Richard W Fisher: Containing (or restraining) systemic risk - the need to
not fail on "too big to fail"
Remarks by Mr Richard W Fisher, President and Chief Executive Officer of the Federal
Reserve Bank of Dallas, before the Market News International Seminar, New York, 6 June
2011.
* * *
The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.
Thank you for that kind introduction. This discerning audience no doubt noted that despite
being overeducated, I am not a formally trained economist. I do not have a Ph.D. in
economics; those who do will correctly deduce that I am somewhat "dismal" in
comprehending the arcana of "the Dismal Science." After my undergraduate education in
economics and my studies at Oxford, I took a different path. I earned an MBA and then went
to Wall Street and into funds management before cashing out and taking to public service.
My perspective on monetary policy and regulation is shaped less by theory and more by my
experience as a market operator.
I confess that in matters of monetary policy and regulation, I am often in the minority. This
does not make me the least bit uncomfortable. The majority opinion is not always right;
indeed, my experience as an investor has biased me to conclude that more often than not,
the consensus view is the wrong view, even among the most erudite. Exhibit A of the
fallibility of consensus thinking is the herd mentality among supposedly sophisticated
financiers as well as theoretical economists who believe in efficient-markets theory and other
nonsense themes that led us into the recent financial crisis. I happen to believe that Margaret
Thatcher, the former British prime minister, was right when she said, "You cannot lead from
the crowd."1 There is a role for contrarians, not just in the investment arena, but also at the
highest level of policymaking; at a minimum, it is important to question and challenge
consensus views, even when they are formed by the most credentialed individuals.
For example, some of you may recall the public letter written by 364 eminent economists
predicting disastrous consequences that would result from Thatcher's policy initiatives. That
letter was published in the Times of London on March 30, 1981.2 The British economy began
a recovery almost immediately afterward, in 1982; by 1983, inflation and mortgage rates
were at their lowest levels in over a decade, while economic growth accelerated. The failure
of the consensus view led Chancellor of the Exchequer Geoffrey Howe to define an
economist as "a man who knows 364 ways of making love, but doesn't know any women."3
To be sure, economic theories and econometric models are of great utility for providing a
framework for policymaking; we cannot make policy without them. But they are imperfect
substitutes for common sense. The late New York intellectual Irving Kristol is reported to
have said: "Don't fall for fantastical notions that have nothing to do with the way people really
are."4 My experience of having worked in real time in the financial markets leads me to a
different perspective on financial operators and markets than that of most of my colleagues
at the Federal Open Market Committee (FOMC). This not only affects my views on the
implementation of monetary policy, but also shapes my perspective on regulation.
Monetary policy and regulation are intricately linked. When conducting its monetary policy,
the Fed is governed by a dual mandate: creating the monetary conditions to foster maximum
employment growth while constraining inflation and its alter ego, deflation. These goals
cannot be realized without financial stability that results from effective regulation. As the
FOMC now sets its sights on concluding the accommodative monetary policy it fashioned to
stave off financial collapse and deflation, our supervision and regulation team is wrestling
with developing the appropriate policy for dealing with the lingering effects of the financial
crisis, and, most importantly, erecting a new regulatory framework to substantially reduce the
chances of financial crises. Or at least make them more manageable, should one occur
again. (In all candor, it would be more historically accurate to say "when one occurs again,"
because crises and panics have occurred repeatedly throughout history, including three
times just in my own career: the mid-1970s, the late 1980s and just recently).
The Federal Reserve's efforts to revamp the regulatory framework are being led by Governor
Tarullo, who is providing focused, important leadership on this critical matter.5 The revamping
is largely shaped by the Dodd-Frank Wall Street Reform and Consumer Protection Act
("Dodd-Frank"), which became law last summer. The act establishes a new regulatory
infrastructure for promoting financial stability. Among its most prominent macroprudential
features is the Financial Stability Oversight Council, an interagency body charged with
detecting and deterring threats to the financial system. The act also establishes an Office of
Financial Research, a mechanism for the orderly winding down of failing financial firms, and
new responsibilities for the Federal Reserve in overseeing certain nonbank financial
companies and certain payment, clearing and settlement utilities. The Federal Reserve
Board is also directed to develop enhanced prudential standards for large banking
organizations and systemically important nonbank financial firms.
Dodd-Frank itself mostly provides only high-level direction, leaving an extraordinary number
of details and critical decisionmaking to regulatory discretion. As a result, the ultimate nature
and future of reform rest in the hands of regulators. As many of you are aware, the various
regulatory agencies are presently seeking public comments on a range of issues involving
implementation of Dodd-Frank.
Most regulatory reform initiatives applied since the Banking Act of 1864 have missed the
mark. They looked good on paper and appeared to solve the problems of the day but later
proved not up to the task. This is especially true with efforts to solve the "too big to fail"
problem, in which an unwillingness to follow through on prior policy commitments to actually
close down large failures and impose losses on their uninsured creditors has led to what
economists call "time inconsistency" in policy. Let's hope this time will be different, that
regulators will make their commitments credible and consistent with future rather than past
needs.6
Having come from the financial industry, I take a keen interest in these issues, and I hold
some strong opinions as to how we should proceed. I believe there are leverage points for
effective reform. There are areas where, if regulators act decisively, they might have
profound positive effects and avoid time inconsistency. Conversely, there are other areas
where regulatory action would at best generate small benefits and, in the worst case, might
actually be counterproductive.
The key to successful reform will be to identify the leverage points that exist and do our best
to ensure regulators are up to the task in those areas while not burdening other aspects of
the financial system with heavy intervention that might trigger the law of unintended
consequences.
Eye on target
the
Let us be clear about the goals of reform. With so much energy being expended on what,
the when and the how of implementing Dodd-Frank, the first risk we run is forgetting the
why-the reasons for the act, its primary goals.
For this, we need only turn to the law itself, the preamble, which spells out the key objectives
as follows: "To promote the financial stability of the United States by improving accountability
and transparency in the financial system, to end "too big to fail," to protect the American
taxpayer by ending bailouts, to protect consumers from abusive financial services practices
and for other purposes."7 On the subject of too big to fail, the legislation is quite blunt. The
Conference Report summary of the legislation's key provisions, provided in plain English by
the Senate Banking Committee, states that it seeks to end "the possibility that taxpayers will
be asked to write a check to bail out financial firms that threaten the economy by: creating a
safe way to liquidate failed financial firms; imposing tough new capital and leverage
requirements that make it undesirable to get too big; updating the Fed's authority to allow
system-wide support but no longer prop up individual firms; and establishing rigorous
standards and supervision to protect the economy and American consumers, investors and
businesses."8
While there is much to criticize about Dodd-Frank, I cotton to those blunt statements on
ending too big to fail. For, if after the myriad rules and regulations are written and
implemented we have not eradicated too big to fail from our financial infrastructure, reform
will have failed yet again.
I have spoken to this topic on several occasions.9 If you pull up a copy of the Sept. 28, 2009,
Wall Street Journal, you will find an article I wrote with my colleague Harvey Rosenblum
about the interference too big to fail poses for the effective conduct of monetary policy. In
looking at regulatory reform and implementing Dodd-Frank, I think a key point worth
repeating is that the distinction between "commercial banks" and "the shadow banking
system" is a false one. The two became intertwined beginning with the bypassing of Glass-
Steagall strictures by Sandy Weill and Citicorp and the deregulatory initiative of Gramm-
Leach-Bliley. The fact is that the largest commercial banks played a major role in many of
the more problematic phenomena of the recent credit boom and ensuing crisis, including the
spread of what I have previously referred to as financial STDs, or securitization transmitted
diseases.
In the aftermath of the Panic, these viruses linger. Last week, the New York Times printed an
interesting article by Joe Nocera, who drew upon the observations of a highly regarded
regional banker from Buffalo, Robert Wilmers of M&T Bank.10 Wilmers claimed that of the
$75 billion made by the six largest bank-holding companies last year, $56 billion derived from
trading revenues. Nocera noted that "in 2007, the chief executives of the Too Big to Fail
Banks made, on average, $26 million ... more than double the compensation of the top
nonbank Fortune 500 executives." A recent survey conducted for the Wall Street Journal of
CEO compensation at 350 public companies shows that financial services compensation has
been tempered; the rate of increase in compensation for 2010 was just 1 percent.11 The
Journal attributed this to higher levels of scrutiny of financial firms as well as pressure from
shareholders and regulators. Even so, some financial-sector CEOs enjoyed robust increases
in their total compensation, including a 74 percent increase and a 51 percent increase at two
of the five largest U.S. banking organizations. Interestingly, the trading revenue of these two
firms accounted for almost half of the $56 billion in total trading revenue mentioned by Mr.
Wilmers. These recent numbers buttress Nocera's reasonable conclusion that bank CEOs
"were being compensated in no small part on their trading profits - which gave them every
incentive to keep taking those excessive risks."
I am sympathetic to these concerns. I have no problem with risk takers being rewarded with
large compensation packages. I put my own and my partners' capital at risk for the 20 years I
operated in the markets and profited handsomely. But I never was provided with capital that
was safeguarded by government guarantees. There is no logic to having the public
underwrite through deposit insurance or subsidize through protective regulation the
risktaking ventures of large financial institutions and their executives. There is a substantial case
to be made for separating the "public utility" - or traditional core function of banking - from
the risk-taking function.
To be sure, financial problems are not limited to large institutions and their complex, opaque
and conflicted operations. Regional and community institutions that have, for the most part,
stuck to the public utility function have faced their own difficulties, especially in the context of
construction lending. But while over 300 banks failed during the crisis, another 7,000 did not.
Community and regional banks that are not too big to fail appear to have succumbed less to
the herdlike mentality and promiscuous financial behavior that affected their megabank
peers.
Moreover, when smaller banks got into deep trouble, regulators generally took them over and
resolved them. In the treatment of big banks, regulators, for the most part, tiptoed around
them. Failing big banks were allowed to lumber on, with government support, despite the
extensive damage they wrought. Big banks that gambled and generated unsustainable
losses received a huge public benefit: too-big-to-fail support.
Postcrisis, the large institutions are even larger: The top 10 now account for 64 percent of
assets, up from 58 percent before the crisis and substantially higher than the 25 percent they
accounted for in 1990. In effect, more prudent and better-managed banks have been denied
the market share that would have been theirs if mismanaged big banks had been allowed to
go out of business. This strikes me as counter to the very essence of competition that is the
hallmark of American capitalism: Prudently managed banks are being victimized by publicly
subsidized competition from less-prudent institutions.
A student of existentialism is tempted to recall Nietzsche's lament that, "He who is punished
is never he who performed the deed."12 An acerbic devotee of H.L. Mencken might be given
to recite his dictum that while "injustice is relatively easy to bear; what stings is justice."13 I do
not doubt for a New York minute that the savvy big players who "performed the deed" did so
with confidence they would be protected by the authorities who might find "justice" difficult to
impose. In solving the crisis at hand during the Panic, it appears that the most imprudent of
lenders and investors were protected from the consequences of their decisions; the sinners
were rescued and the virtuous penalized. In crafting regulations in response to Dodd-Frank,
we need to restore market discipline in banking and let the market mete out its own brand of
justice for excessive risk-taking rather than prolong the injustice of too big to fail.
It is not difficult to see where this dynamic, if uncorrected, will lead - to more pronounced
financial cycles and recurring crises. I would argue that the failure to reform the banking
system in Japan was one of the principal reasons for that country's "Lost Decade(s)." We
must not let that pathology take hold here.
Making matters worse
If we do not keep this ultimate goal of reform firmly in mind, our rule making not only might
fail to promote the original objectives of reform, but could actually work against them.
Ironically, with Dodd-Frank, such a perverse outcome is a distinct possibility.
The Dodd-Frank law entails the writing of more than 200 proposals and rules covering a host
of issues - risk-based capital requirements, ability-to-pay requirements for home mortgages,
protections for consumers sending remittances to foreign countries and so on. The Congress
decided the need for these rules to be written, drawing on the input of many, including some
very thoughtful economists. Here, I think it wise to draw upon the insight of the classical
liberal Frédéric Bastiat in his take on unintended consequences. Bastiat opined, "There is
only one difference between a bad economist and a good one: the bad economist confines
himself to the visible effect; the good economist takes into account both the effect that can be
seen and those effects that must be foreseen."14 The same might be said of regulators. As
regulators grapple with implementation of the voluminous Dodd-Frank reform act, the
unforeseen must be taken into account. The law of unintended consequences is always
lurking in the shadows. To get regulatory reform right, we have a lot of "foreseeing" to do.
One can envision, for example, that the potential cumulative impact of the many regulations
demanded by Dodd-Frank will be to artificially raise the cost structure of the
non-too-big-tofail depository institutions. Imposition of the new requirements and restrictions risks creating
new economies of scale in banking generated by the costs of regulatory compliance, many of
which could be fixed costs not fully proportional to bank size.
To the extent that a large scale becomes necessary to absorb the regulatory cost associated
with reform, Dodd-Frank could intensify the tendency toward bank consolidation, resulting in
a more concentrated industry, with the largest institutions predominating even more than in
the past. Such an outcome would appear to me contrary to the stated spirit and goal of the
act. A more consolidated industry would only magnify the challenge of dealing with
systemically important institutions and offsetting their historically elevated too-big-to-fail
status.
My concerns over regulation-induced economies of scale and the implications for industry
consolidation apply to all the size classes of banks, given the extensive list of new or
enhanced requirements created by Dodd-Frank and their associated compliance costs. As it
affects community banking, my concerns are tempered somewhat, though not completely
alleviated, by the small-bank exceptions that have been granted to several of the new law's
more costly requirements.
Unfortunately, the same cannot yet be said for the case of regional banks. The act indicates
that all banking organizations with more than $50 billion in assets should be subject to
enhanced supervision. Some of the related regulatory proposals have already been
distributed for comment. Still other proposals for new, stricter "enhanced supervision" rules
for these banks will be unveiled soon.
Yet, few really believe a $50 billion bank poses a systemic threat to our $17 trillion banking
system. Nor is a $50 billion bank qualitatively similar along risk dimensions to the very largest
ones that exceed $2 trillion in size. The top 10 banking organizations have a cutoff point of
$300 billion. I posit that this group should constitute the primary target for enhanced
supervision. Interestingly, despite its large share of industry assets, this group holds only
about 20 percent of the small-business loans on bank books. Clearly, these institutions are
engaged in substantial activities outside the traditional banking role. It is within these very
largest banks, and perhaps a few slightly smaller yet highly complex or interconnected ones,
that systemic risk is concentrated.
If the enhanced-supervision requirements are not highly graduated and imposed primarily on
the very largest banks, it is not difficult to imagine how the costs associated with such
supervision could lead mid-tier banks that exceed the $50 billion threshold - yet fall well
short of megabank status - to seek merger partners in order to achieve sufficient scale by
which to help cover the cost of regulation. This would compound the problem rather than
alleviate it.
With regard to enhanced standards for such important factors as capital and liquidity
requirements, leverage limits and risk management, Dodd-Frank instructs regulators to
differentiate among these banks. Enhanced supervision can be implemented on a graduated
scale, based on the extent of assets beyond $50 billion and possibly other factors. Let us do
that fully, then, applying these measures along a highly graduated scale, with only minimal
added mandates directed at mid-tier banking organizations.
However, when it comes to the top 10 or so, I would apply Dodd-Frank extensively and
vigorously. I would apply all the elements of heightened supervision - from enhanced
standards for capital and liquidity requirements, leverage limits and risk management to the
additional measures of living wills and credit-exposure reports, concentration limits, extra
public disclosures and short-term debt limits - with full force.
To this we would add robust annual stress tests conducted by the Federal Reserve, along
with the additional tools and procedures of macroprudential supervision, including in-depth
horizontal reviews across large companies.
Conclusion
I trust regulators will rise to the challenges posed by the financial crisis and too big to fail,
leaving a legacy of success and providing a practicable infrastructure for next-generation
supervision and regulation.
I quoted Bastiat's criterion for a good economist as one who accounts for "effects that must
be foreseen." Economists did not do a good job of foreseeing the financial crisis. Neither did
regulators. Moreover, previous measures directed at containing too big to fail proved
ineffective, with no one too surprised that when crisis came, many large-bank counterparties
were protected under implicit guarantees. Let's hope that going forward, regulators can do
better, avoiding both unintended consequences and time inconsistencies. For if they don't,
and they are unable to solve the too-big-to-fail issue in a timely manner, we will ultimately
have to take more draconian measures and simply break up the largest banking
organizations to eliminate the threat they pose to financial stability and economic growth.
That is my contrarian view, and I'm sticking with it.
Thank you.