As if on a mission, Tom Hoenig, president of the Federal Reserve Bank of Kansas City, has used a number of public forums recently to speak out against the troubling concept that some financial companies are too big to let fail. Actually, the mission — if it can be called that — began a decade ago with the dawn of the Gramm-Leach-Bliley Act of 1999.
Hoenig raised concerns then about too big to fail, arguing that big institutions without constraints would become increasingly large. “There were no antitrust impediments to growth,” he says, “and although we protested that they weren’t too big to fail they were going to become too big to fail and, in fact, did.”
Fast forward to March of this year, when Hoenig made a speech in Omaha titled “Too Big Has Failed.” Apparently he hit a nerve, as requests came for more information on the topic, which led to more speeches to more groups than he had planned. “I thought it was a straightforward speech. I was raising concerns, and I didn’t anticipate it would get quite the reaction it did.”
Now, rather than being encouraged that the issue would be addressed in the Obama administration’s sweeping regulatory reform proposals, Hoenig fears it will be institutionalized. The white paper outlining the Obama plan, unveiled in mid-June, appears to say, in Hoenig’s opinion, “If everyone agrees, we’ll deal with it on an ad hoc basis.” No government or banking agency, he suggests, wants to be the one that says a major institution is going to be allowed to fail and then be blamed for the negative consequences.
What is needed, in Hoenig’s view, is legislation that says when an institution is deemed insolvent due to capital or liquidity deficiencies by its examining authority, specific steps will be taken. “I think we need something that says here is how we will do this and yes we understand the impact and yes we will mitigate those impacts But here is the process and here’s who will step up to the plate before the taxpayer does,” says Hoenig. “Otherwise, as they say, you privatize the gain, socialize the losses and move on.”
Hoenig has suggested that using the resolution of the former Continental Illinois National in 1984 as a model would at least be a starting point and help get the legislation moving forward. “No one has explained to me why it isn’t a starting point,” he says. It wasn’t perfect, he adds; bondholders were protected although stockholders were wiped out. “But at least the model would be a beginning point.”
FDIC Chairman Sheila Bair has suggested that the resolution process for systemically important institutions should be vested in her agency. Hoenig says the deposit insuror is not equipped currently for that role, but expanding its mandate would equip it to do so. “I think it is a good candidate to be the focal point for resolution,” he says.
Curtailing the growth of institutions considered too big to fail or getting too big to fail has also been suggested by Hoenig and the Obama plan discusses possible higher capital ratios for those institutions. But Hoenig suggests that is unrealistic. First, “As soon as you pass that, they would start working to get rid of it,” he says. “They would look at it as discriminatory and no matter how you said you are too big to fail they would argue it’s not applicable and I think over time it would go away as it did with the investment banks.”
Secondly, research clearly shows that once an institution gets to a certain size, the market understands it is too big to fail. It can then issue debt at lower cost and that is a subsidy, in Hoenig’s view. “Just get rid of the subsidy and you would at least have a level playing field,” he says. “To me,” he adds, “it is difficult to appreciate the effect the crisis has had for Bank of America in terms of it ability to nearly double in size. It’s a heck of a subsidy.”
Systemic Risk Supervisor
On the issue of whether the Federal Reserve should be what is being called a “systemic-risk regulator,” Hoenig’s position is that the nation’s central bank already is the “systemic authority.” The systemic elements of the economy are centered around monetary policy, he explains, for which the Fed is responsible and for which it should be held accountable. It is the lender of last resort and supervisor over all holding companies, including, now, the investment banks. What the administration reform plan does is makes it explicit, he suggests.
As to whether that role is in conflict with Fed’s responsibility for monetary policy, as some have suggested, “That’s just nonsense,” Hoenig says. “You can’t conduct monetary policy without being concerned about the institutions through which it flows.” The two were separated by the United Kingdom when it nationalized the big mortgage lender Northern Rock. The result was “absolute chaos,” in his view, and now they are talking about putting the monetary policy and lender of last resort roles back together in one entity. “You can’t separate them,” Hoenig emphasizes, “and this merely confirms it for me.”
Responding to suggestions emanating from some in Congress that the Federal Reserve should be less independent, Hoenig says, “I think that would be a tragedy.” If they think the Fed is unaccountable, he suggests, all they have to do is look at the number of times members of the board and the bank presidents testify. “They can require us to explain ourselves,” he says, “and if there is something wrong, they can, in fact, change the law.”
He points out that when the Federal Reserve was being organized — a process that took took six years, from 1908 to 1913 — there was concern about independence and being responsible to the people, the fear being that lack of independence risked a clear bias toward inflation. They put together a structure that was part private, part public, he explains, and not concentrated in Washington or on Wall Street.
“Now they want to say is hasn’t worked,” Hoenig says. “I think it has. It has been accountable, we’ve had independent thought and we’ve had input from around the country. We have a base of support. How would you improve on that?”
He acknowledges the Fed has become more politicized by the circumstances of the current crisis. “You can’t be involved this closely with the Treasury and not have lines blurred,” he says. “I think we have to get through this and step back from that so that we don’t compromise our independence for the future.”
After pumping in massive amounts of liquidity, it will be harder taking it out, according to Hoenig. “And that’s when the independence will be more critically important than ever,” he says, “and we have to maintain that for the long-term good of this country. If we don’t the inflationary bias will be there.
“It’s not there today because we’re in recession,” he continues, “but it’s inevitably before us if we don’t do this right and independence will be critical to that. There will be a lot of resistance by a lot of different groups, as we all know.”
Hoenig, who joined the Kansas City Fed in 1973 as an economist, is guardedly optimistic with his current forecast. The most recent data are a mix of good news and bad news, which he sees as an improvement over all bad news. “That tells you we at least have the possibility of being on the bottom,” he says. Another positive is the “enormous amount of stimulus in play.”
He believes there are a number of factors pointing to recovery, but it won’t be rapid, he suggests. A lot of leverage still in place needs to be dealt with by consumers, by the government and by some businesses, he notes. And there are institutions that are still under pressure, as are the commercial real estate markets. “Personally, I think the worst is behind us,” he says. “But there is more to deal with.”
Hoenig doesn’t agree with those who say a period of above-average inflation is necessary “to even things out” with the current low inflation. “That is ridiculous,” he says. “I think you need to allow the economy to improve, manage inflation to keep it low but not kill the economy as you do. Those are challenges that we have to face and deal with, but I think we can.”
Nor does he believe another stimulus is called for, suggesting patience because much of what’s in place remains to be played out. Acknowledging that it’s an inefficient process, “I think it peaks in 2010,” he says, “so we have to get to there, but we have a bit of a climb yet.”
How should community bankers approach the coming months as they work through commercial real estate woes, higher FDIC premiums and other troublesome issues? “There are no simple answers to that,” says Hoenig. Some banks have more risk than others and they will have to judge their own portfolios and manage the risk carefully. “Don’t go into denial,” he advises. “If you have an issue, face it. That’s hard in these circumstances but if they if they step up to it they have the best chance to survive and prosper.”
Community bankers also need to be involved in addressing too big to fail, “because it puts them at a disadvantage,” he explains. “They also have to look at the proposed consumer legislation because what it means is a greater regulatory burden for them and they had better understand that and address it.”
There is tremendous momentum for a consumer protection agency, he notes. “It’s a little like motherhood and apple pie.” The legislation, he points out, would move the examination of commercial banks as it relates to consumer protection out of the banking agencies and into a separate agency.
The legislation is not clear, however, on how that agency would address and examine the entities that caused the problems — mortgage brokers and finance companies. “All these things are left unsaid, but we are making sure that banks have another regulator,” he says. That will raise the cost to the banking industry and that cost will be passed on to consumers.
And it isn’t just a matter of moving consumer protection to another agency. “When you examine a credit, you have to examine it for compliance with consumer rights,” he explains. “That doesn’t go away because you move the responsibility out.” That overlap is going to confuse the issue further, he believes.
“I think this needs to be thought through much more carefully than it has been,” he says. “It’s being done in a rush and, unfortunately, when you do things in a rush, as we keep learning, the unintended consequences overwhelm the intended consequences.”
In a final few words of advice, Hoenig says community bankers should look at their assets, take a realistic view, and where they have capital and where there are opportunities. “Don’t go into the foxhole,” Hoenig says. “Continue to be part of the community, lend prudently and we’ll get through this. We have before and we will again.”
Bill Poquette is editor-in-chief of BankNews.
Copyright © August 2009 BankNews Publications