Transcript
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to bbrophy@mercatus.gmu.edu
[00:00:00] Brian Knight: Welcome to the FinRegRant, the audio blog of the FinRegRag website. My name is Brian Knight. I'm joined by Tom Hoenig, my colleague. You may notice a slight difference in audio quality. We are recording this off of my iPhone because big news has happened and we didn't want to delay any further, and that is that Federal Reserve Vice Chairman for Supervision, Michael Barr, announced, on September 10th, he would be recommending a full re-proposal of the Basel III Endgame capital rules, which these rules are highly controversial. They've been subject to quite a bit of Sturm and Drang, and the initial proposal, I guess, was determined to be either not politically viable, not wise as a policy matter, or some combination of the two.
To talk about what this might mean, talk about what Vice Chair Barr said, and where these things may go in the future-I'm joined by my colleague Tom Hoenig, former Kansas City Fed president, former FDIC vice chair, noted capital proponent, and bank regulatory gadfly. Tom, it's good to have you, as always, on the rant.
[00:01:14] Tom Hoenig: Thank you. It's good to be with you, as always.
[00:01:18] Brian: Let's talk about what's going on here. Vice Chair Barr had a speech, and I read the speech, and it sounds like he said, "We got a lot of feedback on this. We realize we need to significantly rethink some of what we proposed, and so we're going to do that." He had some specific recommendations of what he was going to suggest the board reconsider, but he also made clear that, when the comment period opens up, people can comment on anything. This does appear to be a full re-proposal.
[00:01:59] Tom: Yes, it is. Let's go back. When they put this out a year ago, this proposal for particularly operational risk and market risk, and then they added a few other things in, it was highly controversial, as you said. The banking industry were upset about it. There was even various consumer groups who were upset because they thought it would reduce the ability to get mortgages and consumer loans. It was just blasted by everyone.
They had to go back and rethink this, and that's what this is a result of, and it is a significant change. I think it's a full re-proposal. Basically, they're cutting the increase in capital as a result from the original proposal a year ago by half. It's 9% for the largest banks, less for the other regional banks, and still less for the smaller banks. It is a major re-proposal, and I think necessary.
Now, I will tell you, as you know, I'm an advocate for capital, so I think having an increase in capital is probably a good thing. I think the risk-weighted way that they went about it that time and even this time is unfortunate. I think it misleads and gives a false impression that capital is very strong when in fact, it's less so. It gives the impression that this is going to facilitate loans and borrowing and it probably will have a minor effect on that. It's more of a political document, a recasting of a desire to get more capital in the industry.
[00:03:39] Brian: Let's back up for a second. I imagine if someone's listening to this, they're interested in bank capital and have some familiarity with it. What is Basel? I know Basel is a town in Switzerland, but otherwise, what are these Basel proposals?
[00:03:55] Tom: Basel is a conglomerate of nations that come into Basel, Switzerland, and negotiate international capital standards. The idea behind that was to give what I call more of a level playing field among the nations and their banks within those nations so that one country isn't giving their banks high leverage so they can make cheaper loans and take market share versus others, and to give a general improvement in the overall stability of the international financial system, which is dominated by very large banks.
This is a way to try and negotiate an agreement for capital internationally. It's been in place for decades. It has had very mixed results. Basel I was simple but not very useful. Basel II was highly complicated and misled. We had the great financial crisis, in some sense, contributed to by these very arcane Basel capital statements that put very low weights on very high-risk assets because regulators thought they had it figured out when in fact they didn't. It's a means to an end, but the means is, I think, fairly weak as a useful tool.
[00:05:17] Brian: You mentioned risk-weighting a couple of times, and as I understand it, risk-weighting is-- you can have a rule that says, "If you have X amount of liabilities out there," or I guess in banking it'd be assets, right? Yes. You've made X number of loans, which means you have X amount of exposure, and you have to hold a certain amount of capital in reserve so that if those loans go bad, you remain solvent, the bank doesn't fail, we don't have a run, we don't have systemic effects, et cetera.
You could do it just on a simple basis, or you can say, "Well, okay, all of these risks are not the same. All of these assets are not the same. They don't pose the same risks." We could try to fine-tune, we being the regulators, could fine-tune how much capital you have to hold against one thing versus another.
For example, you're holding US Treasury bonds. The odds of those defaulting are basically zero. If they do, we have bigger problems. You don't have to hold very much money against those, because we know that those debts are good. Whereas a subprime mortgage, the risk of default is much higher. Maybe we need you to hold more money against it. Now obviously, as fans of the SVB drama will remember, default risk is not the only risk. Still, as sort of a simple schematic. It seems like the Basel system is very much into risk-weighting.
[00:07:00] Tom: The Basel system is a risk-weighted system. Let me, if I can, go back. I'll use a little different terms than you do.
[00:07:07] Brian: Use the correct terms.
[00:07:09] Tom: I wouldn't use the word hold capital and reserve. To me, here's the way you think about it. First of all, capital is investor funds, just like deposits are depositor funds. They're used to make loans, and they're used to make investments in government securities and so forth. It's just a different source of funds. It's not something you hold in reserve. They have reserves that you can carve out. This is capital that people buy the stock for and you operate on. That's very important.
What this says is that we as regulators, when Basel sets these risk weights, they say, if you make a loan, you have to hold, say, 8% of investor funds. You have to use 8% investor funds against the total loans. The rest you can use from borrowed funds, depositors, and so forth. Now, if you're going to invest in government bonds, well, those are less risky, as you said, for credit risk, so we won't require you to use as much of your investor capital to invest. Now, you can use more depositor funds.
It's saying, "We want you to commit your investor funds to the riskier assets rather than the less risky." That assumes that the regulator knows what's more risky and less risky, which let me give you an example. You mentioned bonds. Government treasury bonds and bills are less credit risky than a loan, but interest rate risky, they're very risky. Yet you require them to hold little or no capital against that because there's no credit risk.
The regulator is making decisions for the investor that says, "Put your money here." From the government's point of view, that's a very good thing, because now banks can hold more government securities, which actually crowds out loans. If you think about it, the largest banks in this country have about 40% of their assets in loans and a very large percent of their assets in government securities, whereas smaller banks, community banks, small regions, have about 70% of their assets in loans and a much smaller part in treasuries. You get these very—what I'll call allocated results—from the regulators saying, "I know where the risks are." Let me go on from there.
My point is to tell the industry, you have to have so much capital against your total assets. You have to use so much of your investor funds to operate. History will tell you what the right number is. There's a lot of research on that. You can use your risk rating systems to allocate your capital, how you want to allocate it to the different assets, whether it's loans or government security, you make that decision.
[00:10:01] Brian: You mean the bank?
[00:10:02] Tom: The bank makes that decision. You'll end up, I think, in a better place because risks change by the minutes, and banks can, if they're smart, not all of them are, but if they're smart, they'll change their risk allocation. Whereas regulators have to go through a notice of proposal, rule making, just like we're doing with the Basel III Endgame that Vice Chairman Barr talked about. You're getting these very convoluted outcomes.
If I can make one other comment is, when you look at the risk-weighted capital ratios, as are calculated for the largest banks in this country, they're about almost 15%. Sounds very, very strong. When you look at their leverage ratio, how much capital they have of their investors to absorb losses before it falls back on the taxpayer or the depositor, it's about 7%. It's half as much as you would think when you hear this risk-weighted capital rate. It misleads as well.
I'm not a fan of risk-weighted capital. I think one of the reasons we still have it is it allows government debt to be increased without it impacting the capital ratios for the largest banks, which are the broker-dealers who buy that debt.
[00:11:17] Brian: There's a lot to impact there. Going back to the very beginning, just so I understand the mechanism, is the reason why you'd want more investor money backing a risky loan compared to depositor money, that, in the event of a failure, the depositor is going to be-- well, one, they'll be entitled to FDIC insurance to the extent they're entitled to FDIC insurance and or to the extent the FDIC decides to be magnanimous, see Silicon Valley Bank, whereas the investor, particularly an equity investor, bankruptcy policy being what it is, even a debt investor is expected to be zeroed out. It's like that money's just gone, poof.
[00:12:06] Tom: They take the first loan before the depositor does, and if the FDIC decides to be magnanimous, before the insurance fund does, and then finally, if it's big enough, before the government does. You really want that investor to be engaged in that bank, and the more the investor has into it, the more attention they pay to it, and the more attention that the management will have to pay to it. You get better outcomes by requiring more investor capital.
[00:12:36] Brian: You talked about Basel as a political document, and in a way, it has to be. It's an act of government. It is subject to government rather than market processes. It is government actors rather than market actors making these decisions. Politics is inevitably going to get involved. To ask you to expand your thoughts on that, do you-- on the one hand, there's just a knowledge problem about what assets are truly risky, and to truly know that, you'd have to know the future.
You could probably make reasonable guesses based upon the past, or based upon the structure, or whatever, but that type of knowledge should be equally available to market actors and to government actors. Everyone can read financial history. Everyone can hire economists and finance people to do analyses. To what extent is politics, or does politics distort that sort of analysis?
[00:13:53] Tom: I think it distorts it greatly, because, number 1, the idea of the banker, if-- first of all, the banking industry has a very large subsidy—deposit insurance, the discount window with the Fed, the liquidity backstop from the government, so they have a huge subsidy. For the creditor, the depositor in that, they're also protected, so they don't have any interest in following the bank and making sure it's run soundly. They know they're going to get their money. It changes behavior. It allows the bank management to lever up more, that is, to use more borrowed funds rather than investor funds, so that they can increase their return on equity, makes their stock more attractive, makes the management get bigger bonuses, all kinds of benefits, because you can level up.
That increases the risk, and the risk is now, when you don't require more of investor funds, the risk is now being barred by everyone else in the chain, that is, the debt holder, the depositor, if they're not bailed out, and of course, the government, if everything fails and the government has to come in as they did with Silicon Valley and guarantee things for everyone. It increases the cost of the taxpayer. That's the problem. Now, they have the same information, although the bank management should have the best information.
They're the ones who are looking at the choices, they look at the loan, how much risk is in the loan. The regulator can come in and look at it, they sample, but they don't make every loan. They have less information, and the politician, they have almost no information other than the public document or what their staff can find out, so they have the least amount. Still, because there is this backstop of government, you have the politician involved, the regulator who thinks, "I oversee these, I'm accountable, I want to have a role in this," and the bank management who says, "Well, I want to keep it as low as possible so I can raise my--"
The incentives are all, if you will, pardon the expression, screwed up. They're just all over the place, they all have different incentives around them. When you had more of a market environment, then it is the investor who is at risk, and they will pay attention to it. I think you're losing that when you use a risk-weighted system that is directed by the regulator who has less information and not the investor who has the most to lose if they make the wrong choice.
[00:16:33] Brian: It does seem like another avenue for political influence, which I think we saw, and you alluded to earlier in this case. Consumer groups lobbied against this on the grounds that, "Hey, this is going to raise the cost or lower the availability of things like mortgages to more marginal constituencies," where perhaps the credit risk posed by a mortgage would be higher
If the bank had to hold more investor capital against such a mortgage, it would be less profitable, and so they're less likely to do it. The consumer groups are like, "No, we want to make certain that these things are available to our constituents." From a pure risk perspective, if all that mattered was we want a banking system that is as safe and stable as possible, there's an argument to be made that that's not what we want. If that is what these rules are supposed to be about, then the answer would be, "I'm sorry, but the requirements of safety dictate this."
We want to accurately assess the risk. If, on the other hand, this is a broader political action in amongst all of the other political actions, concerns about access to credit, access to home ownership, all of these things, which are perfectly reasonable political concerns. Then it seems like this provides an avenue for influencing the risk-weighting in particular. First, let me stop and say, does that square with your understanding? Does that seem plausible?
[00:18:20] Tom: That's very plausible. That's exactly what's going on. It's about incentives. What you're doing is saying, if you really want home ownership, and they're saying, "Well, if you raise the capital standard, I have to have more of a down payment because I have to reduce the risk for them to invest in me," what you're doing then is saying, politically, we want you to take this risk for us, for these homeowners, at your expense.
We're going to make it possible for you to lever up a little bit more because we're going to artificially put the capital ratios down, or shoot the capital investors requirements down. I say to them, "Well, wait a minute, if that's your goal, and that's a political goal, that's Congress's. If they want to give grants, if they want to themselves back the loan, give a guarantee, those are things they can do, but that's there." To change the capital and say, "You should take on this risk, and we're going to allow you to hold less capital against it because we want you to take on this risk, more risk than your capital would otherwise justify," well, that's what we're going to do.
You shift that burden towards the bank, or you actually indirectly shift it back on the taxpayer because you are allowing them to underwrite a higher-risk loan at less of investor commitment to it than you otherwise would. You get a very, I think, distorted outcome. As witnessed, the great financial recession, when subprime loans went in the tank, there were major losses there, but those were heavily subsidized because the amount of capital that was required from your investors to fund those was very marginal. You could use depositor funds much more extensively or borrow funds much more extensively. You got very convoluted outcomes and a crisis.
[00:20:09] Brian: In my head, I'm picturing one of two models, and I'm curious which one jives more with your experience. One model, the regulator puts on a risk weighting to a particular type of asset that is perhaps political, that risk-weighting is perhaps politically influenced. The bank just takes that as gospel and says, "Well, I guess these things are fairly safe. Let me do a lot of them because they're profitable and they're safe." It's the best of both worlds.
The regulator's happy because I'm doing the thing and I'm holding the appropriate amount of capital on the thing. My customers are happy because I'm able to serve them. No bank makes money by not serving customers. I'm happy my shareholders are happy because it's very profitable, and I get a nice bonus and my shareholders get a nice dividend and everything's great.
Then, turns out, "Oh no, these things are actually much riskier than we thought. Kaboom, 2008."
[00:21:08] Tom: Exactly.
[00:21:08] Brian: That's one model. The other model is basically the regulator says, "Oh, here we're assigning a risk weight," and winks at the bank manager. The bank manager looks at the risk weight, realizes, yes, this isn't an actuarially correct risk weight, but boy, these things are going to be profitable. Winks back at the regulator, starts making a bunch of loans, and then you just hope that when the music stops, you have a chair. Those are two extremes. In your experience, do either of those have a ring of truth to them? Do both of them have a ring of truth to them? Is the truth somewhere in the middle? What do you think?
[00:21:47] Tom: I think both have a bit of truth with them, but I think-- what you're doing is-- so the regulator says, "I'm going to put these weights on here. I'm going to look at historical data. We had a decade of good mortgage loans, they went through, so we're going to put a low weight on those." Then you go over here and you put that low weight on, and so you're telling the bank, these are relatively low risk, in our opinion, and you incentivize the bank to say, "Well, look, here's what they're yielding."
They're actually yielding a little bit more than this so-called risk weight would justify, but we'll take it. We'll lever it up on that because we don't have to use our funds to do it. We use depositor funds. We'll make more money. In the short run, they do. Then later as, oops, they are more risky. In fact, by artificially putting that low-risk weight on there, we increased the leverage in that part of the industry, but made it more vulnerable to a downturn or a change in interest rates or whatever. Now we have these major losses, and who's going to assume those losses?
If the bank's large enough, the government will assume, and if the bank's small enough, investors will lose everything, but the depositors will still be saved by the government. It all falls back on the taxpayer in both cases. Yes, a little bit of both, but in the long run, the outcome is the same. Too much risk, too little investor funds to discipline the market and the industry, and you have a problem down the road as things turn for the worse. You don't have enough investor capital to absorb it all because you've allowed them to arbitrage the game.
In other words, their amount of capital they have in the industry has fallen because you have these risk weights that allow you to hold less and less in these so-called preferred assets. You end up with a more leverage industry, vulnerable industry, and then a crisis.
[00:23:58] Brian: You also mentioned this but I want to expand on this as a concept, that it seems like risk-weighting is also a means by which the government can direct investment, because if a bank is agnostic, the bank is like, "Look, I want to be profitable and not fail. These are the two things I want, these are the things my investors want. Under the Milton Friedman School of Corporate Governance, this is my obligation. Maximize profit, don't fail."
The regulator says, "Well, we are going to artificially, in effect, adjust prices to you, the bank, for various types of assets." It seems like it's a tool that's been used in this way to say, "Well, as a matter of public policy, we want more capital going in one direction and less capital going in another."
[00:24:55] Tom: Yes. More funding going. Let me give you an example, and it's harsh, but sovereign debt. Most governments wanted their debt to be issued and have a strong demand for that debt. If you tell the bank, "You don't have to hold capital against that, and you can earn a 3% or 4% return," what's the bank going to do? No risk, they think. No investor capital. They can use all borrowed funds and margin it out. They can lever for extremely high levels and make a lot of money doing that. What investor wouldn't want that?
Your ROE goes up. By doing that, you're incentivizing the institution to direct their funds towards a particular asset, and in this case, government debt. Then the other political part of this is it's an international agreement. You may say the US debt is credit risk-free, but is Greek debt credit risk-free in 2011? I don't think so, but it had a low weight. You get all these convoluted outcomes when you engage in setting these around the supervisor and the political influence, the social influence that goes with that rather than a market, "Here's the risk. I have to have this because I know I'm going to have certain losses. I have to cover those losses."
That's the market work, but now you have the interplay of politics, investors, and supervisors defining capital, all with different motives. Usually, you come out with what I'll call a very distorted capital number.
[00:26:51] Brian: Moving on from capital for a second, let's talk about operational risk, because Vice Chair Barr also spent a lot of time talking about operational risk. First off, for the listener, what is operational risk?
[00:27:03] Tom: It assumes you encounter fraud. It assumes you have a--
[00:27:08] Brian: A cyber security attack.
[00:27:10] Tom: Fiber security, any kind of attack like that, that's one. Fraud, which means you hack and you get $100 billion in funds somehow. These are all possibilities. Or your computer breaks down, your payment system's fouled up, which has happened to banks. Those are all operational risk. Now what you're trying to do is model that to some extent or use past earnings hiccups that might've occurred to say you need capital for this particular-- If you have a history of having had a cyber attack, you're going to have to hold more capital because that falls into our formula. Assuming the past is an indication of the future, that's a pretty slim read to base operational risk on.
[00:28:08] Brian: I do think Barr said that he was going to recommend they move away from past being prologue in their analysis.
[00:28:15] Tom: Now they're using net earnings, net fees, and so forth. I don't know how that'll work. I'll be interested in the comments people make on that who have to deal with that. To me, operational risk is a risk. That's why you have capital. That's why you have investor funds there to absorb that. Just like you have investor funds, if you make a bad loan, you don't do it on purpose, but you know you're going to have a certain degree of that.
That's why you have to say, "You have to hold a certain amount. Here's what history has told us. Here's what we know from the research done with the leverage ratio." It's how much capital gives you the greatest protection. You don't necessarily want 100% capital by any means. 10% to 15% has been the number that research has shown to give us the greatest protection and still allow the market to work.
Those are things that I think should be thought about, but we have the regulators and the banking industry at this point, the largest banks, have married themselves to risk-weighted capital and to get them to go back to,"Here's how much capital we need and we'll allocate it," is, I find, almost impossible to convince people is necessary. Congress doesn't understand it. They're going to say, "We just want to make sure things are balanced that our constituents, which are the banks, are not unhappy that we still have a safe bank, which we rely on supervisors. Negotiate this out, give us an answer," rather than how much risk do we really have in the system.
[00:29:54] Brian: I'm going to ask you about what your recommendations would be. You started getting into that, but first, one thing you said just prompted question 1. To what extent, if at all, do you think that the rise of things like risk-weighting has caused bankers ability to be effective bankers and really assess risk and opportunity holistically, to atrophy? In a world where a bank has to hold a certain amount of capital, investor capital, and then take its chances and pick its portfolio of risk, presumably, the people who are really good at figuring out where risk is underpriced or overpriced—whatever, either way, where you can get a better risk-adjusted return—they're the ones who are going to thrive and others will falter.
In a world where the regulator is basically like, "Look, here's a menu. We've preset pricing on these things to some degree," to what extent do you think that just, if at all, does that incentivize banks to be, like, "Yes, we want our portfolio to look a certain way. We want to find the best opportunities within each of these categories. The categories are somewhat set for us. Let's think within that box." Is that an actual concern? Do you think banks still have plenty of--
[00:31:34] Tom: I think bank management have all the necessary incentives to make choices based on risk. The difficulty is, by putting risk weights on the assets for them, you are incentivizing them to adjust their analysis. In other words, you're incentivizing them to say, "Well, if you are going to underweight this asset, and I have a return at this level, given the conditions I'm in tonight, I'm going to take that incentive, and I'm going to over-invest in that asset, because you've made it possible for me to do so by requiring my investors to put less money in it."
The bank management always will judge the risk-return trade-off. When you change that risk-return trade-off, by your supervisory assignment of risk, you're going to get different outcomes. Really, if the supervisor really downgrades the amount of risk for that asset, you create a over-leverage situation as you put too many resources towards a particular category of asset, and therefore you create greater instability or greater risk relative to the return you have, based on that market factors, but on supervisory factors, and someone else's judgment.
That's where you get these terrible outcomes. We all want, for example, a very healthy housing market. We want people to be able to own a home. However, if you say, "We're not going to have you use your own capital to do that, bank. Lend all this out." You say, "Hmm," and I have to also be pretty confident that there'll be a bailout. Yes, I'll do what you say. I'm going to put a lot of money in mortgages, even subprime mortgages, because I don't have to use my own money for it. I'll get a high return for my investor until, of course, things change. Then I have to be ready to either shift quickly or get the government to come in and bail out. That's what happened.
[00:33:50] Brian: Do you think-- you're certainly not known as a huge fan of the largest banks, and I don't think they're huge fans of you, but do you think that sometimes it results in an unfair outcome where the banks do what the government pushed them to do, and then when it goes bad, they become the scapegoat?
[00:34:11] Tom: Right. To answer your-- I don't really dislike large banks. I think they have a competitive advantage granted by the government, and they act to incentives like anyone else does. My complaint is they shouldn't have these advantages. They shouldn't be too big to fail, for example. To me, the risk-weighted is to their advantage and also to the government's advantage because it directs resources towards where the government wants it rather than where the risk analysis would be without the government support.
I don't necessarily blame them. I just think that we need to remove the subsidy, the sizable subsidy they have, so that then the market can actually operate a little more like a market and a little less like a public utility where assets are allocated by government intervention as well as management decisions.
[00:35:09] Brian: All right. It's March of next year. The president, President Harris, President Trump, who knows, calls you up, and says, "Tom, I'm open-minded. What should we do about bank stability?" What do you tell him?
[00:35:28] Tom: I'd say, amend Dodd-Frank. Simplify it enormously. If you think that's at all possible, you should do that. That's the first thing because it puts enormous costs on banks, especially regional and smaller banks relative to the asset size they have. Let's take care of that, number 1. Number 2, let's have a capital ratio. Now, before you have the safety net, before you have the Federal Reserve and the FDIC, banks held between 10% and 15% equity. Now they still had failures, but there was less of it coming back on the taxpayer. The banking industry actually was more stable because banks held more capital.
Let's look at the research, it's out there. Let's look at history and let's set a standard on leverage ratio, 10% to 15%. Mr. President--
[00:36:23] Brian: Or Mrs. President.
[00:36:24] Tom: Or Ms. President, let me also point out to you that you want to be aware that your debt levels, that your ability to issue sovereign debt, will be affected by this ratio. The largest banks can't get away with holding almost no capital anymore for that risk. There is interest rate risk there. Just be forewarned, we may actually have to take care of our national debt problem too.
[00:36:57] Brian: I feel like that's the point where you hear the phone hang up.
[00:37:00] Tom: [laughs] That will be the hard part.
[00:37:02] Brian: I was going to say, I was being a little optimistic but I think that's the point where you hear a click on the other side of the line.
[00:37:11] Tom: Unfortunately, that's probably right, but that's something we need to think about too.
[00:37:16] Brian: That is certainly true, but who wants to face that horrifying reality? All right. Well, is there anything else that you're just desperate to get off your chest about Basel Endgame, the re-proposal?
[00:37:31] Tom: Let me just say, it proves-- in a sense, it's a political document. Capital numbers that were 20% increase in capital are now 9% and 6% and almost nothing in terms of increases in capital. It is what it is. It is a political document. Hopefully, in the end, we'll have a better-capitalized industry, a safer industry, but it's going to be a very expensive transition.
[00:38:01] Brian: Yes. Thank you so much for joining us.
[00:38:04] Tom: Thanks for having me.
[00:38:05] Brian: Thank you, listeners, for listening to this, a bit pirate radio version of the FinRegRant. Again, apologies for the audio quality, but we just wanted to get this done in the can while it was still fresh. Thank you very much, and look forward to talking to you again soon.
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