The following is an excerpt of a speech by Federal Deposit Insurance Corp. Chairman Sheila Bair at Kansas State University last week.
We’re tackling the aftermath of a financial and economic crisis that has done damage to our country.
How will we weather the crisis? How will we protect consumers from the abusive practices of the past few years?
How do we stop the excessive risk-taking? How do we keep people in their homes? How do we prevent more of those massive bailouts of giant financial institutions?
As a lifelong Republican and market advocate, it’s not been easy for me. The government has been going into places where we don’t want to be. We’ve been doing things we’d rather not be doing, but have had little choice.
Credit markets are now slowly thawing, and liquidity has vastly improved with short-term credit spreads returning to normal levels. Equity markets have recovered somewhat but are still well below their pre-crisis levels.
With the worst of the crisis apparently behind us, it’s time to consider the fallout from this calamity.
While government intervention has been successful in preventing wider failures, it has also introduced “moral hazard” into our financial system by providing previously unimaginable amounts of taxpayer support for open institutions.
Government intervention in too many cases has protected stockholders, bondholders and managers from the consequences of their mistakes.
We must make fundamental changes to our financial regulatory system to reduce this “moral hazard” and to make sure a financial crisis does not happen again. We simply cannot afford to maintain the status quo.
End of Too Big to Fail
We must end the policy of too big to fail. To do so, we must find ways to impose greater market discipline on systemically important institutions and ensure that no firm is too big or too interconnected to fail.
After all, in a properly functioning market economy there will be winners and losers. And when firms—through their own mismanagement and excessive risk taking—are no longer viable, they ought to fail.
One thing we learned from our handling of this crisis is that too big to fail has become explicit, when it was once implicit. By contrast, small institutions and their investors know that they can and will be allowed to fail. This competitive disparity makes it more expensive for small banks to raise capital and secure funding.
Firms that the market believes are too big or too interconnected to fail distort our system. These firms can raise large amounts of debt and equity at favorable terms that do not reflect their true risk profile. When investors and creditors believe a firm is too big to fail, they grow more complacent.
We do not have an effective resolution process for handling large, complex financial firms that become troubled or are failing. The FDIC’s process only extends to insured depository institutions. And without the ability to close and impose losses on systemic firms that get into trouble, we run the risk that we will have to repeat the costly and unpopular taxpayer bailouts of the past year.
Foremost on the reform agenda is the need for a special legal and regulatory framework to ensure the orderly wind down of systemically important financial firms while avoiding financial disruptions that could devastate our financial markets and economy.
FDIC Model
A resolution mechanism that makes it possible to break up and sell the failed institution offers the best option. It should be designed to protect the public interest, prevent the use of taxpayer funds, and provide continuity for the failed institution’s critical financial functions. The FDIC’s authority to resolve failing banks and thrifts is a good model.
This is the same model that has allowed the FDIC to seamlessly resolve thousands of institutions over the years. We protect insured depositors while preserving vital banking functions. The FDIC has the authority to move key functions of the failed bank to a newly chartered bridge bank. Losses are imposed on market players who reap the profits in good times, but who also should bear the losses in the case of failure.
Shareholders of the failed bank typically lose all of their investment. Creditors generally lose some or all of the amounts owed them. Top management is replaced, as are other employees who contributed to the institutions’ failure. And the assets of the failed institution are sold to a stronger, better managed buyer.
If this process is applied to systemically important financial institutions—whether banks or non-banks—it would prevent instability and contagion, while promoting fairness. Financial markets would continue to function smoothly, while the firm’s operations are transferred or unwound in an orderly fashion. The government would step in temporarily to provide working capital for an orderly wind down, including providing necessary funds to complete transactions that are in process at the time of failure.
We propose that working capital for such resolutions come from a reserve, which the industry would fund in advance. This would provide better protection for taxpayers. Building the fund in advance would also help prevent the need for assessments during an economic crisis and assure that the firm which failed paid something into the fund. To avoid double counting for banks that already pay deposit insurance premiums, the assessments should be based on assets held outside of insured depositories.
Any costs associated with the resolution not covered by the fund would be recouped through additional industry assessments. This resolution mechanism would address systemic risk without a taxpayer bailout and without the near panic we saw a year ago. It would provide clear rules and signals to the market. Most importantly, over the long run, it would provide the market discipline that is so clearly lacking today.
A reserve funded in advance through industry assessments would also provide economic disincentives to size and complexity. Another way to address the risks of systemic institutions is to make it expensive to be one. Industry assessments could be risk based, with firms engaging in higher risk activities paying significantly more. Proprietary trading, complex structured finance and other high risk activities would warrant higher fees.
In addition, systemic firms would be required to have in place their own liquidation plan—a living will so to speak—which would demonstrate that they could be broken apart and sold in an orderly way. This would mean greater legal and functional separation of affiliates within these large financial holding companies and, in particular, greater autonomy and firewalls surrounding insured banks.
Systemic Risk Council
We also need better regulation of systemic risk and systemic institutions. What we need is a Systemic Risk Council of national regulatory agencies with the authority and responsibility to identify, monitor and take action to prevent future systemic risks.
It should have broad authority and responsibility for identifying institutions, products, practices, services and markets that create potential systemic risks. It should have the authority to step in and fill regulatory gaps when they are exploited in a way that threatens the safety and soundness of the financial system. And it should have authority to establish and implement minimum, mandatory, macro-prudential standards for such things as capital, liquidity and leverage when individual regulators fail to act.
Concentration and complexity of the derivatives markets were yet further sources of risk in the current crisis. While these markets perform important risk-mitigation functions, they also have proven to be a major source of contagion during the crisis.
Losses on mortgages were exponentially magnified by trillions of dollars in derivatives whose values were derived from the performance of those mortgages. And concentrations of derivatives exposures among certain dealers helped catalyze systemic breakdown. When the market decides a derivatives dealer is weakening, other market participants can demand more collateral to protect their claims.
At some point, the firm cannot meet additional collateral demands and it collapses. The resulting fire sale of collateral can depress prices, freeze market liquidity and lead to the collapse for other firms.
Derivative counterparties have every interest to demand more collateral and sell it as quickly as possible before market prices decline. The collateral calls generated by derivatives counterparty credit risk management mimic the depositor runs of the past.
One way to reduce these risks while retaining market discipline is to make derivative counterparties keep some “skin in the game” throughout the cycle. Under this approach, the receiver for a failed institution could impose losses of up to 20% of the secured claim. This would ensure that market participants always have an interest in monitoring the financial health of their counterparties. It also would limit the sudden demand for more collateral because the protection could be capped. Standardized derivatives contracts should also be required to trade on a nationally regulated exchange or through a regulated, centralized counterparty system.
Reform Backlash
Many in the industry are working constructively in Washington for meaningful reform. Some, however, are working furiously against it. Fear is their tactic.
They say reform would stifle innovation. They say reform would impede the ability of our country to grow and compete in the global economy. But these are the very same arguments used to justify deregulation in the first place. Some want to keep the status quo. And, by implication, they want to keep the taxpayer on the hook.
That makes me angry.
My mentor and former boss, Bob Dole, has always lived his life by his father’s view of the world as “stewers versus doers.” He is a doer. These “stewers” would have us do nothing, even after millions in lost jobs and trillions in lost wealth.
So I believe as Bob Dole believes that “when it’s all over, it’s not who you were—it’s whether you made a difference.” I believe that government has a role to play in setting rules for protecting the common good. I believe that government is a “doer,” and it can make a difference, especially in the face of adversity and unfairness.
