hen the September 2008 financial crisis roiled markets around the world, it set in motion a re-examination of how banks manage their retail and investment sectors and spurred reforms designed to prevent another meltdown. In July 2010, the United States passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires that large financial institutions have “living wills” that spell out how they will protect assets in the event of a crisis and even plan for resolution or bankruptcy. In September 2010, global banking regulators announced the Basel III reforms, which require the largest banks to triple the size of their capital reserves. The Vickers Report, released in September 2011 by the Independent Commission on Banking, would require Britain’s large banks to protect private checking accounts, mortgages and other retail operations with a “ring fence” that would screen out riskier investment and global banking activities.
FTI Consulting recently gathered six of the world’s top financial leaders to discuss the financial crisis, the new reforms, and whether they can truly protect global markets from another meltdown. Discussion leaders were former Federal Deposit Insurance Corporation Chairman William M. Isaac, who is now Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, and Stephen Kingsley, Senior Managing Director in FTI Consulting’s London office. The panel comprised Mark Carawan, Chief Internal Auditor at Citigroup; John C. Dugan, former Comptroller of the Currency and now a partner at Covington & Burling; Cornelius K. Hurley, Director of Boston University’s Center for Finance, Law & Policy and Senior Provost Fellow Professor of the Practice of Banking Law; and Simon Samuels, Managing Director, European Banks Equity Research at Barclays Capital.
WILLIAM M. ISAAC: We have four topics to cover, and we will lead off with John Dugan. The first question: Will the global financial reforms prevent the next crisis?
JOHN C. DUGAN: I don’t think we’ll ever fully prevent the next crisis, whatever it will be. I do think it was very important to increase the amount of common equity capital in the banking system. Once we did that, the crisis began to ease. But there has been too little work done on developing liquidity standards for the banking system, and I don’t think what is being put in place now is right yet — it needs a lot of work.
ISAAC: Was Dodd-Frank necessary? Regulators have always had the authority to deal with capital and liquidity issues.
DUGAN: I think the most important thing was to raise capital across the board, not just in the United States but also in other countries. You need an agreement among regulators, but you didn’t need Dodd-Frank for that or for setting new liquidity standards. Dodd-Frank addresses those subjects, but they’re not really at the heart of what Dodd-Frank gets at. I do think some of the Dodd-Frank reforms were necessary, especially the regulation of systemically significant nonbanks — but some reforms went too far.
CORNELIUS HURLEY: We are not better off with Dodd-Frank, mainly because there’s no structural reform. We’ve just nibbled around the edges. The Vickers Report proposes real structural and competitive reform.
I would have recognized the too-big-to-fail genie for what it is: a loose, destructive spirit in the land. Dodd-Frank called every financial institution over $50 billion systemically important, and that’s just not credible. The Vickers Report suggests a much more reasoned approach. It would confine the retail bank and allow the separate investment bank to do proprietary trading.
SIMON SAMUELS: I personally think the crisis was fundamentally about credit underwriting standards and liquidity. And ultimately the reason why Lehman fell was not from its starting position of capital, which was fine. It was due to a liquidity failure because people didn’t trust the underwriting.
DUGAN: I also believe that if we’d had some bare minimum mortgage underwriting standards, real documentation of income and even modest down payments, the whole crisis would have been much smaller. I would say, though, that a lot of people thought Lehman was very undercapitalized.
ISAAC: When I was running the FDIC my highest priority was increasing tangible equity in the largest banks. Going into the recent crisis, many of the largest firms simply did not have enough tangible equity capital, and the regulators allowed them to get away with it. The liquidity crisis occurred in significant part because the markets perceived that the banks had insufficient capital in relationship to the risks in their portfolios.
HURLEY: I think the lawyers were to blame too. Entire legal careers are spent looking for ways around regulation. I don’t see anything in the culture of the legal profession that says lawyers won’t do the same thing with Dodd-Frank or the Vickers Report — “We’ll guide our clients around regulations rather than helping them to comply with the spirit of the law.” That’s the gorilla in the room that no one dares to talk about.
MARK CARAWAN: One of the areas that we’ve not focused on is the role of management. While we are looking at enhancing capital and liquidity regulation, we should also ensure that management is ultimately responsible and held accountable for ensuring adequacy. Do we need more rules or is there scope to better enforce the ones we have?
ISAAC: It seems to me that we in this country didn’t make the structural reforms to prevent this crisis from happening again. Dodd-Frank slapped the regulators on the wrist and said, “Start worrying more about capital and liquidity. Do your job right.” But regulators already had the authority to get out in front of this crisis and take action if they had recognized the problems and had the political will to deal with them.
DUGAN: As comptroller, one of the problems that I saw was that there were a lot of practices that were okay, not great, inside the banks. But they were much worse outside the banks. There was no way to have a common set of rules that applied to both banks and nonbanks. I think odd-Frank has addressed that, although at times in a very cumbersome way. We will now have common mortgage underwriting and risk retention standards for all mortgage providers, although a lot of regulators have to agree on the rules. The CFPB [Consumer Financial Protection Bureau, the new consumer protection agency] will set common consumer protection standards for all providers too. Also, while the SEC [Securities and Exchange Commission] did not do a good job of regulating some of the investment houses that had increasingly become like banks, these companies are now deemed bank holding companies and can be regulated as such.
ISAAC: Okay, that will have to be the last word, as we need to move to the second topic: “too big to fail.”
STEPHEN KINGSLEY: How you think about too big to fail depends on where you are in the world. The United States has been used to banks failing regularly. In the United Kingdom, until Northern Rock, the last time we had a run on a bank was when Queen Victoria was on the throne. The cost of rescuing the banking system in some countries, including my own, has been very substantial. In some places, like Ireland and Iceland, the impact is going to be felt for decades. And taxpayers may not have the appetite for repeating what they did in 2008 and 2009.
One question is whether larger financial institutions will be allowed to fail next time or whether the politicians will rush back in. And can one large firm fail without precipitating a wider market collapse?
CARAWAN: We should be figuring out how to put in place the appropriate frameworks to ensure that government agencies focus on a robust commercial solution and not a politically driven one. They should be ready to make the tough decisions and close down banks that are insolvent so that there are market consequences for those that don’t manage or restructure properly.
DUGAN: Does anyone think that the existence of too big to fail caused the crisis?
ISAAC: I think it played an important role. The perception that some firms are too big to fail diminishes discipline that would otherwise be present in the marketplace. The suppliers of wholesale funds and capital need to believe that they are truly at risk. If they do believe that, behaviors will change in banks. I do not believe things could have gotten so far out of hand precrisis had suppliers of capital and liquidity believed they were at risk. Once thecrisis hit, the government going back and forth — bailing out one large firm and then letting the next one fail — utterly confused the markets and created panic.
HURLEY: Too-big-to-fail banks get a subsidy because they can buy funds at a cheaper rate, just like Fannie [Federal National Mortgage Association] and Freddie [Federal Home Loan Mortgage Association] did, knowing the sovereign will come to their rescue. We should quantify that subsidy and require those banks to segregate it on their books as a reserve account. That reserve account would be capital in the event of a bankruptcy.
SAMUELS: I’ve never understood the idea that you’d somehow act recklessly if you get bailed out, because you would long ago have been fired. And from a shareholder’s perspective, you get wiped out. So this is purely about the debt market.
This is the kind of debate that you have years down the line but not months down the line. The funding markets are so extraordinarily fragile. There’s a lot of uncertainty in the wholesale funding markets in the United Kingdom because of the Vickers Report. The presumption is that if you’re outside the ring fence, your wholesale funding costs will be higher. You’ve seen senior bondholders suffer haircuts [absorbing losses] in Denmark, and now large Danish banks are struggling with funding.
KINGSLEY: The liquidators of Lehman faced problems on both sides of the Atlantic because Lehman was very complex. Lots of institutions continue to live in that complex global environment. And it strikes me that those organizations are going to find it very hard to do a proper living will.
ISAAC: The Vickers Report is essentially a living will. You take the part of the institution that the people on the street worry most about in a crisis — checking accounts, mortgages, small business lending — set that aside and then put the more complex parts in another part of the organization.
CARAWAN: Both retail and commercial customers want global capability, low cost and instant information about their accounts. To compete in the marketplace means that you offshore, outsource and have service centers around the world in many jurisdictions. In a crisis, each regulator will ring fence activities in its own jurisdiction and follow its own course to stabilize its marketplace and resolve insolvent institutions. To structure readily resolvable global institutions is very complex and will involve huge organizational coordination, a web of service-level agreements and ample time to make things happen. One must not underestimate the challenge.
ISAAC: Let’s turn to question three: Are we focused too much on regulation and too little on improving prudential supervision of financial institutions?
SAMUELS: I think ultimately credit bubbles will damage financial institutions when the bubbles burst, regardless of what supervisors do. And arguably banks in some of the bestsupervised systems in the world, like Spain, have suffered terribly as the credit and housing market bubbles collapsed. I also think the complexity of some of the new rules that they’re being asked to apply represents a huge impediment to economic recovery.
The macro prudential angle is very important. Fixing things like the structure of the U.S. housing market, the nonrecourse lending in many states and loan-to-value caps would help the industry tremendously to withstand subsequent cycles and avoid bubbles.
Also, the Basel III capital framework includes a buffer to deal with market bubbles. The idea is that capital requirements will increase as a cycle reaches a crescendo, essentially to choke off that last piece of the bubble. In theory that could help enormously. But somebody has to decide, “We’re in a bubble and it’s now time for that buffer to kick in.”
KINGSLEY: A highly empowered, rightminded person at the center of the financial system in each country could say, “That’s enough, guys. We’re now going to stop the party, and we’ll raise capital requirements for particular kinds of loans. We will actually outlaw particularly unsound loan-to-value ratios,” or whatever it happens to be. And the fascination for me is: In a democracy, how do you actually empower somebody who can face off against the elected politicians?
ISAAC: I’m old enough to recall when the Federal Reserve, back in the 1970s, got concerned about the economy, and it told expansion-minded financial companies, “No. Your capital is too low, considering how overheated the economy is getting. Increase your capital and then we’ll think about your application.” We need to get back to the days when regulators actually had to think and use judgment.
The system needs firm underwriting standards, and firm capital and liquidity standards. And we need to allow the examiners to go in and actually look at assets and off-balancesheet exposures. That’s the job of management and the board of directors first, and regulators are a check on that system. But they should all
be using some judgment rather than just blindly relying on flawed models they don’t really understand — models that told us that residential real estate loans and sovereign debt were relatively riskless assets.
DUGAN: I think you do need some firm rules; it can’t be all about discretion and judgment. I just don’t know how much of this you can legislate — how much you can tell someone to be a better supervisor. When the system goes wrong, it’s hard to sort out how much failed supervision or failed regulation was at fault. The only way policymakers can react is with increased regulation. They can’t mandate better supervision.
KINGSLEY: That is a perfect segue to the last discussion topic: the impact — unintended or intended — of these regulatory and other changes on the banks and the economic recovery.
SAMUELS: I see a very slow economic recovery happening. I expect credit shrinkage or very anemic credit growth and I see banks being required to hold more capital. But I am just not sure that there is a clear linkage between all three. I think it is realistic to expect that when a recession was created by too much debt, then its recovery process will likely result in lower levels of debt. Whether or not banks need more capital now, it’s entirely reasonable to expect the economic recovery to be very sluggish because that is what usually happens after a financial crisis. I should also point out that the banking industry in Europe spent the whole of the 1980s and 1990s generating a return on tangible equity below its cost of equity. Today the bankers cry, “If you do this and this, our return on equity will go down too much and it will be unacceptable to our stakeholders and eventually we won’t be able to provide credit for the economy.” But throughout the ’80s and ’90s, economic growth across Europe was fine.
ISAAC: I’m chairman of Fifth Third Bancorp, and it has increased its capital rather dramatically. The bank is eager to make loans, but it can’t find enough decent ones to grow the loan book after you net out the paydowns of existing loans. A lot of people are deleveraging voluntarily or they’re bypassing the banking system and going right into the markets to lock in long-term debt at low rates. Having said that, if we keep increasing capital and liquidity requirements and imposing other significant regulatory burdens on banks, credit will continue to be less available and more expensive, which will impede economic recovery.
HURLEY: In each of our countries, the largest five or six banks occupy about 80% of the banking system, so they dominate the field. Their too-bigto- fail subsidy, depending on whose study you read, is between 25 and 75 basis points. In this kind of economy, there’s little incentive for the mega banks to do anything that is going to stimulate the economy when they can sit back and enjoy the bounty of that subsidy. So I think this question of the subsidy is linked inextricably with the capital issue and the timing of when we emerge from this crisis. Until there’s a sense of urgency, we will not get out of it.
DUGAN: I’m not sure I agree with that, for the reason Bill said. I think bankers make money through loans and want to put that capital to work — especially in a low interest rate environment where they can’t earn much spread by investing in Treasury securities or Fed funds. So I think they have every
incentive to try to make loans right now; it’s just hard to find them.
HURLEY: And the No. 1 problem facing bank management these days is “What do we do with all this money?” Banks in New York have started charging large depositors to put deposits in the bank!
SAMUELS: I think one of the enduring features, post–financial crisis, is that the idea of a level playing field goes out the window. Take capital: If you’re a regulator of a very large banking system that collapsed, your view toward how that should be regulated would differ from the view of a regulator of a smaller banking system that didn’t collapse. And so the United Kingdom’s starting point is a banking system that is, depending on how you measure it, between five and six times the gross domestic product of the United Kingdom. The starting position of the United States is a banking position that is a tenth that size relative to the U.S. economy. And so the chances of those two regulators agreeing on the same magic capital ratio number, I’d say, is zero.
HURLEY: When we use the term regulation, it means different things to Republicans and Democrats [in the United States]. Just the word regulation has become an attack these days. Regulation comes in many forms — I have a list of about 35 different types. And some of those regulations are really designed to promote market discipline, especially in the area of disclosure. So often the debate about regulation or overregulation or underregulation ends up being just a political diatribe where the parties never really have a discussion. They never start from the point, “What are we trying to accomplish, and what is the least burdensome way of getting there?” If we could just have that discussion, we might get to a place that yields a stronger, more resilient financial system that fosters sustainable economic growth.
ISAAC: That is a perfect thought to end on, Con. I wish we could continue all day, as this has been a fascinating discussion. Thanks to each of our panelists for taking the time to share your thoughts and wisdom.