WASHINGTON (MNI) – The following is the oral statement of Kasas
City Fed President Thomas Hoenig Thursday before a subcommittee of the
House Financial Services Committee on the systematic increase in debt
and leverage in the economy:
Chairman Moore, ranking member Biggert, and members of the
committee.
Among the factors that contributed to this recent financial crisis,
there is no question that leverage was key. And the unwinding of this
leverage contributed to the escalation of this crisis into the worst
recession in 75 years, hurting Americans at all economic levels.
I have spent more than 36 years at the Federal Reserve deeply
involved in bank supervision, and it has been apparent to me for some
time that our nation’s financial institutions must have firm and easily
understood leverage requirements. Leverage tends to rise when the
economy is strong as investors and lenders forget past mistakes and
believe that prosperity will always continue. If we don’t institute
rules now to contain leverage, another crisis is inevitable.
My written testimony addresses the systematic increase in debt and
leverage that has occurred in all major sectors of our economy over the
past two decades. My comments today, however, will focus specifically on
what occurred at the largest financial firmswhich were the catalysts
for this crisis.
Leverage is the ability to use debt to build assets as a multiple
of a firm’s capital base. The leverage at banking organizations has
risen steadily since the mid-1990s, but was not immediately obvious
because of the many different ways capital and leverage can be measured.
In my judgment, the most fundamental measure of a financial
institution’s capital is to exclude intangible assets and preferred
shares and focus only on tangible common equitythat is ownership
capital actually available to absorb losses and meet obligations.
Looking at tangible common equity, you see that leverage for the entire
banking industry rose from $16 of assets for each dollar of capital in
1993 to $25 for each dollar of capital in 2007. More striking perhaps,
this aggregate ratio was driven most significantly by the 10 largest
banking companies. At these firms, assets rose from 18 times capital to
34 over the same period, and that does not include their off-balance
sheet activities.
These numbers, in my opinion, reflect two essential points. First,
that based on capital levels, the 10 largest banking organizations
carried fundamentally riskier balance sheets at the start of this crisis
than the industry as a whole. Second, their greater leverage reflects a
significant funding cost advantage. Not only is debt cheaper than
equity, but their debt was cheaper than for smaller organizations
because creditors were confident these firms were too big to be allowed
to fail.
This was a gross distortion of the marketplace, providing these
firms an advantage in making profits, enabling them to build size, and
then, in the end, leaving others to suffer the pain of their collapse.
This is not capitalism, but exploitation of an unearned advantage. And
the list of victims is long, including families who lost homes, workers
who lost jobs, and taxpayers who were left to pay the tab.
This increase in leverage in the banking industry spread broadly to
the other sectors of the economy, creating a general excess of credit
growth over the past 10 years, especially among consumers.
This economy-wide rise in leverage was based on the assumption that
asset prices would continue to rise, especially those in housing. When
prices fell and defaults and losses mounted, capital ratios that had
been systematically reduced over time proved grossly inadequate. To
illustrate, suppose the 10 largest banking organizations had been
required to confine their leverage to a historically more reasonable
level of $15 of tangible assets for every dollar of tangible common
equity rather than the $34 they had. Under this historically limit, they
would have been forced to hold an additional $326 billion of equity, 125
percent more than they actually had, to absorb potential losses, or they
could have cut back on their growth by nearly $5 trillion, or more
likely, some combination.
The point is that institutions got away from the fundamental
principles of sound management. And those institutions with the highest
leverage suffered the most. Financial panic and economic havoc quickly
followed. The process of deleveraging is underway, rebuilding capital
has begun, but during this rebuilding loans are harder to get, which is
impeding the economic recovery.
With this very painful lesson fresh in our minds, now is the time
to act. I strongly support establishing hard leverage rules that are
simple, understandable and enforceable and that apply equally to all
banking organizations that operate in the United States.
As we saw in the years before the crisis, leverage tends to rise
during economic expansions as past mistakes are forgotten, and pressure
for growth and higher return on equity mounts. Straightforward leverage
and underwriting rules require bankers to match increases in assets with
increases in capital and prevent disputes with bank examiners over
interpretations of the rules. As a result, excess is constrained, and
a countercyclical force is created that moderates booms and forms a
cushion when the next recession occurs.
I firmly believe that had such rules been in place, we would have
been spared a good part of the tremendous hardship the American people
have gone through during the past two years. Critics of more
conservative capital ratios say this will restrict growth. Yes, it will.
The success of the U.S. economy is not the result of the size of
financial institutions but the strength of the financial system. I would
be pleased to answer your questions.
** Market News International Washington Bureau: 202-371-2121 **
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