IN THE WEEKS after the release of the Treasury plan, Tim’s staff put the administration’s broad proposals into legislative form, and Barney Frank introduced a series of bills based on them. From mid-October through early December 2009, his committee met to consider amendments to the bills. Barney ultimately combined the results into one gargantuan bill—1,279 pages. It cleared the full House on December 11 by a vote of 223 to 202, with no Republicans in favor.
There were compromises along the way. In September, even before his committee considered the legislation, Barney had cut a deal with Camden Fine, president of the Independent Community Bankers of America, an organization representing more than five thousand community banks. Fine’s bankers were wary of the new consumer agency. They did not want an additional bureaucracy to deal with. But Fine agreed not to lobby against it—so long as Barney exempted banks with less than $10 billion in assets (virtually all of Fine’s members) from regular examination by the new agency. The consumer agency would still write the rules for all lenders, large and small, but would enforce the rules only in big banks. The Fed, the OCC, and the FDIC would continue to examine smaller institutions for compliance with the regulations.
Barney agreed to Fine’s demand because he needed to split the banking industry on the question. United, it might have had the political strength to torpedo the consumer protection agency. The large banks continued to oppose it, but with popular anger at Wall Street still intense, few politicians were willing to stand with them, at least publicly. Moreover, virtually every member of Congress had at least one community bank in his or her district. Fine, a square-jawed former small-town banker from Missouri, as well as the former director of the state’s tax division, was a shrewd and vigorous advocate for small banks. He believed, with justification, that they had little to do with causing the crisis and were in danger of being punished for big banks’ sins. I met with him regularly and addressed his group’s annual convention nearly every year that I was in office. In the fall of 2009, community bankers seemed to be one of the few outside groups backing the Fed.
In the meantime, we faced assaults on the Fed’s independence from the far right and far left. Two such campaigns, though, were gathering momentum under the banner of transparency: one to “audit” the Fed, and the second to disclose which firms had borrowed from our discount window and our emergency lending facilities during the crisis. Both measures seemed reasonable on their face—and thus difficult to counter—but both posed serious threats to the Fed’s effectiveness and ability to make policy free of political pressure.
I found the audit-the-Fed campaign the most frustrating—mostly because our books and operations are, and long have been, intensively audited. By constant disingenuous repetition of their “audit the Fed” slogan, however, and by intentionally inducing confusion about the meaning of the word “audit,” proponents managed to convince people that we were somehow exempt from scrutiny. Who could be against auditing an organization with a balance sheet the size of the Federal Reserve’s? In fact, the financial statements of the Reserve Banks are audited by a private outside accounting firm, and the
Board’s financial statement is audited by an outside firm retained by our independent inspector general’s office. All this information, together with the auditors’ opinions, is made public on the Board’s website. And, as with most federal agencies, our inspector general’s office conducts wide-ranging investigations and reviews of the Board’s operations.
On top of this full range of financial audits, the Government Accountability Office (GAO), which reports to Congress, evaluates the efficiency and integrity of all the Board’s operations, with one crucial exception—monetary policy decision making. The GAO’s reviews are not audits, in the common meaning of the term (a review of financial statements). Instead they review policy and performance. While often valuable, these reviews are quite different from an audit in the usual sense. Congress had decided in 1978 to exclude monetary policy—but not other Federal Reserve functions such as banking supervision—from GAO review. The exclusion reaffirmed the understanding that the Fed, to make monetary policy in the longer-term interests of the economy, must be free of short-term political pressure. In lieu of GAO reviews, Congress required regular reports and testimony on our actions in pursuit of the goals it had given us: maximum employment and price stability.
The careful congressional compromise between holding the Fed accountable, on the one hand, and protecting it from undue political pressure, on the other, would have been shattered by audit-the-Fed provisions, which would have allowed the GAO to review any aspect of monetary policy decision making, including second-guessing decisions made at particular meetings. Since GAO reviews are generally initiated by members of Congress and often reflect a political objective, the reviews could easily become vehicles of harassment. I exaggerate only slightly when I tell audiences that, if they are impressed with Congress’s management of the federal budget, they should support audit-the-Fed legislation to give Congress the responsibility for making monetary policy as well.
The audit-the-Fed movement, in the House, was led by Ron Paul of Texas, an obstetrician-turned-congressman who retired from Congress after 2012. His son Rand Paul was elected to the Senate in 2010. The elder Paul, who ran for president on both the Libertarian and Republican tickets, spoke fondly of the gold standard. The audit-the-Fed leader in the Senate was Bernie Sanders from Vermont, the self-described democratic socialist. Paul and Sanders shared a strong populist streak. They distrusted technocratic institutions like the Fed, as well as what they saw as the excessive concentration of financial power in few hands. A dose of populism is healthy for any democracy. It reminds us that the government is supposed to serve the people and warns us to be wary of undue influence exerted by powerful elites in government and industry. Policymakers, including me, needed to hear those messages. But in extreme forms, on either the left or the right, populism can also lead to cynical manipulation of legitimate public anger and to contempt for facts and logical argument. When these aspects of populism dominate political discourse, good governance is nearly impossible.
I never worried particularly about my personal encounters with either Paul or Sanders. There was a refreshing purity to their views, which seemed often unaffected by real-world complexities. The principal
difference between the two, other than their ideologies, was that Sanders had a tendency to shout until he was red-faced while Paul usually rambled amiably. Paul’s thinking, though, veered toward conspiracy theories. To justify his push for intrusive GAO reviews of monetary policy, he alleged in a hearing in February 2010 that the Fed had supplied the cash used in the Watergate burglary and that the Fed in the 1980s had facilitated a $5.5 billion loan to Saddam Hussein, which the Iraqi dictator spent on weapons and a nuclear reactor. In surprise, I dismissed the allegations as “absolutely bizarre,” a judgment later confirmed by an extensive investigation by the Board’s inspector general.
Each man, compared with most politicians, could on occasion demonstrate disarming honesty. I told Paul, in a May 2009 hearing of the Joint Economic Committee, that auditing the Fed, as he and his allies construed it, seemed like an attempt to dictate to the Fed how to make monetary policy. In response, he readily acknowledged, “Of course, it’s the policy that’s the only thing that really counts.” After the release of his 2009 book End the Fed, Paul stated plainly that he saw auditing the Fed as a “stepping stone” to eliminating it. I had cordial private discussions with the congressman, including over breakfast at the Fed. He was certainly sincere, but his thinking was dogmatic. He lacked a clear understanding of how the historical gold standard actually had worked (as opposed to the idealized version).
Paul, working on the House Financial Services Committee with Florida Democrat Alan Grayson, succeeded on November 19 in inserting an amendment removing the monetary policy exemption for GAO reviews—despite opposition from Barney and North Carolina Democrat Mel Watt, who would later head the agency overseeing Fannie Mae and Freddie Mac. (Grayson was a fitting partner for Paul. He was an extreme anti-Fed populist despite having earned multiple Harvard degrees, and he delighted in badgering me and other Fed representatives at hearings.) The next day, Warren Buffett, in a CNBC interview, warned Congress not to fool around with the Fed’s independence. Senator Judd Gregg of New Hampshire threatened to filibuster any legislation with the Paul amendment when it reached the Senate.
Compared to the audit-the-Fed crowd, I had a bit more sympathy for lawmakers pushing us to disclose the identities of our borrowers. Transparency, in central banking and in government generally, is vitally important, especially when great power is being wielded. At the same time, I knew that immediate transparency in this instance would pose a serious problem during any future financial panic. If we were forced to immediately disclose the identities of borrowers, all but the most desperate banks would shun the discount window. That would cripple our ability to lend freely and thereby calm panics, as central banks had done for centuries.* Unfortunately, many of our critics conflated our more than fully collateralized, short-term liquidity loans to solvent institutions with the much longer-term loans associated with the rescues of teetering institutions such as Bear Stearns and AIG. Our liquidity loans weren’t gifts to individual institutions; they were an effort to replace funding that had evaporated in the panic. We lent to financial institutions because we wanted to keep credit flowing to their customers, including families and Main Street businesses.
Still, I understood when Bernie Sanders said it was difficult to go home and tell his constituents,
“Your money was lent out and we don’t know where it went.” I decided to push the Fed’s transparency envelope. For many years, as required by law, we had published a weekly summary of our balance sheet in a little-noticed release known internally as the H.4.1. Board staff had developed a new website, unveiled in February 2009, to make that information more accessible. It included detailed information about each of our crisis-era lending programs and an interactive chart showing balance sheet trends. I also asked Don Kohn to head an internal task force to review our transparency practices with the goal of releasing as much useful information as possible. In June 2009, we started issuing monthly reports on our lending that included new information on the number of borrowers, borrowing amounts by type of institution, and collateral accepted by type and credit rating. With the financial system and the economy far from out of the woods, however, we continued to resist naming names, even in the face of Freedom of Information Act (FOIA) lawsuits from Bloomberg News and Fox News.
WHILE THE LEGISLATION wound its way through Congress, we reflected on the shortcomings of our own banking supervision and began working to improve it. Turning once more to Don Kohn, I asked him to lead other policymakers and staff at the Board and Reserve Banks in developing a list of “lessons learned”—both for bankers and for our own examiners. Throughout 2009, implementing recommendations flowing from Don’s project, we insisted that U.S. banks add loss-absorbing capital, increase their liquid assets that could be sold in a run, and improve risk management. We pushed our examiners, when they uncovered shortcomings, to press harder for corrective action and not to hesitate to bring concerns to top managers at banks.
Dan Tarullo led our supervision reform efforts. Deeply knowledgeable, stubborn, and sometimes impatient, Dan was in many ways the ideal person to take on the change-resistant Federal Reserve System. With my support, Dan reduced the supervisory autonomy of the Reserve Banks—the goal that Sue Bies had been unable to attain in 2005. His efforts resulted in greater consistency in supervision across districts and more coordinated oversight of the largest institutions. He was hard-charging and sometimes ruffled feathers, but the Fed’s supervisory culture gradually began to change. Breaking down organizational silos within the Fed, we built on the multidisciplinary approach used in the big-bank stress tests in the spring of 2009, and, increasingly, our supervisors, economists, attorneys, accountants, and financial experts worked in teams. When Roger Cole retired in August 2009 as director of the Board’s Division of Banking Supervision and Regulation, we replaced him with Pat Parkinson, the senior economist we had lent to Treasury to work on financial reform. Pat personified the wider perspective we were trying to bring to bank supervision. He had never worked as a rank-and-file examiner, but he possessed deep knowledge of the financial system and its role in the economy, and he brought “outsider’s eyes” to directing the work of the division.
Besides changing our own culture, we also aimed to change the culture at the banks we oversaw, requiring senior managers and boards to pay more attention to factors that had led to excessive risk taking
before the crisis. For example, we and the other bank regulators told the banks that compensation should be tied to long-term performance, not to short-term profits gained through risky bets. We applied that principle not only to senior executives but also to lower-level employees, such as traders and loan officers, whose decisions could put banks at risk.
CONGRESS’S WORK WAS naturally focused on domestic regulation, but new rules and tougher supervision for U.S. banks alone wouldn’t ensure stability in a globalized financial system. Without international coordination, tougher domestic regulation might result only in banking activity moving out of the United States to foreign financial centers. Moreover, even if foreign jurisdictions adopted comparably tough rules, in the absence of international coordination those rules might be inconsistent with U.S. standards, which could fragment global capital markets and otherwise diminish the effectiveness of new rules. The potential solution to these problems lay in Basel, with the Bank for International Settlements. The BIS, besides being a gathering place for central bank governors, was also the host of an international forum called the Basel Committee on Banking Supervision. More than two dozen countries, including major emerging-market economies, were represented.
Early in September 2009, the Basel Committee began negotiations over new international requirements for both bank capital and liquidity. Dan Tarullo, Bill Dudley, and I represented the Fed in these discussions. The FDIC’s Sheila Bair and Comptroller of the Currency John Dugan completed the U.S. delegation. The negotiations led to an agreement that would be known as the Basel III accord. The first Basel accord, completed in 1988 and now referred to as Basel I, had established the principle of risk-based capital—that is, that banks should hold more capital to absorb potential losses from risky assets, such as business loans, than they do to absorb potential losses from relatively safer assets, such as government bonds. However, over time, banks had found ways to circumvent Basel I’s rudimentary risk weightings, either by loading up on assets that met the definition of low-risk under the rules but actually carried higher risk or by pushing riskier assets into off-balance-sheet vehicles (as Citi did with its SIVs). A second agreement, unveiled in 2004 and known as Basel II, established a more sophisticated (but also very complex) approach to calculating capital needs at the largest banks, overseen by the supervisors but relying in part on the banks’ own risk models. These new rules for determining the amount of capital to be held against each type of asset (never fully implemented in the United States) were intended to discourage banks from gaming the system but did not aim to raise or lower the total amount of capital held by banks.
However, as we now were painfully aware, many banks around the world had come into the crisis without enough capital. Consequently, a primary goal of Basel III was to increase the capital held by banks, particularly the systemically important institutions whose operations crossed international borders. The new accord, released in December 2010, called for increased capital requirements in general and also an extra “countercyclical” capital buffer. The buffer would ensure that banks built up their capital in good times, so that they could absorb losses and keep lending in bad times. The following year, the Basel
Committee would add a requirement that financial institutions deemed systemically important would have to hold more capital than other banks.
Basel III also established a new international capital requirement—a minimum leverage ratio—in addition to the risk-based requirements. A leverage ratio is simply the ratio of a bank’s total capital to its total assets, without any adjustments for the riskiness of the assets. Unlike most other countries, the United States had required its banks to meet a minimum leverage ratio before the crisis, albeit at a relatively low level. Basel III extended the requirement to all internationally active banks; and U.S. regulators, including the Fed, would subsequently raise the leverage ratio for U.S. banks above the Basel minimum.
The leverage ratio, and where it should be set, stirred considerable controversy both in the international negotiations and domestically. Advocates of a high leverage ratio argued that the complex risk-based standards in Basel II and III are too easy for banks to manipulate—only the leverage ratio gives a real picture of bank capital, in their view. Opponents pointed out that a leverage ratio, unaccompanied by a risk-based requirement, allows banks to hold the same amount of capital against their riskiest assets as against their safest, which provides them an incentive to take on more risk. The reasonable compromise, I think, is to use both types of capital requirements, as we do in the United States, with the leverage ratio serving as a backstop—the suspenders to the belt of risk-based standards.
Basel III would ultimately tackle another important concern. During the crisis, some institutions met minimum capital standards but still came under significant pressure because they did not have enough cash and easily sellable liquid assets on hand to meet payment demands. For example, Wachovia Bank met regulatory capital standards but nearly failed (and had to be acquired by Wells Fargo) because its funding sources dried up. To address this issue, Basel III supplemented its tougher capital standards with new liquidity standards. By international agreement, banks would be required to hold enough cash and other liquid assets to survive all but the severest runs without having to turn to their central bank.
AS WE WORKED on Basel III, regulatory reform efforts continued in Congress. A month before the House passed Barney’s bill, Chris Dodd had unveiled his own 1,136-page opus. Unlike Barney, he had not started with the administration’s proposal, believing that only bipartisan legislation could clear the Senate, where the minority party has far more ability to block action than in the House. Unable to entice Richard Shelby into real negotiations, Dodd released a discussion draft of his proposed legislation on November 10, 2009. Shelby denounced it at a Senate Banking Committee session on November 19. In particular, Shelby could not accept the creation of a new agency to protect consumers of financial services, which he saw as unduly burdensome to banks and insufficiently accountable to Congress.
As I went through Dodd’s bill with the Board’s lawyers, I was pleased to see that it included a mechanism for the FDIC to safely unwind failing systemically significant financial companies, a key provision of the administration plan and a high priority of mine. But I was dismayed to see that he had stuck with his plan to strip the Fed of virtually all of its duties other than monetary policy. In addition to
losing both our consumer protection and bank supervision authorities, under Dodd’s bill we would also have little role in ensuring systemic stability. Instead, Dodd had proposed a new financial stability agency, to be led by an independent chairman appointed by the president.
I defended the need for Fed involvement in both bank supervision and fostering financial stability in an op-ed column published November 29, 2009, in the Washington Post—a common tactic for Washington policymakers but quite rare for a Fed chairman. “The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation,” I wrote. I argued that the Fed offered a unique mix of expertise and experience that couldn’t be replicated soon, if ever, at a new financial stability agency. Moreover, to serve as an emergency liquidity lender during a financial panic, we needed to understand both the sources of the panic and the conditions of firms that might borrow from us; for that, we needed some role in supervising financial institutions. Globally, post-crisis, the trend was toward central banks getting more, not less, responsibility for bank supervision and financial stability. For example, the Bank of England had lost the power to supervise banks in 1997 and, partly as a result, had been caught by surprise by the 2007 run on the mortgage lender Northern Rock. In 2012, Parliament would return bank supervision to the Bank of England and create a new Financial Policy Committee at the Bank, with responsibility for the stability of the British financial system as a whole. Similarly, the European Central Bank would be given an important new financial stability role and, in 2014, would begin supervising banks in the eurozone.
On January 6, 2010, Dodd announced that he would not seek reelection. His personal popularity and his influence in the Senate had eroded, in part because of a string of controversies, including allegations that Angelo Mozilo’s Countrywide had refinanced mortgages on Dodd’s homes in Connecticut and Washington at favorable rates. With no need to campaign, he could turn his full attention to one of the last important pieces of legislation in his thirty-six-year career in Congress. But Shelby’s vocal opposition meant that there was a lot more work to do to develop a bill that the Senate would approve. That would take time. It gave us some months to make our case to senators, on and off Dodd’s committee.
THE RESERVE BANK presidents were particularly alarmed at the prospect of losing bank supervision duties —one of the Reserve Banks’ primary functions. The banks had already endured rounds of staff layoffs over the previous decade as many of the Federal Reserve’s financial services, such as check clearing, were consolidated into fewer locations. In particular, with the advent of electronic check clearing, many employees who had once processed paper checks were no longer needed. Reserve Banks still participated in making monetary policy, distributed currency and coins, kept an eye on their region’s economies, and engaged in community development efforts—but a large proportion of their remaining employees examined and supervised banks and bank holding companies.
From the start, some presidents were skeptical about the Board’s commitment to keeping the full range
of our supervisory authorities. Tim Geithner and the administration were insisting only that Congress retain Fed supervision of the thirty-five bank holding companies with $50 billion or more in assets. Tim was willing to move Fed oversight of state-chartered member banks elsewhere—as was Dan Tarullo, if that was the price of keeping oversight of the largest institutions. I agreed that supervisory authority over the largest banks was crucial to the Fed’s ability to manage financial crises. However, I also wanted to retain supervision of the smaller bank holding companies, as well as the state-chartered member banks.
In part I was responding to the concerns of the Reserve Bank presidents, who saw the loss of supervision as an existential threat. But I also agreed with their substantive arguments. Losing the authority to supervise smaller banks could create a dangerous blind spot. Examining banks of all sizes, from all over the country, allowed us to better understand the industry as a whole and to detect potential problems earlier. Examining smaller banks also strengthened our connections with local communities and improved our ability to monitor economic developments at the grass-roots level, leading to better monetary policy. After all, who knows more about the local economy than a community banker? Whenever I could, I made the case for leaving the Fed’s supervision of both big and small banks unchanged. I raised the issue during the dozens of congressional meetings arranged as part of my reconfirmation process, and I made phone calls to many more legislators over the winter and spring. I also pressed the issue at congressional hearings.
I knew I could count on strong support from the Treasury and the White House for keeping the largest banks. Indeed, Dodd’s determination to freeze us out of bank supervision softened in large part because of a plea from President Obama during a meeting in the Oval Office. The bill Dodd would take to his committee in March 2010, in contrast with his November 2009 proposal, left us the supervision of bank holding companies with more than $50 billion in assets. Authority over smaller holding companies, in Dodd’s bill, was to be split between the OCC and the FDIC. Supervisory responsibility over the state-chartered banks that were members of the Federal Reserve System would go to the FDIC.
We were making progress, but the Reserve Bank presidents remained deeply concerned about Dodd’s latest proposals. The New York Fed supervised six of the top seven bank holding companies and ten of the top thirty-five. No other Reserve Bank supervised more than four of the top thirty-five, and two—St. Louis and Kansas City—supervised none. Kansas City, on the other hand, supervised 172 state-chartered banks, more than any other Reserve Bank. Not surprisingly, Kansas City Fed president Tom Hoenig, along with Richard Fisher of Dallas, led the Reserve Banks’ campaign to preserve their role in banking supervision. Hoenig met with senators on his own and organized meetings and calls with his fellow presidents. On May 5, 2010, he and three other Reserve Bank presidents met privately with a group of legislators. His activities threatened to undermine our efforts to speak to Congress with something approaching a unified voice. Hoenig sent Board members and Reserve Bank presidents a summary of his meetings with senators and wrote, “The leadership of the Fed (especially the Chairman) must get aggressive.” In fact, despite my understated style, I was as aggressive on this issue as on any during my
time in Washington. In one phone call with Senator Bob Corker, I pushed for retaining Fed supervision of state-chartered member banks so forcefully that he upbraided me for acting like a lobbyist.
The Fed’s tradition of collegiality ultimately prevailed, and Board members and Reserve Bank presidents were able to work together. In July 2009 the Board had hired a new congressional liaison director, Linda Robertson, who had served in a similar capacity in the Clinton administration’s Treasury Department. A Capitol Hill veteran who seemed to know every single staffer and member we dealt with in Congress, Linda understood viscerally how the institution worked and how its members responded to incentives and pressures. She worked hard to make our case and to keep the presidents informed and singing, if not in perfect harmony with the Board, at least from the same hymnal.
In the end, despite some frictions, I credit the Reserve Bank presidents with helping the Fed navigate a period of great political peril. Many of them made good use of relationships with local legislators that they had cultivated over the years. Hawks like Hoenig reminded like-minded legislators that the Fed was not a monolith, and that their views on monetary policy were being represented within the institution. The Reserve Banks had also developed broad and deep ties in their districts through their private-sector boards, the boards of their twenty-four branch offices, members of advisory councils, and former directors. Thus, dozens of prominent citizens in each district belonged to what we liked to call “the Fed family.” Many of them offered to go to bat for us in one capacity or another. Their efforts helped, although Linda strove to coordinate communications with Congress and to limit freelancing, which she feared would do more harm than good.