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Sheila Bair: Everything the IMF Wanted to Know About Financial Regulation and Wasn’t Afraid to Ask

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By Sheila Bair, Chair of the Systemic Risk Council. Cross posted from VoxEU

I was honoured when the IMF asked me to moderate the Financial Regulation panel at this year’s Rethinking Macro II conference. And while naturally, I delivered one of the more enlightening and thought-provoking policy discussions of the conference, I did fail in my duties as moderator to make sure my panellists covered all the excellent questions our sponsors submitted to us. Of course, this was to be expected, as panellists at these types of events almost never address the topics requested of them (I certainly never do), but rather, like Presidential candidates, answer the questions they want to answer. However, being the conscientious person I am, who accepts responsibility for my mismanagement (unlike some bank CEOs we know), I will now step up and answer those questions myself.

1) Does anybody have a clear vision of the desirable financial system of the future?

Yes, me. It should be smaller, simpler, less leveraged and more focused on meeting the credit needs of the real economy. And oh yes, we should ban speculative use of credit default swaps from the face of the planet.

2) Is the ATM the only useful financial innovation of the last thirty years?

No. IF bankers approach the business of banking as a way to provide greater value at less cost to their customers, (I know – for a few bankers, that might be big ‘if’) technology provides a virtual gold mine for product innovations. For instance, I am currently testing out a pre-paid, stored value card which lets me do virtually all my banking on my I-phone. It tracks expenses, tells me when I’ve blown my budget, and lets me temporarily block usage of the card when my daughter, unbeknownst to me, has pulled it out of my wallet to buy the latest jeans from Aeropostale. The card, aptly called Simple, was engineered by two techies in Portland, Oregon. (Note to mega-banks: ditch the pin stripes for dockers and flip flops. The techies are coming for you next.)

3) Does the idea of a safe, regulated, core set of activities, and a less safe, less regulated, non-core make sense?

No.

The idea of a safe, regulated, core set of activities with access to the safety net (deposit insurance, central bank lending) and a less safe, MORE regulated, noncore set of activities which DO NOT UNDER ANY CIRCUMSTANCES have access to the safety net – that makes sense.

4) How do the different proposals (Volcker rule, Liikanen, Vickers) score in that respect?

Put them all together and you are two-thirds of the way there. The Volcker Rule acknowledges the need for tough restrictions on speculative trading throughout the banking organisation, including securities and derivatives trading in the so-called “casino bank”. Liikanen and Vickers acknowledge the need to firewall insured deposits around traditional commercial banking and force market funding of higher risk “casino” banking activities. Combining them would give us a much safer financial system.

But none of these proposals fully address the problem of excessive risk taking by non-bank financial institutions like AIG. Title I of Dodd-Frank empowers the Financial Stability Oversight Council to bring these kinds of “shadow banks” under prudential supervision by the Fed. Of course, that law was enacted three years ago and for nearly two years now, the regulators have promised that they will be designating shadow banks for supervisory oversight “very soon”. This was repeated most recently by Treasury Secretary Jack Lew on 22 May 2013, before the Senate Banking Committee (but this time he REALLY meant it). For some reason, the Fed and Treasury Department were able to figure out that AIG and GE Capital were systemic in a nano-second in 2008 when bailout money was at stake, but when it comes to subjecting them to more regulation now, well, hey we need to be careful here.

5) How much do higher capital ratios actually affect the efficiency and the profitability of banks?

You don’t have to be very efficient to make money by using a lot of leverage to juice profits then dump the losses on the government when things go bad. In my experience, the banks with the stronger capital ratios are the ones that are better managed, do a better job of lending, and have more sustainable profits over the long term, with the added benefit that they don’t put taxpayers at risk and keep lending during economic downturns.

6) Should we go for very high capital ratios?

Yep. I’ve argued for a minimum leverage ratio of 8%, but I like John Vickers 10% even better (and yes, he put out that news-making number during my panel…)

7) Is there virtue in simplicity, for example, simple leverage rather than capital ratios, or will simplicity only increase regulatory arbitrage?

The late Pat Moynihan once said that there are some things only a PhD can screw up. The Basel Committee’s rules for risk weighting assets are Exhibit A.

These rules are hopelessly overcomplicated. They were subject to rampant gaming and arbitrage prior to the crisis and still are. (If you don’t believe me, read Senator Levin’s report on the London Whale.) A simple leverage ratio should be the binding constraint, supplemented with a standardised system of risk weightings to force higher capital levels at banks taking undue risks. It is laughable to think that the leverage ratio is more susceptible to arbitrage than the current system of risk weightings given the way risk weights were gamed prior to the crisis, e.g. moving assets to the trading book, securitising loans to get lower capital charges, wrapping high risk CDOs in CDS protection to get near-zero risk charges, blindly investing in triple A securities, loading up on high-risk sovereign debt, repo financing … need I go on?

8) Can we realistically solve the “too big to fail” problem?

We have to solve it. If we can’t, then nationalise these behemoths and pay the people who run them the same wages as everyone else who work for the government.

9) Where do we stand on resolution processes, both at the national level and cross border?

Good progress, but not enough. Resolution authority in the US could be operationalised now, if necessary, but it would be messy and unduly expensive for creditors. We need thicker cushions of equity at the mega-banks, minimum standards for both equity and long-term debt issuances at the holding company level to facilitate the FDIC’s “single point of entry” strategy, and most importantly, we need regulators who make clear that they have the guts to put a mega-bank into receivership. The industry says they want to end “too big to fail” but they aren’t doing everything they can to make sure resolution authority works smoothly. For instance, industry groups like ISDA could greatly facilitate international resolutions by revising global standards for swap documentation to recognise the government’s authority to require continued performance on derivatives contracts in a Dodd-Frank resolution.

10) Can we hope to ever measure ‘systemic risk’?

Yes. It’s all about inter-connectedness which mega-banks and regulators should be able to measure. Ironically, inter-connectedness is encouraged by those %$#@& Basel capital rules for risk weighting assets. Lending to IBM is viewed 5 times riskier as lending to Morgan Stanley. Repos among financial institutions are treated as extremely low risk, even though excessive reliance on repo funding almost brought our system down. How dumb is that?

We need to fix the capital rules. Regulators also need to focus more attention on the credit exposure reports that are required under Dodd-Frank. These reports require mega-banks to identify and quantify for regulators how exposed they are to each other. Mega-bank failure scenarios should be factored into stress testing as well.

[Since these questions relate to financial regulation, I will not opine on measuring systemic risks building as a result of loose monetary policy.]

10) Are banks in effect driving the reform process?

Sure seems that way.

11) Can regulators ever be as nimble as the regulatees?

Yes. Read Roger Martin’s Fixing the Game. Financial regulators should look to the NFL for inspiration.

12) Given the cat and mouse game between regulators and regulatees, do we have to live with regulatory uncertainty?

Simple regulations which focus on market discipline and skin-in-the-game requirements are harder to game and more adaptable to changing conditions than rules which try to dictate behaviour. For instance, thick capital cushions will help ensure that whatever dumb mistakes banks may make in the future (and they will), there will be significant capacity to absorb the resulting losses. Unfortunately, the trend has been toward complex, prescriptive rules which smart banking lawyers love to exploit. Industry generally likes the prescriptive rules because they always find a way around them, and the regulators don’t keep up.

You can see that dynamic playing out now, where the securitisation industry is seeking to undermine a Dodd-Frank requirement that securitisers take 5 cents of every dollar of loss on mortgages they securitise. They say risk retention is no longer required because the Consumer Bureau has promulgated mortgage lending standards. But these rules are pretty permissive (no down payment requirement, and a whopping 43% debt-to-income ratio) and I’m sure that the Mortgage Bankers Association is already trying to figure out ways to skirt them.

Rules dictating behaviour can sometime be helpful, but forcing market participants to take the losses from their risk-taking can be much more effective. One approach tells them what kinds of loans they can make. The other says that whatever kind of loans they make, they will take losses if those loans default.

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38 comments

  1. craazyman

    those are all good questions, here’s one more for next time:

    13) With predatory psychopaths or delusional boneheads in charge of nearly every institution in America, especially financial institutions, at what point do things get so bad the entire society simply implodes into something out of Cormac McCarthy’s THE ROAD?

    The panelists and guests at these gatherings no doubt wouldn’t have a clue since they don’t live in the real world. They live in a little bubble (no pun intended) of policy influence, power and prestige — and their entire life consists of talking to each other about each other, which is their favorite topic.

    But anyway, as long as we’re dreaming, we’ll imagine just asking the question and watching the dull, blank-brained stares fill the room. It could be hilarious.

  2. jake chase

    For all her good intentions, it does not occur to Sheila Bear that the only sensible kind of bank regulation is returning banking to its pre 1994 past. Confining banks to one state and reinstating Glass Steagall would be a good start. Even better would be confining banks to one location.

    Monopoly finance is a cancerous tail on the real economy dog. Cutting off the tail might not save the dog, but it certainly wouldn’t hurt.

    Just exactly what societal functions do mega banks perform? I am unable to think of any.

    1. jake chase

      Whoops, I guess it’s Bair, not Bear. Well, at least I didn’t say Bare, right?

    2. Carla

      But to your point:

      “…the only sensible kind of bank regulation is returning banking to its pre 1994 past. Confining banks to one state and reinstating Glass Steagall would be a good start. Even better would be confining banks to one location.” –

      I entirely agree!

      It would not suit the international banking cartel, but hey! Are we an independent country or NOT????

  3. juliania

    Sheila is wonderful. The only one I don’t like is her #2 answer. Everything else (even what’s above my head) is wonderful.

    1. jurisV

      Juliania –

      Why do you not like her answer to #2 ?

      I’m curious that you apparently don’t approve of “Simple” and am wondering what about doesn’t meet with your approval.

  4. Susan the other

    It sounds like Sheila knows where the tangles are. She has insisted all along that the “behemoths” must be downsized. And although all those derivatives are making things obscure (they’re just now figuring out how to track them to the end of their financial lives?), resolution of these points of ignorance is possible. That’s good to know. So, how long will it take? And if it is possible to trace a system of entitlement for derivatives so they can be made legal financial instruments, why can’t the land title system be cleared up. It’s the same kind of tangle. And why the hell isn’t anybody doing it?

  5. F. Beard

    The idea of a safe, regulated, core set of activities with access to the safety net (deposit insurance, central bank lending) Sheila Bair

    No, Sheila. That’s not principled. The monetary sovereign ITSELF (e.g. the US Treasury Department) should provide a risk-free fiat storage and transaction service that makes no loans (leaving those decisions to individual depositors) and which pays no interest. And this service should be free up to normal household limits on account balances and number of transactions. This service obviously needs no deposit insurance since the deposits are not at risk. Nor is a central bank needed since the deposits are always 100% liquid. THIS SHOULD BE THE RISK-FREE CORE.

    and a less safe, MORE regulated, noncore set of activities Sheila Bair

    Apart from strict enforcement of fraud and insolvency laws, why should we care what gamblers do?

    which DO NOT UNDER ANY CIRCUMSTANCES have access to the safety net – that makes sense. Sheila Bair

    Of course. Gamblers (including depositors if they have a risk-free choice) should bear their own risk.

    But how then will investment be funded, you might ask?

    Ethically, of course. Saving/borrowing of fiat at free market interest rates would be one option. “Sharing” of capital and risk with common stock as a private money form is another.

    1. ChrisPacific

      Apart from strict enforcement of fraud and insolvency laws, why should we care what gamblers do?

      Right now, because of interconnectedness, tight coupling and TBTF, which ensures that we bear any losses while they get to keep the gains.

      Even if those were addressed, though, we would still need to care because of the negative social consequences. For instance, gamblers like to blow bubbles, and the resultant mispricing can have major negative effects on the economy, especially if it occurs in markets involving necessities like food and housing.

      1. mansoor h khan

        ChrisPacific,

        We should outlaw usury (any dealing in interest) just like the bible and quran suggest.

        Mis-matched maturity lending increases the currency supply and therefore steals from the public. Sudden collapse of a mis-matched lender causes deflation which needs to be dealt with but yes the mis-matched lender should be allowed to fail as punishment.

        But even matched lenders over time will cause currency to accumulate to them if they are real smart and go after “deadbeat” borrowers with sufficient vigor and bankruptcy laws exist which aid them.

        This will still lead to removal of currency from the economy and it will accumulate in the hands of few leading to deflation. Which the government can deal with by simply printing more money and handing it out to the public.

        When the lord (the CEO of the universe) forbids something to humanity the complete wisdom of (goodness in and reason for) the commandment is not known to humanity. But over time humanity does figure out part of the wisdom via experience and failures.

        Before this is over (global banking system collapse) everybody and their mother will know the wisdom of (at least partially) biblical and quranic prohibition against dealing in interest.

        http://aquinums-razor.blogspot.com/2013/02/the-banking-system-and-economic-growth.html

        Mansoor H. Khan

        1. Chris Engel

          We should outlaw usury (any dealing in interest) just like the bible and quran suggest.

          No we shouldn’t. If I lend my savings out to somebody, I want compensation for risk, opportunity costs, and inflation.

          When the lord (the CEO of the universe) forbids something to humanity the complete wisdom of (goodness in and reason for) the commandment is not known to humanity. But over time humanity does figure out part of the wisdom via experience and failures.

          The authors of the Bible and Quran were con artists. If there is a god, those books certainly do not represent his word. Nothing in economic or public policy should be based on the deluded ramblings of nomadic grifters from over a millennium ago.

          1. F. Beard

            Nothing in economic or public policy should be based on the deluded ramblings of nomadic grifters from over a millennium ago. Chris Engel

            I disagree. Example: The Bible presents this paradox: Profits are good but profit taking isn’t. This rules out usury and dividends (because they take profits) but neatly leaves the possibility of common stock as a private money form because the profits need not be taken. Instead, profits can accumulate in the value of the shares and be distributed (but not taken!) to the share holders via stock-splits.

      2. F. Beard

        For instance, gamblers like to blow bubbles, ChrisPacific

        Sure, with borrowed money and for that reason the bubble must eventually collapse. One might think that credit, the lending of money into existence, could keep the bubble going forever but not so because eventually the compound interest required is greater than real growth.

        But what if a money was spent into existence? With no debt to repay, why should the boom collapse? Of course, price inflation in that money would be a risk but what if the existing money owners could vote on new money issue and what it was invested in or at least nix any increase should price inflation be a problem?

        Such a scheme already exists – the common stock company. Then why isn’t common stock widely used as private money? ans: Because companies that “share” are at a competitive disadvantage to companies that steal via the government-backed credit cartel.

  6. F. Beard

    As for “safe”, a government-backed credit cartel is inherently unjust. Was “redlining” safe or was it a social time bomb such as those that exploded in the urban riots of the 1960s?

  7. F. Beard

    One other thing:

    The reason so many need credit in the first place is because their EQUITY has been stolen by the credit cartel!

    What we need is at least a temporary ban on new credit creation and a universal bailout, including non-debtors, with new fiat to restore that equity.

    The remaining Jews in Jerusalem and Judea around the time of the Babylonian Captivity could have been spared death or even exile if they had not reneged on their pledge to release their illegally held Jewish debt slaves. See Jerimiah 34:6-22 for the details.

    1. Jackson Bane

      Sheila is a wet nurse of sorts to the established order. Nothing about the IMF is benign. From destruction of the enviroment to famously loansharking countries and then jamming the world’s poor with the bill when the whole thing crashes. I wonder if Sheila understands that when Banks (in her neighborhood) for example, behave like pirates and give people loans they can’t afford, it is the Bank’s problem, the entire neighborhood and the victim don’t need to be shaken down and destroyed to pay off the bad loan. The IMF is famous for this antisocial behavior on a larger scale.
      Such talk is loud and threatening, and Sheila won’t spray the white drapes with unsettling colors.

  8. Chauncey Gardiner

    Agree. Thank you for this post, Yves. Particularly appreciated that Sheila Bair’s systemic recommendations encompassed but were not limited to the “TBTFs”, that she used the term “mega-banks” instead, and that No. 1 on her list was speculation in CDS.

    Regarding “inter-connectedness”, wonder if she would be willing to consider and recommend broader monetary system reforms, specifically the current basis of money and the roles of the central banks, Primary Dealers, and the financial markets under the current structure.

    Enjoyed her sense of humor (and Jake’s too).

  9. impermanence

    Although the system will occasionally reign-in its excesses, the base human desire to get ‘something for nothing’ will ALWAYS be the motivating force behind all collective activity.

    So, you will see some moderation in banking activities over the next several years, until people are, once again, lulled back into intellectual hibernation, the signal for the most depraved among us [the financial services community] to fire up the engines of avarice and fraud, initiating another round of ‘something for nothing’ creative destruction.

  10. allcoppedout

    The only banking innovations that matter are those that mean we don’t have to deal with bankers. Thus ATMs and internet banking are sound. What’s really simple is we don’t need the IMF or World Bank and do need democracy. The only innovation in banking we need is a machine that tracks money without secrecy.

  11. MichaelC

    She had me at ” %$#@& “…

    The plain language explanations and recommendations Sheila Bair has been promoting give lie to the myth that this is all incomprehensible to mere mortals. It’s a simple story that a few common sense reforms would change for the better.

    It’s good see her here.

    1. Manic Mechanic

      It’s not good to see her in Chevy Chase and Bethesda amongst the class war, where indifference and wealth blend serenly with militarism. She should do the right thing and support the the Covington Seven. Women who are deserving are of far more respect than a largely unobjectionable careerist. After all, we would defend her if the sheriff pounded her and her family out onto the street because it had been determined she was otherwise obligated to “pay someone.”

      http://www.homedefendersleague.org/2013/06/08/tuesday-take-action-to-support-the-covington-7/

  12. Elbridge Spaulding

    1) Does anybody have a clear vision of the desirable financial system of the future?

    Yes, me. It should be smaller, simpler, less leveraged and more focused on meeting the credit needs of the real economy. And oh yes, we should ban speculative use of credit default swaps from the face of the planet.

    Would you not agree this is what Adair Turner proposed in his Keynote at INET?

    http://youtu.be/ZhrY_coLK_k

    Thanks.

  13. TomDor

    Regulation is a small aspect of stopping the gambling casino bank – - small small part. Of course it is the regulations that are most easily defeated or gamed.

    The best regulation would be law from the Constitution. The levy of taxes. Tax the crap out of economic rent extraction – 99% to bring that money back from the speculators hand and back into wealth creating economy – you know…that economy which employs labor, land and capital to produce something other people buy.

  14. steelhead23

    What do Yves Smith, Sheila Bair, and Elizabeth Warren have in common? Ovaries? Of course, but that’s hardly the point. These women care. They care about us. At least they care about us a lot more than say Barack Obama or Jamie Dimon. The antithesis of Objectivism (where one’s sole objective in life is one’s self). I hope they keep it up. Maybe it’ll catch on.

  15. 1ST Merchant Funding

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