Thomas M Hoenig: Do SIFIs have a future?
Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal
Reserve Bank of Kansas City, before the Pew Financial Reform Project and New York
University Stern School of Business "Dodd-Frank One Year On", Washington DC,
27 June 2011.
* * *
The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve
System, its governors, officers or representatives.
Introduction
We are approaching the one-year anniversary of the Dodd-Frank Act. With so much of the
Act's implementation work unfinished, it is not an anniversary that we can celebrate; rather it
is an opportunity to take stock. In that vein, I congratulate the organizers of this conference
for bringing together such an excellent group of individuals to do just that. In particular, I want
to recognize the New York University Stern School of Business and economics faculty for the
outstanding research they have done on critical financial reform issues. Their collaborative
efforts have produced a series of must-read books that have a combination of rigorous
economic analysis and practical policy prescriptions that is rarely seen these days.
Much of the Dodd-Frank discussion revolves around the economic distortions and
disruptions caused by the largest and most complex financial companies, the so-called
systemically important financial institutions, or SIFIs.
As we consider the topic of SIFIs, let me ask the following questions: how can one firm of
relatively small global significance merit a government bailout? How can a single investment
bank on Wall Street bring the world to the brink of financial collapse? How can a single
insurance company require billions of dollars of public funds to stay solvent and yet continue
to operate as a private institution? How can a relatively small country such as Greece hold
Europe financially hostage? These are the questions for which I have found no satisfactory
answers. That's because there are none. It is not acceptable to say that these events
occurred because they involved systemically important financial institutions.
Because there are no satisfactory answers to these questions, I suggest that the problem
with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently
destabilizing to global markets and detrimental to world growth. So long as the concept of a
SIFI exists, and there are institutions so powerful and considered so important that they
require special support and different rules, the future of capitalism is at risk and our market
economy is in peril.
To more fundamentally address this issue, we must go beyond today's Dodd-Frank. We
must confine the use of the safety net to its original intent. We must reduce the artificial
complexity of existing financial structures. The rewards of success must be balanced against
the credible consequences of failure. In achieving such goals, we will enhance the stability of
the fundamental mechanism through which monetary policy is conducted and the economy
depends.
The decline in competition and accountability in banking
The U.S. economy is the most successful in the history of the world. It achieved this success
because it is based on the rules of capitalism, in which private ownership dominates markets
and individuals reap the rewards of their success. However, for capitalism to work,
businesses, including financial firms, must be allowed, or compelled, to compete freely and
openly and must be held accountable for their failures. Only under these conditions do
markets objectively allocate credit to those businesses that provide the highest value.
For most of our history, the United States held fast to these rules of capitalism. It maintained
a relatively open banking and financial system with thousands of banks from small
community banks to large global players that allocated credit under this system. As late as
1980, the U.S. banking industry was relatively unconcentrated, with 14,000 commercial
banks and the assets of the five largest amounting to 29 percent of total banking organization
assets and 14 percent of GDP.
Today, we have a far more concentrated and less competitive banking system. There are
fewer banks operating across the country, and the five largest institutions control more than
half of the industry's assets, which is equal to almost 60 percent of GDP. The largest
20 institutions control 80 percent of the industry's assets, which amounts to about 86 percent
of GDP.
Here's the irony: this marked increase in concentrated power, and therefore, more
concentrated risk, reflects past efforts to assure greater economic stability. This might best
be described as "good intentions/bad outcomes" syndrome. For example, the Federal
Reserve was founded following the 1907 Banking Panic and was charged with providing
liquidity support to solvent banks that were experiencing funding problems. After the Great
Depression, the Federal Deposit Insurance Corp. was created to provide limited deposit
insurance to protect small depositors and to further increase the resiliency of the financial
system.
Then, over the past 30 years, this safety net has expanded far beyond its original intent.
More recently, Glass-Steagall was repealed, giving high-risk firms almost unlimited access to
funds generated through their new access to the safety net. Finally, following a series of
crises during the late 1980s and 1990s, the government confirmed that because of systemic
impact, some institutions were just too big to fail - the largest institutions could put money in
nearly any asset regardless of risk, and their creditors would not be held accountable for the
risk taken. Predictably, the industry's risk profile increased dramatically. The SIFI was born.
Is it any wonder then that in the fall of 2008 we experienced the greatest financial crisis since
the Great Depression? Financial institutions had again become irresponsible in their lending
practices. They had increased their leverage ratios to unprecedented levels. They became
"dry kindle" for a financial fire and, with the end of the housing boom, the match was struck.
Now, with their bailout costs amounting to billions of taxpayer dollars, SIFIs are larger than
ever. Strikingly, they are arguing that they should not be held to stronger capital standards if
the United States hopes to remain globally competitive. That assertion is nonsense. The
remainder of my remarks today will describe how the United States can achieve a stronger,
more stable financial system in order to secure its future as a global economic leader.
Proposal to reduce costs and risks to the safety net and financial system
Following this financial crisis, Congress and the administration turned to the work of repair
and reform. Once again, the American public got the standard remedies - more and
increasingly complex regulation and supervision. The Dodd-Frank reforms have all been
introduced before, but financial markets skirted them. Supervisory authority existed, but it
was used lightly because of political pressure and the misperceptions that free markets, with
generous public support, could self-regulate.
Dodd-Frank adds new layers of these same tools, but it fails to employ one remedy used in
the past to assure a more stable financial system - simplification of our financial structure
through Glass-Steagall-type boundaries. To this end, there are two principles that should
guide our efforts to restore such boundaries. First, institutions that have access to the safety
net should be restricted to certain core activities that the safety net was intended to protect
- making loans and taking deposits - and related activities consistent with the presence of
the safety net.
Second, the shadow banking system should be reformed in its use of money market funds
and short-term repurchase agreements - the repo market. This step will better assure that
the safety net is not ultimately called upon to bail them out in crisis.
Consistent with the first principle, banking organizations with access to the safety net should
be generally confined to the following activities: commercial banking, underwriting securities
and advisory services, and asset and wealth management services. Underwriting, advisory,
and asset and wealth management services are mostly fee-based services that do not put
much of a firm's capital at risk. In addition, asset and wealth management services are
similar to the trust services that have always been allowable for banks.
Restricting activities of banking organizations
In contrast, banking organizations should be expressly prohibited from activities that include
dealing and market-making, brokerage, and proprietary trading, which expose the safety net
but have little in common with core banking services.1
Thus, banking organizations would not be allowed to do trading, either proprietary or for
customers, or make markets because such activity requires the ability to do trading. In
addition, allowing Within the protection of the safety net, they create expansive risks that are
difficult to assess, monitor or control.
Thus, banking organizations would not be allowed to do trading, either proprietary or for
customers, or make markets because such activity requires the ability to do trading. In
addition, allowing customer but not proprietary trading would make it easy to game the
system by "concealing" proprietary trading as part of the inventory necessary to conduct
customer trading. Also, prime brokerage services not only require the ability to conduct
trading activities but also essentially allow companies to finance their activities with highly
unstable uninsured "deposits." This combination of factors, as we have recently witnessed,
leads to unstable markets and government bailouts.
Critics of this proposal contend that institutions grow to be large and complex because of
economies of scale and scope and they need the size and related complexities to be
profitable and to compete globally. They believe firms must have broad, mostly unrestricted
access to all financial activities to provide one-stop shopping and compete on a global basis.
Arguments also are given that large banks and securities firms are necessary to make
efficient markets for securities trading essential for carrying out monetary policy.
These arguments are unconvincing and, in fact, mislead. First, yes, it would be unfortunate if
restricting activities were to drive U.S. banks and jobs to other countries. However, we have
200 years of banking success in this country to refute that assertion. More recently, under
Glass-Steagall, U.S. banks and investment banks were highly competitive and successful as
each specialized in lending to or underwriting businesses all over the world. There is
considerable evidence that under Glass-Steagall the United States was at no competitive
disadvantage to Europe, with its mingled merchant banking system. The United States led
the world - because it had strong, prudently run institutions that knew how to manage money
in the best interests of the client.
Second, there is no strong evidence of unlimited economies of scale and even less for wide
economies of scope. Although both exist, they are captured at an asset size far less than that
of SIFIs today.
Third, large corporations would have ample convenient access to commercial and traditional
investment banking services inside commercial banking. They would have to go to securities
dealers to purchase swaps and other derivatives for hedging purposes, something that has
been done in the past without difficulty.
Finally, it also seems improbable to me that any country should be willing or able to expand
its safety net or to expose its taxpayers to the undefined risks of protecting ever-larger and
more complex banking organizations. Instead, what countries should be focused on now is
getting back to fundamentals aimed at simplifying highly complex and unstable SIFIs. The
focus should be on financial stability.
Reforming the shadow banking system
A legitimate concern of limiting the safety net is that this could worsen the risk of financial
instability by pushing activities to the unregulated shadow banking system. Clearly, focusing
solely on the regulated banking industry and ignoring the unregulated shadow banking
system would not solve the problem and, in fact, might expand the shadow banking sector
that was an integral part of the financial crisis.
Much of the instability in the shadow banking system stems from its use of short-term funding
for longer-term investment. The solution to this instability problem is not to provide a safety
net for the shadow banks and regulate them more but, instead, to remove exceptions in
which money market instruments are treated essentially as deposits. The current exceptions
encourage significant short-term funding of longer-term assets.
First, investors in money market mutual and other investment funds that are allowed to
maintain a fixed net asset value of $1 have an incentive to run if they think their fund will
"break the buck." Thus, if the fixed $1 net asset value is eliminated and the share values of
such funds are required to float with their market values, shadow bank reliance on this
source of short-term funding and the associated threat of disruptive runs would be greatly
reduced.
Second, the potential disruptions to funding stemming from the repo financing of shadow
banks should be ended. One of the sources of instability during the crisis was repo runs,
particularly on repo borrowers using subprime mortgage-related assets as collateral.
Essentially, these borrowers funded long-term assets of relatively low quality with very
shortterm liabilities.
These practices would be greatly reduced by rolling back the bankruptcy law for repo
collateral to the pre-2005 rules. Prior to then, if a repo borrower defaulted, mortgage-related
collateral could not be immediately taken and sold by the creditors. Returning to these rules
would discourage the use of mortgage-related assets as repo collateral and reduce the
potential for repo runs. Term lending through securitization would continue, probably at a
smaller scale, with more closely matched term wholesale funding provided by institutional
investors such as mutual funds, pension funds and life insurance companies.
These changes to the rules for money market funds and repo instruments would increase the
stability of the shadow banking system because term lending outside the safety net would be
less dependent on "demandable" funding and more reliant on term funding, and the pricing of
risk would better reflect the actual risk incurred.
A final note: implications for monetary policy
Finally, as a member of the Federal Open Market Committee, I realize that we must consider
the potential effects of these proposals on the conduct of monetary policy. The impact could
be significant because, as currently practiced, monetary policy operations are channeled
through a limited number of counterparties called primary dealers. These dealers are
required to participate in all auctions of U.S. government debt and represent a key element in
the implementation of policy.
Currently, there are only 20 primary dealers. They are the largest financial firms operating in
the United States, and most are affiliated with commercial banks. It is with this relationship
that the changes I propose could affect the conduct of monetary policy. Specifically, given
that primary dealers could no longer be affiliated with commercial banks, would this inhibit
market-making in securities, including Treasuries, and therefore interfere with the conduct of
monetary policy?
The answer is "no." It is not necessary that primary dealers be affiliated with banks. It is only
necessary that they be institutions that deal in U.S. Treasuries and participate in auctions of
U.S. government debt. Prior to the 1990s merger boom among investment banks and the
Gramm-Leach-Bliley Act, it was typical that half or more of the primary dealers were not
affiliated with commercial banks. Therefore, the fact that primary dealers are not commercial
banks would have little effect on the Federal Reserve's ability to conduct monetary policy.
I would add that although commercial banks could not be primary dealers, they could remain
a key part of the monetary policy mechanism. Recently, the Federal Reserve gained
experience in using the Term Auction Facility (TAF). The TAF might very successfully be
used in conjunction with primary dealer operations to conduct policy well into the future.
As you may recall, during the financial crisis, the TAF was an important component of
monetary policy. For example, the TAF was introduced in December 2007 with an initial
auction of $20 billion. The facility was then ramped up to almost $500 billion by March 2009 -
about one-fourth of the assets on the Federal Reserve's balance sheet. The maturity of TAF
loans was generally 28 days or 84 days.
By broadening the Federal Reserve's monetary tools to include the TAF to provide term
funds through the banking system in parallel with the primary dealers, we could greatly
expand the number of counterparties used in the conduct of monetary policy. Thus, the TAF
and primary dealers would provide deep markets for the term portion of policy; primary
dealers and traditional open-market operations would continue as the means for managing
day-to-day operations and for maintaining the federal funds rate close to the target. With
more counterparties, we enhance competition and enable nearly all banks to play a role in
the conduct of monetary policy. This would make the largest banks less "SI" and more "FI."
Conclusion
The financial system has become far less competitive and far more volatile with the onset of
systemically important institutions. Though large firms remain a critical part of our economic
system in the United States, they should not become so dominant that they become
unaccountable to our capitalistic system. We can make the necessary reforms to end the
unique status of the SIFI and, in doing so, restore much of our global competitive vigor. Only
from a position of financial strength can the United States remain the global economic leader.