Fed’s George:Policymakers Need Resolve To End Too-Big-To-Fail

By Steven K. Beckner

(MNI) – Kansas City Federal Reserve Bank President Esther George
said Wednesday that the federal government’s “too big to fail” policy
regarding large financial institution and other misguided government
incentives helped cause the financial crisis and said that if future
crises are to be avoided those policies must change.

George, in remarks prepared for delivery to a Levy Economics
Institute conference in New York, stressed that policymakers must not
shrink from using the new orderly resolution powers included in the
Dodd-Frank financial reform bill and shut down large financial
institutions when they get into trouble.

She also emphasized the need for more capital and constraints on
banks’ activities.

Although she did not talk about the economy or monetary policy in
her text, she did note that very low interest rates were a contributing
factor to the housing bubble that burst in 2007 and led to a near
implosion of the financial system.

George, a former bank examiner and protege of former Kansas City
Fed President Thomas Hoenig, warned against complacency and inertia in
reforming banking supervision.

“Many policymakers and market participants thus become reluctant
when it is time to make the hard judgments about effective reforms and
instituting greater risk restraints,” she said. “Signs of this are
already occurring with the efforts by financial institutions and others
to weaken or delay stronger capital standards and other provisions of
the Dodd-Frank Act.”

George blamed the crisis on a combination of factors, including the
fact that “both the private marketplace and regulators had become
complacent and greatly underestimated the risks taken on by our
financial system. Too many were convinced that we had entered a new era
and fully believed that we had new tools that could more accurately
measure, price and control risk, even as financial instruments became
far more complex and often were untested.”

“Another factor in the crisis was misguided incentives to take on
more risk,” she said. “These included low short-term interest rates that
encouraged financial institutions and other market participants to
‘borrow short and lend long’ and to ‘search for yield.’”

“These funding and lending incentives, along with other factors
such as the low Basel risk weights assigned to certain financial
instruments, further motivated major institutions to adopt very similar
risk exposures,” she continued. “These exposures, in turn, contributed
to the liquidity and funding breakdowns that were central to this

“Other misaligned incentives included the belief that larger
institutions were ‘too big to fail’ and the implicit guarantees behind
the government-sponsored enterprises and certain other parts of the
financial system-all of which gave creditors and stockholders added
protection from default and less reason to be concerned about risk,”
George said.

Underlaying these faulty government policies, she said, was a
change in the financial “culture,” such that there was “a complacency
and false confidence in new risk management practices and a substantial
and largely unrecognized build-up in leverage and risk that laid the
groundwork for this crisis.”

Looking ahead, George said, “If we are to construct a stronger
financial system, we must address the significant problems and obvious
shortcomings that led to the crisis.”

“First and foremost is to correct the misaligned incentives and the
improper expansion of federal safety net protections that encouraged and
enabled institutions to take excessive risks,” she said, adding that
“the most important challenge we face is in constructing an appropriate,
but carefully limited, public safety net.”

“During this crisis, our safety net was stretched far beyond
anything we had previously done, and this expansion in safety net
protections has left us with a broad and pervasive range of moral hazard
issues,” she noted. “Not only did we expand deposit insurance coverage
during the crisis, but we also guaranteed bank debt instruments, used
the discount window to lend to nonbank institutions and conduct special
lending programs, and bailed out large institutions and segments of the
financial markets not covered by the traditional safety net.”

“The largest financial institutions in the United States further
received significant injections of public capital through TARP,” she
went on. “Some would argue the only ones not protected from losses were
the taxpayers.”

The biggest problem, she suggested, is the “too-big-to-fail” policy
of extending the federal safety net to protect the largest banks.

“This link between large institutions and special public support
has left us trapped in a pattern in which public authorities believe
they must expand the safety net each time a crisis is brought on by
excesses in risk-taking at large institutions,” she said. “This
broadening of the safety net facilitates the next and even more severe
crisis, as new moral hazard issues are introduced and major institutions
are left with greater incentives for taking on risk.”

“The critical and defining question for us is how to break this
pattern of growing safety nets and escalating crises, while restoring
much-needed market discipline to the financial system,” she added.

George said “the first and most important step that we can take is
to eliminate TBTF policies.”

Because of those policies, she said the largest banks enjoy
“enormous” funding, capital and other advantages and take excessive

The Dodd-Frank Act gave the Federal Deposit Insurance Corporation
orderly liquidation authority for resolving the failure of a
“systemically important” financial institutions. But she said “having
this legal framework … is only the first, and perhaps easiest, step in
dealing with TBTF.”

For that authority to exert a disciplining influence on bank
behavior, she said, policymakers must have “the resolve to follow

“In a crisis, there will always be concerns about creditor or
depositor panics, public confidence issues, interconnections with other
institutions and disruptions in financial services,” she said, adding
that “ending TBTF is the only sure way to curtail the expansion of
public safety nets and break the pattern of repeated and ever-escalating
financial crises.”

George said a second important step is to “strengthen bank capital
standards with particular emphasis on leverage requirements tied to
equity capital.”

“In addition, we should weigh carefully the lengthy transition
period contemplated by Basel III,” she said, because “there is risk that
banks will be caught short again if we adopt a lengthy phase-in period
and let banks manage their capital down to the minimum transition
standards through substantial dividend payouts and stock buybacks.”

George said she also favors “some constraints on the type of
activities that can be conducted by institutions protected by the safety

“The expansion in activities conducted by banking organizations
over the past few decades has greatly increased the level of complexity
in such organizations, making effective management and supervision of
these entities much more difficult,” she said.

** MNI **

[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$,M$$BR$]

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