were far more ambitious than the work of the small staff group I had created in my early days as chairman. But I didn’t want to oversell what we were doing. Systemic threats are notoriously hard to anticipate. If bubbles were easy to identify, for example, far fewer investors would get swept into them in the first place. But I was convinced that changing our approach would give us a better chance for success.

In particular, I urged Nellie and her staff not only to think through what they saw as the most likely outcomes but also to consider worst-case scenarios. I had come to believe that, during the housing boom, the FOMC had spent too much time debating whether rising house prices reflected a bubble and too little time thinking about the consequences, if a bubble did exist, of its bursting spectacularly. More attention to the worst-case scenario might have left us better prepared to respond to what actually happened.

Recognizing that financial shocks are often unpredictable, I also encouraged the staff to look for structural weaknesses in the financial system and to find ways to make it more broadly resilient. That idea was already motivating many of our reforms, such as requiring more bank capital, which strengthened the banking system’s ability to absorb losses, no matter what the cause.

AFTER THE SNOW from the February blizzard melted, spring came a bit early to Washington; the cherry trees around the Tidal Basin hit peak bloom at the end of March. The economy remained quite weak, but I hoped that the green shoots I had observed in financial markets in my 2009 appearance on 60 Minutes

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