Federal Reserve documents 31 page

For me, these positions pushed the party further away from the mainstream and from traditional Republican views. I still considered myself a conservative. I believed in the importance of personal autonomy and responsibility and agreed that market economies were best for generating economic growth and improving economic welfare. But I had lost patience with Republicans’ susceptibility to the know-nothing-ism of the far right. I didn’t leave the Republican Party. I felt that the party left me.

Of course, the Democrats suffered their own delusions, especially on the far left (though if both the far right and the far left opposed me, I figured I must have been doing something right). Senator Bernie Sanders of Vermont, a self-described socialist who caucused with the Democrats, seemed to see the world as a vast conspiracy of big corporations and the wealthy. (Corporations and the wealthy have lots of power, certainly, but in the real world most bad things happen because of ignorance, incompetence, or bad luck, not as the result of grand conspiracies.) When I became chairman I resolved to be nonpartisan, which was appropriate for my role. My experiences in Washington turned me off from political parties pretty much completely. I view myself now as a moderate independent, and I think that’s where I’ll stay.

On January 28, 2010, after some active administration lobbying on my behalf as well as some arm-twisting by Chris Dodd, the full Senate voted, 70–30, to confirm me—not an especially close margin for many matters but nevertheless the closest vote by which any Fed chairman had ever been confirmed. I wasn’t surprised. People were understandably dissatisfied with the economy and financial conditions,

and Congress reflected that.

I was more disturbed by several phone calls I received from senators after the vote. Each had a common theme: The senator believed I was doing a good job but, for political reasons, had to vote against me. The callers seemed to believe that voting in opposition to their personal views for political reasons was perfectly natural. One call was striking. After the senator expressed his confidence in me and apologized for his no vote, I asked him why he voted as he did. “Well,” he replied blithely, “sometimes you just have to throw some red meat to the knuckle-draggers.”

Comments like that brought to mind an observation attributed to the comedian Lily Tomlin: No matter how cynical you become, you just can’t keep up. If I could have, I would have stayed as far away from politics as possible. But, as head of the Federal Reserve, about to be sworn in for a new four-year term, I knew that politics would continue to occupy much of my time and energy.

* I tried, without success, to get the media and markets to use the term “credit easing,” a phrase suggested by Dave Skidmore, rather than “quantitative easing.” Quantitative easing was the term applied to (unsuccessful) Japanese programs earlier in the decade, which differed from our securities purchases in many respects. In particular, the Japanese QE programs were aimed at increasing the money supply, while the Fed focused on purchasing longer-term Treasury and mortgage-backed securities as a means of reducing longer-term interest rates.

† Ideally, we would have purchased private-sector debt, like corporate bonds and private-label MBS, affecting the rates on those securities directly. But, unlike most central banks, the Fed does not have that authority, except by invoking 13(3).

CHAPTER 20

Building a New Financial System

Even as the fires of the financial crisis continued to rage, we were thinking ahead to what would need to be done after the flames burned low. The questions were both difficult and consequential: What should the new financial system, built on the ashes of the old, look like? Could we prevent future financial crises? Or, more realistically, what could we do to ensure that future crises would be arrested before they burned out of control?

As we considered these questions in late 2008 and early 2009, we drew from a global conversation on financial reform already under way. In August 2007, President Bush had asked the President’s Working Group on Financial Markets (which consisted of the heads of the Treasury, the Fed, the Securities and Exchange Commission, and the Commodity Futures Trading Commission) to review the causes of the financial turmoil that, as it turned out, was just getting going. Internationally, in October 2007 the G-7 industrial countries had asked the Financial Stability Forum (which included central bankers, finance ministers, and regulators from major financial centers) to do the same. Even before the crisis began, in June 2007, Hank Paulson’s team at Treasury had started work on a “blueprint” to reform the outmoded and balkanized financial regulatory structure in the United States.

The three reports generated by these separate efforts all would make useful recommendations, but of the three, Hank’s “blueprint” was both the most ambitious and the most helpful to me for thinking about wholesale regulatory reform. It focused squarely on the daunting task of rationalizing the hodgepodge of federal financial regulatory agencies while eliminating overlap and closing gaps.

Hank’s report, issued in March 2008, made both shorter- and longer-term recommendations, but its ultimate goal was to create a “three peaks” regulatory structure. The first peak would be a single,

“prudential” regulator focused on ensuring the safety and soundness of individual financial institutions, such as banks, savings and loans, credit unions, and insurance companies. The report envisioned the Office of the Comptroller of the Currency as the agency primarily responsible for prudential supervision.

The second peak would be a new “conduct of business” agency charged with protecting consumers and investors served by banks and also nonbank entities ranging from securities dealers to mutual funds. The new agency would combine many of the existing powers of the SEC and the CFTC, and it would also take over most of the consumer protection authorities vested in the Fed and other banking agencies.

The first two elements of the Treasury plan essentially reorganized and expanded existing regulatory functions. The third peak was new. It called for an agency responsible for the stability of the financial system as a whole. The agency would also oversee critical infrastructure, such as the systems used by financial institutions for making payments or transferring securities. In Hank’s proposal, this broad role would fall to the Fed, which would monitor the financial system and address any vulnerabilities it found. It would also have the authority to examine individual institutions, in cooperation with the prudential regulator, when doing so was necessary to meet the financial stability objective.

The Treasury plan stood out for its conceptual clarity about the main objectives of financial regulation and the institutional structure needed to attain them. But Hank (and we) understood that the blueprint’s longer-term recommendations had to be viewed as aspirational. Congress would not take up reforms of this magnitude in a presidential election year. In any case, we knew that changes of this sort shouldn’t be implemented in the middle of the crisis.

On March 27, 2008, four days before Hank unveiled his blueprint, candidate Obama in a speech at Cooper Union, a college in Manhattan, had laid out his own core principles for a twenty-first-century regulatory framework. He argued that the Fed should have supervisory authority over any institution that could borrow from it. Obama also urged streamlining overlapping regulatory agencies (without getting into specifics), strengthening capital requirements for banks, and creating a new oversight commission (analogous to Hank’s financial stability regulator) to identify unanticipated threats to the financial system. I was glad to see Obama bringing these issues, normally below the radar for most voters, into the campaign debate. The principles in his speech seemed sensible and pragmatic to me.

Their many other constructive suggestions aside, the reports and studies of financial regulation completed before and soon after the onset of the crisis all failed to tackle what became one of the most pressing issues in the wake of Bear Stearns and Lehman: how to shut down a big, complex, financial firm without taking down the entire system with it. Hank and I had raised this critical concern at a hearing before Barney Frank’s House Financial Services Committee in July 2008. But before Congress had an opportunity to give serious consideration to these issues, Lehman had failed, the financial world had changed yet again, and the TARP proposal soon would dominate legislative debate.

IN LATE 2008, amid the crisis firefighting, we at the Fed began working on our own proposals for financial

reform. I wanted to have a well-formulated position before the legislative debates went into high gear. Kevin Warsh led a committee of Board members and Reserve Bank presidents that laid out some key principles.

Kevin’s committee considered a more explicitly “macroprudential,” or system-wide, approach to supervision and regulation. Historically, financial oversight had been almost entirely “microprudential”—focused on the safety and soundness of individual firms, on the theory that if you take care of the trees, the forest will take care of itself. In contrast, the macroprudential approach strives for a forest-AND-trees perspective. It looks not only at the health of individual institutions but also at factors that may affect the stability of the financial system as a whole, including linkages among institutions and risks that may span multiple institutions and markets. For instance, a few lenders overexposed to subprime mortgages aren’t necessarily a systemic problem, but many institutions with significant subprime exposures may well be. The goal of macroprudential regulation is to identify and defuse more broad-based risks that may not be evident when looking at individual institutions in isolation.

Warsh’s group also explored the concept of a financial stability supervisor to implement the macroprudential approach—an idea close in spirit to the third peak in Hank’s blueprint for reform. By the fall of 2008, after witnessing firsthand the complex interactions among markets and firms that had so gravely worsened the crisis, I had been thoroughly persuaded that a system-wide approach to supervision was essential for financial stability in a modern economy. I raised the need for more holistic oversight of the financial system in a speech in March 2009 to the Council on Foreign Relations. I also pushed again for a new system for the orderly wind-down of systemically important nonbank financial firms like Lehman and AIG.

HANK WAS FOCUSED on addressing the immediate threats posed by the crisis until he left office in January 2009, which left the task of developing a legislative proposal for financial regulatory reform to now-Secretary Geithner and his team at Treasury. White House chief of staff Rahm Emanuel had initially pressed Tim, unrealistically, to produce draft legislation before a G-20 meeting scheduled for April 2009. “You never want a serious crisis to go to waste,” was Rahm’s motto. But the administration had higher priorities during the first hundred days, including its economic stimulus package and the bank stress tests. Also, hampered by the slow confirmation process for senior Treasury officials, Tim was operating with a very lean staff. “Tim has nothing like a full team in place and they are simply overwhelmed,” David Wilcox emailed early in February 2009. To help fill the gaps, we lent Treasury several senior staffers, including economist Patrick Parkinson, who had helped design some of our emergency lending facilities, and attorney Mark Van Der Weide, a specialist in banking regulation. Tim and I agreed that Pat would help the administration put together the legislative proposal. “Poor Pat has not been informed of this yet,” I wrote to Kohn and others after a lunch with Geithner in late February. Pat accepted the assignment stoically.

Tim rolled out the administration’s proposal on June 17, 2009, in an eighty-eight-page white paper. If passed, the plan would trigger the most comprehensive overhaul of federal financial law since the Depression. Yet the plan was also pragmatic. It did not try to remake the financial system or financial regulation from scratch but built instead on existing institutions and arrangements.

The administration, for instance, chose not to take a radical approach to the problem of too-big-to-fail financial institutions. Understandably, given public anger at bailouts, support had been gathering from both the right and the left for breaking up the largest institutions. There were also calls to reinstate the Depression-era Glass-Steagall law, which Congress had repealed in 1999. Glass-Steagall had prohibited the combination within a single firm of commercial banking (mortgage and business lending, for example) and investment banking (such as bond underwriting). The repeal of Glass-Steagall had opened the door to the creation of “financial supermarkets,” large and complex firms that offered both commercial and investment banking services.

The lack of a new Glass-Steagall provision in the administration’s plan seemed to me particularly easy to defend. A Glass-Steagall–type statute would have offered little benefit during the crisis—and in fact would have prevented the acquisition of Bear Stearns by JPMorgan and of Merrill Lynch by Bank of America, steps that helped stabilize the two endangered investment banks. More importantly, most of the institutions that became emblematic of the crisis would have faced similar problems even if Glass-Steagall had remained in effect. Wachovia and Washington Mutual, by and large, got into trouble the same way banks had gotten into trouble for generations—by making bad loans. On the other hand, Bear Stearns and Lehman Brothers were traditional Wall Street investment firms with minimal involvement in commercial banking. Glass-Steagall would not have meaningfully changed the permissible activities of any of these firms. An exception, perhaps, was Citigroup—the banking, securities, and insurance conglomerate whose formation in 1998 had lent impetus to the repeal of Glass-Steagall. With that law still in place, Citi likely could not have become as large and complex as it did.

I agreed with the administration’s decision not to revive Glass-Steagall. The decision not to propose breaking up some of the largest institutions seemed to me a closer call. The truth is that we don’t have a very good understanding of the economic benefits of size in banking. No doubt, the largest firms’ profitability is enhanced to some degree by their political influence and markets’ perception that the government will protect them from collapse, which gives them an advantage over smaller firms. And a firm’s size contributes to the risk that it poses to the financial system.

But surely size also has a positive economic value—for example, in the ability of a large firm to offer a wide range of services or to operate at sufficient scale to efficiently serve global nonfinancial companies. Arbitrary limits on size would risk destroying that economic value while sending jobs and profits to foreign competitors. Moreover, the size of a financial firm is far from the only factor that determines whether it poses a systemic risk. For example, Bear Stearns, which was only a quarter the size of the firm that acquired it, JPMorgan Chase, wasn’t too big to fail; it was too interconnected to fail. And

severe financial crises can occur even when most financial institutions are small. During the Great Depression, the United States, with its thousands of small banks, suffered a much more severe financial crisis than did Canada, which had ten large banks and only a few small banks. (For that matter, Canada, whose banking system continues to be dominated by large institutions, also came through the recent crisis relatively well.)

With these considerations in mind, I agreed with the administration view that breaking up large firms was likely not the best way to solve the too-big-to-fail problem, at least not until other, more incremental options had been tried and found wanting. In particular, more important than limiting the size of financial institutions per se is ensuring that size confers no unfair advantages on large institutions, including no presumption of a bailout if they get into trouble. That’s a difficult challenge. The administration’s plan sought to address it in three ways.

First, it proposed tougher capital, liquidity, and risk-management standards for systemically important institutions—both banks and nonbanks (such as AIG and the Wall Street investment firms). If large, complex institutions posed more risk to the financial system, then they should be required to operate with a wider margin of safety. The stricter requirements, in turn, might spur large firms to assess whether the true economic benefits of their size exceeded the extra costs associated with tougher rules and capital requirements. If not, then market forces should, over time, lead those firms to get smaller and less complex, or at least not grow further.

Second, the administration proposed that the Fed supervise all systemically important financial companies—not only the big bank holding companies that it already supervised but also the big Wall Street investment banks and, potentially, large insurance companies and other major financial firms. Large and complex financial companies that happened not to be banks would no longer evade meaningful oversight.

Third, and critically, the administration’s plan would give the government the legal tools to take over and dismantle, in an orderly way, systemically important financial institutions on the brink of failure. The government would no longer have to choose between bailing them out or facing the dangers of a chaotic, Lehmanesque bankruptcy. These provisions seemed to me essential for ending the too-big-to-fail problem. Besides reducing the risk of another Lehman, the very existence of a credible mechanism for safely dismantling a systemic firm should reduce the potential benefits of being perceived as too big to fail. We had done what we had to do to stabilize systemically critical firms during the crisis, but nothing would please me more than being able to get the Fed out of the bailout business.

The proposal took another essential step by emphasizing the need for macroprudential regulation and supervision to complement the oversight of individual firms and markets. Tim had originally envisioned that the Fed would be responsible for monitoring the system as a whole, much as Hank’s earlier plan had proposed. But Sheila Bair, who had the ears of key members of Congress, including Chris Dodd, had been lobbying aggressively against enhancing the Fed’s authority. Sheila seemed prepared to concede to

the Fed a role as the supervisor of very large institutions, as the administration had proposed. But she wanted a council of regulatory agencies—chaired by its own independent head, appointed by the president—to handle oversight of the system as a whole and, in particular, to decide which institutions the Fed should oversee. Under her proposal, the council also would be able to write rules for those institutions if it considered the Fed’s regulations inadequate.

Neither Tim nor I was thrilled with Sheila’s plan. The Fed already possessed the bulk of the government’s expertise and experience needed to serve as the financial stability regulator, and another layer of decision making in the form of a council could inhibit rapid and effective responses to systemic risks. Ultimately, however, the administration’s plan included a watered-down version of Sheila’s idea. It proposed a Financial Services Oversight Council headed by the Treasury secretary, instead of a separate presidential appointee. This council wouldn’t write rules or designate specific financial institutions as systemically critical, as Sheila had proposed, but would advise the Fed on which institutions should be designated and consult on the formulation of standards for those institutions. The council would also help member agencies keep informed about developments in parts of the financial system lying outside their immediate jurisdiction, provide a forum for the resolution of interagency disputes, and pool regulators’ insights to help identify emerging financial risks.

By including a version of Sheila’s proposal in the white paper, Tim and his administration colleagues had bowed to political reality. For one, Chris Dodd and Richard Shelby—far from giving the Fed more authority—were determined to strip us of our supervisory duties, leaving us responsibility for monetary policy alone. Dodd envisioned combining all of the bank supervisory agencies into one mega-agency. Reacting to Tim’s plan, even with the inclusion of the regulators’ council, Dodd said, “Giving the Fed more responsibility . . . is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.” I thought that Dodd’s comments were less about principle and more a reflection of his assessment that bashing the Fed was politically popular. Shelby was also eager to leverage anti-Fed sentiments. However, even Barney Frank, who had leaned toward designating the Fed as the financial stability regulator, switched to the council-of-regulators concept after the controversy over the AIG bonuses erupted in mid-March. He judged that making the Fed the financial stability regulator had become politically impossible. I trusted Barney’s political instincts and concluded that fighting the council proposal would be fruitless. In any case, I was getting more comfortable with the idea as I better understood how the council would work.

The administration’s reform plan included a host of other measures. It sought to drag the shadow banking system, where so many of the bad securities had originated, into the sunlight. For example, it would require that mortgage lenders or securitizers retain some “skin in the game” (some of the credit risk should the loan default)—a particular goal of Barney Frank.

The plan would also strengthen the regulation of derivatives, such as those that had contributed to AIG’s deep losses. Importantly, it would require that more derivatives transactions be standardized and

cleared centrally on exchanges, rather than settled privately between the parties to the contract. Open and transparent derivatives trading would help regulators and others better understand the interconnections among firms and markets. Also, because most exchanges, backed by their members, guarantee that transactions will be honored even if one party to the transaction defaults, trading most derivatives on exchanges would help limit contagion if a large firm unexpectedly failed. To help ensure that the exchanges themselves operated safely, the Fed—in its capacity as systemic stability regulator—would gain new supervisory authority over exchanges and other organizations playing similar roles in the financial system.

IN CONTRAST TO Hank’s blueprint, which had envisioned a radical simplification of the regulatory bureaucracy, the administration’s more evolutionary proposal left the existing set of regulators largely intact. Political practicalities were an important consideration. For example, Tim and his colleagues opted not to propose merging the SEC and the CFTC, though many of the financial markets and instruments they regulated served similar purposes. (The SEC regulates corporate bond trading, while the CFTC oversees trading in bond futures contracts, for example.) Merging the SEC and CFTC was a political nonstarter because they were overseen by separate committees in Congress. The congressional oversight committees jealously guarded their turf because the market players regulated by the two agencies could be counted on to provide lucrative campaign contributions.

The plan did include two changes in the regulatory bureaucracy—one relatively minor, the other more significant. The minor change was the abolishment of the hapless Office of Thrift Supervision, the regulator of savings institutions. Two big S&Ls (Washington Mutual and IndyMac) had failed on its watch, and another (Countrywide) nearly failed. Also, nominally, the tiny thrift office had been responsible for overseeing AIG’s far-flung operations. Under the administration plan, the thrift office’s duties would be assumed by the other banking regulators.

The more significant change was the proposed creation of a Consumer Financial Protection Agency. A 2007 article by Harvard law professor Elizabeth Warren, who was later elected to the U.S. Senate from Massachusetts, provided the impetus. In the article, Warren had called for a Financial Product Safety Commission, which would protect consumers from faulty credit cards and defective mortgages, just as the Consumer Product Safety Commission protects consumers from toasters that burst into flames. Hank’s 2008 blueprint had a somewhat similar idea, the “business conduct” agency, except that it would have protected stock and bond investors—as well as borrowers and users of financial services—from shady practices. (The administration proposed to leave investor protection with the SEC.) We had gotten an early hint that the new administration was leaning toward moving consumer protection duties outside the Fed when, about four weeks before the inauguration, Don Kohn reported on a conversation with Dan Tarullo, then a leader of Obama’s transition team. Tarullo raised “the possibility of consumer migrating elsewhere,” Don said.

I was ambivalent about the proposal for a new consumer protection regulator. The Fed, like the other bank regulatory agencies, enforced federal consumer protection laws in the institutions it supervised— roughly five thousand bank holding companies and more than eight hundred state-chartered banks that had joined the Federal Reserve System. We also wrote many of the detailed rules needed to implement consumer protection laws. I had acknowledged on numerous occasions that, for a variety of reasons, the Fed had not done enough to prevent abuses in mortgage lending before the crisis. But, under the leadership of division director Sandy Braunstein and with my strong encouragement, the Fed’s consumer protection staff had made great strides. They were particularly proud of the regulations banning unfair mortgage lending practices adopted by the Board in July 2008 under the Home Ownership and Equity Protection Act, and of our sweeping reform of credit card regulations, approved in December 2008.

Our new credit card rules overhauled the disclosures required at account opening and on monthly statements, based on our extensive testing with consumers. They also protected card users from unexpected interest charges and required that they get a reasonable amount of time to make their payments, among other measures. Our reform would serve as the basis for the Credit Cardholders’ Bill of Rights, which became the Credit CARD Act of 2009, passed by Congress in May at the urging of the Obama administration. A few news articles noted that the bill largely reflected regulations that the Fed had already adopted, but for the most part our contributions were ignored.

Still, I understood the Obama administration’s argument for having a single agency devoted to protecting consumers of financial services. It was the one provision in their plan that they could unambiguously depict as a win for Main Street. Most central banks don’t have a role in consumer protection, so I could hardly argue that it was at the heart of our mission. In terms of legislative priorities, I thought it more important for us to maintain our significant role as a safety-and-soundness bank regulator and to increase our role in macroprudential, systemic regulation. The tipping point for me may have been a meeting of the Board’s Consumer Advisory Council, a panel that included both lenders and consumer advocates. I asked the council members whether they thought the Fed should keep its consumer protection authorities. Even though the members had worked closely with Fed staff for some years and had seen our increased activism, a sizable majority said they preferred a new agency. In the end, as in the case of Sheila’s financial stability council, I didn’t actively resist the administration’s plan to take away the Fed’s consumer protection authority.

Unsurprisingly, my decision caused dismay among affected staff members. Sandy Braunstein organized a town hall meeting so I could hear their concerns. I pointed out that, even if we fought, we were unlikely to win. I also explained that the law would likely give each of them the right to transfer to the new agency, retaining pay and seniority, if they chose. But it was a tough meeting. They all cared deeply about protecting consumers and had worked long hours to develop the new rules, only to receive what they perceived as a vote of no confidence. I understood and shared their frustration.

Date: 2016-04-22; view: 650