WASHINGTON (MNI) – The following is the second of three sections of
the text of the remarks of Kansas City Federal Reserve Bank President
Thomas Hoenig prepared for the William Taylor Memorial Lecture Sunday:
What Federal Reserve chair, FDIC chair, or secretary of Treasury
would risk an economic collapse when by making some creditors whole, the
panic might be stopped? And I can assure you that when the regulatory
authorities begin the process for recommending receivership, they almost
certainly will find themselves facing an atomic force of resistance from
those at risk.
I have another practical reason for doubting that our
too-big-to-fail problem has been solved. Prior to Dodd-Frank, the Bank
Holding Act allowed regulators to force the termination of activities or
sale of subsidiaries that are a risk to the safety and soundness of an
affiliate bank. To my knowledge, this authority has never been
successfully used for a major banking organization.
The reality is that unless the rules are written so tightly that
there remains no bailout option, we cannot be confident that “too big to
fail” has ended.
Volcker Rule
The possible continued existence of “too big to fail” highlights
the importance of other provisions of the Act, especially the Volcker
Rule.
It has been noted that commercial banks hold the franchise for our
nation’s payments system. They carry the responsibility of trusted
intermediary for our deposits used in payments and trusted repository
for much of our savings and trust assets. These critical roles explain
why commercial banks are provided a substantial safety net – which
includes access to the enormous resources of the central bank and
deposit insurance.
For several decades following the Great Depression and the reforms
of that time, it was understood that commercial banks would be afforded
these special protections and privileges but in return they would be
limited in their risk-taking. The Glass-Steagall Act codified this
understanding.
In 1999 with the Gramm-Leach-Bliley Act, the separation of
commercial banks and the more highly risk-oriented investment banks was
ended under the rationale that it would enhance competition and extend
services to the public. The largest institutions lobbied extensively for
this change using their great wealth and influence to see it
successfully passed.
Some of us who had experienced the chaos of the ’80s, including
individuals like Paul Volcker and Bill Taylor, had long-held concerns
that if the separation of commercial and investment banking activities
were ended, it would lead to ever-larger concentrations of financial
assets and would worsen the problem of “too big to fail.” The truth is
it took less than a decade for our first major crisis related to this
merging of activities to occur.
In the period leading up to this most recent crisis, the regulatory
authorities, like the industry, trusted that the market would
self-regulate. It didn’t, it can’t and it won’t. The industry’s
structure and incentives are now inconsistent with the market being the
disciplinarian.
The Volcker Rule does not reinstitute Glass-Steagall. It does
improve the odds toward financial stability by instituting a partial
return to the separation of commercial and investment banking
activities. It strives to affirm the principle that those institutions
that by their franchise have access to the safety net should be
separated from those firms that are free to speculate with shareholder,
not taxpayer, funds.
Paul has it right.
Capital Standards
What about capital and our banking system? To me, it is a simple
fact that the rules around bank capital define the strength of our
financial system in the long run. Capital, which I define simply as
tangible common equity, serves first as a discipline on a bank’s
appetite for risk and, when needed, helps absorb losses from unexpected
shocks. And finally, it gives confidence to depositors and other
creditors that a firm can reasonably be expected to withstand an
economic downturn.
However, the expansion of the safety net and the incentives this
engenders discourages equity capital on a bank’s balance sheet.
Financial firms enhance the returns to investors by “leveraging up”
assets against this capital. The market, knowing the safety net is in
place and assuming the most influential firms will be bailed out, lends
at favorable rates and facilitates the trend toward ever-greater
leverage and risk. Like Gresham’s Law on money, bad capital drives out
good capital.
To address this weakness in the system, the Dodd-Frank legislation
instructs the regulatory authorities to set up appropriate capital and
leverage standards. This process is also under way at the international
level, with the completion of the Basel standards, requiring higher
levels and stronger forms of capital.
Although this is a good start in establishing meaningful capital
levels, those responsible for financial oversight will face a heavy
burden to hold firms to any enhanced capital standard. It takes time to
build capital. It inhibits the payments of dividends that banks are
eager to restart.
We can be certain that there will be an enormous effort put forward
to substitute other forms of liabilities for equity or to change the
terms. The industry and others will remind us often that to place too
high a capital requirement or too short a time horizon on the industry
will constrain credit and slow the recovery and expansion. However, we
can be just as confident that current equity capital standards must be
set much higher than recent levels if the industry is to retain the
public’s trust and be a source of sustained credit and economic growth.
–more– (2 of 3)
** Market News International Washington Bureau: 202-371-2121 **
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