Transcript
Note: While transcripts are lightly edited for clarity, they are not rigorously proofed for accuracy. If you notice an error, please reach out to bbrophy@mercatus.gmu.edu
Steph Miller: Welcome to a special episode of FinRegRant, the audio companion to our FinRegRag blog post series. I'm Steph Miller, a senior research fellow at Mercatus. Today, I'll be interviewing my colleague and distinguished senior research fellow, Tom Hoenig, about his perspectives on how the culture of bank supervision has changed. To give you an idea of why I thought it would be a great idea to do this, this is my attempt to get Tom to reconstruct an off-the-cuff lecture he gave our former colleague Brian Knight and I earlier this year.
If you'll recall, there was some discussion in the aftermath of the bank failures last year about how there might have been some deficiencies in supervision and how that was unfolding within the regulators. Tom gave this off-the-cuff lecture and I thought, "Wow, more people need to know about this." After that, we would have these subsequent meetings and when the topic of supervision came up, I'd ask Tom to repeat what he told us. After the third, fourth, fifth time, you start to feel bad that you asked someone to repeat themselves. This is, once and for all, my attempt to get Tom to put all of this in audio form and transcript form. With that in mind, Tom, thank you for joining me.
Tom Hoenig: Glad to be here, Steph. It's a pleasure. If I can remember everything I told you before, it'll be great. Otherwise, we'll stumble through.
Steph: Sounds great. Sounds like a plan. I think I'd like to start by having you briefly introduce yourself, especially for the new subscribers to FinRegRag. Let's say you get your PhD in economics from Iowa State in the early '70s. Then what happened after that?
Tom: I got my PhD in money and banking. I had a special interest in the banking institutions themselves, not just the money part of it. I had an opportunity to join the Federal Reserve Bank of Kansas City. Not in the research division, but in its supervision division as an economist, working on banking structure and supervision topics and issues.
I worked through that and then took on some management roles and became involved as a leader within the division in charge of bank holding company supervision. I was well versed in the bank supervision business before I got re-involved in monetary policy when I became president of the bank in 1991.
Steph: Okay, great. Now, also during your time in bank supervision, you saw a lot of crises unfold. Aa number of them, '70s and '80s. To give our listeners some context to what we'll be talking about, can you run through some of what was happening at that time?
Tom: As some will recall, and as history will recall, the '70s was a period of a fair amount of volatility and a lot of inflation. In fact, it's entitled the Great Inflationary Period. It was also,a boom time, it wasn't just inflation. Banks were lending very freely. They were lending on collateral values as much as on cash flow and earnings. A bubble economy developed, not just in one area, but across a series of asset classes.
For example, commercial real estate boomed. Banks were making loans, construction loans, for 100% of the construction costs, on the confidence that the value of the property would be higher when it was completed and a long-term loan could be easily found. It was done in farming, as farm prices were high, although volatile. Farmers were borrowing more to extend and expand their operations. They were highly leveraged during that period, and increasingly so.
Commercial real estate became even more, shall we say, balloon-like. Finally, we saw it in energy, especially in the Southwest, the Midwest, Colorado, and Wyoming. Banks were willing to make speculative loans on new drilling opportunities. It was an environment of very strong optimism and freewheeling for the economy and for bankers who were lending in that economy.
Steph: There was also, during the '80s, you had the S&L crisis and subsequent banking crises.
Tom: The follow-on to that great inflationary period was the correction, as inflation had gotten out of hand. It was as high as 14% when Paul Volcker became Chairman of the Fed. He was determined to break the back of inflation. In doing that, though, he raised the interest rate dramatically, as high as 20% in the Fed funds market. You had a whole series of industries affected by inflation. You mentioned the S&L industry. It had made fixed 30-year loans at relatively low rates, even at 8%, which seemed high at the time, compared to where the cost of funds were going within the Volcker years. The S&L were upside down. They had high borrowing costs, and low income streams from the fixed rate mortgages. The industry got into big trouble. The banking industry, too. Many of the banks, the largest to the smallest banks, had made loans sometimes longer than they would have otherwise made in more normal times, based on inflated collateral. The assumption being that if anything went wrong they could liquidate the collateral and recover their money when, in fact, with high interest rates those collateral values were collapsing, and they weren't in the best position to liquidate and fund themselves.
You had in the region that the Federall Reserve Bank of Kansas City covered, hundreds of banks fail. Also, throughout the country you had some of the largest banks fail during that period. Continental Illinois, one of the largest banks in the country, I think it was the fifth largest, failed because it too was upside down, insolvent.
I was the discount officer, the lending officer for the Federal Reserve Bank of Kansas City, when the famous bank called Penn Square Bank, which was an energy industry lender, failed. The havoc from that was tremendous in the southwest part of the country. It was a very difficult period of crises. That was when too big to fail was introduced. For example, Continental Illinois,while its investors did lose, creditors did not lose.
Later, after I had become president of the bank, we had a period of, again, very accommodative monetary policy in the 2000s, leading to a great financial recession that followed in 2008. Hundreds of banks failed, and businesses failed as well. Those are the kinds of things that happen. Supervision was faulted in some cases, as it should have been. However, the cause of the crisis was primarily poor monetary and fiscal policies that created bubbles that then required correction. Inadequate bank supervision played a role, but it was secondary to the greater role of the bubbles that were created during those periods of easy money.
Steph: Okay, great. Thanks for that rundown. I think we talk about the effectiveness of regulation, how to do it all the time, but we don't talk as much about bank supervision and how to have effective bank supervision. Before we start getting into how the culture of supervision changed while you were an official, can you give us a sense of what you think makes for effective bank supervision? Aside from the very hardworking, dedicated people.
Tom: We do have hardworking, dedicated people in bank supervision. I would tell you that when I was first involved in bank supervision during the '70s, it was far more decentralized.
Fed bank presidents were involved, and their heads of supervision reported to them. The Board of Governors was in charge of regulation, and while they were also responsible for supervision, they delegated much of it to the reserve banks. Similarly, I observed this to be the case for the FDIC and the OCC, that supervision was delegated to the regional directors. Those regional directors or those Fed presidents and heads of supervision at the Fed were accountable for outcomes, and they knew it.
After the Paul Volcker years, bank supervision in all the agencies became far more centralized, more directed out of Washington, more of the decisions were made out of Washington. There was less involvement by the Fed presidents, and more of an administrative role for the regional directors, and so you lost a sense of responsibility and accountability there as it all moved to Washington. I think that weakened supervision.
Strong, accountable supervisors can't offset the effects of questionalbe monetary policy and bubbles, but they can mitigate its effects. I think that's where we need to return. It's hard because everyone wants answers coming from Washington, when in fact you have to get those answers out of the regions where the institutions are located, and that takes more time, but it's more effective in the long run, in my opinion.
I admit, I come from a regional background, but I saw it firsthand, I saw the change from when reserve bank presidents would meet with those bankers and discuss issues, to where now it's less hands on, as far as they're concerned, and I think that's a bad turn of events.
Steph: Okay, thank you. You mentioned Paul Volcker as-- Would you say he was the first chair of the Fed who really took supervision, or made that part of the role of the chair? What exactly did he do to make that happen?
Tom: I don't know if he was the first chair- -but he was a chair that I observed most directly in comparison to those who followed him. Paul was more involved in supervision. For example, if there was a difference of opinion between Washington staff and Reserve Bank staff, the Reserve Bank staff would be asked, I'll use that word, to come to Washington and with the Washington staff brief the board, not just the chairman, but the entire Board of Governors, and if there were differences of opinion, to express those differences.
The Board of Governors itself was far more involved in bank supervision than I think it is today. I think that was a strength of the system. It gave the governors not just a briefing document, not just a document that summarized financial conditions, but a hands-on look at individual institutions that were having difficulty, or regions that were having difficulty. I think that served the board well, and I think we've lost some of the insight.
Paul was very open to this approach. In fact, he would meet with heads of supervision across the country and listen to them as well. It was a more open, inviting environment. It allowed for differences of opinion. It better informed governors regarding conditions within a region and the country more broadly.
Steph: Then Volcker's time at the Fed comes to an end, and then you have Greenspan becomes the chair. How did supervision change after that?
Tom: During Volcker's time at the Fed, his head of supervision in Washington was very much like him. He involved the Reserve Bank head’s of supervision in broad policy issues and on-going supervisory issues. He was an outstanding leader.
Steph: This is Bill Taylor?
Tom: Yes, Bill Taylor, who I had great admiration for. He built up a great unit within the board. He also worked with the regional Reserve Bank staffs. I also think his approach to supervison was also practiced at the FDIC and the Comptroller offices. Bill Taylor was the example of how to lead. He involved the regional directors. He briefed the presidents. He along with Volcker expected the presidents to be involved in supervision.
It's now much more centralized at all the agencies. I know it is so at the Federal Reserve and the FDIC. I think that has been a disadvantage rather than an advantage. I think it actually makes the Fed more political than it otherwise would be, and I think it makes the other agencies more political as well.
Steph: Then, of course, Bill Taylor passed away unexpectedly shortly after he left the Fed to become the FDIC chair. Would you say that really had a strong effect or important effect on how supervision was conducted?
Tom: No, I don't. I think the main effect was that these agencies just decided on a new direction, it's all about leadership. The Federal Reserve had a very strong leader in Paul Volcker who named a very strong leader in Bill Taylor. I think the other agencies did this as well. As it's become more centralized, those roles have become less important. That's because leadership wants to bring things more quickly to the center, so they have better and more direct knowledge, when in fact, by not inviting the regions involved and available to brief them, they have less.
I think it's just the change in the culture from one of decentralized involvement accountability to centralized control, and this has weakened supervision nationally.
Steph: This would be effectively what you're calling for a decentralized hierarchy where you're getting information from top down but also bottom up.
Tom: Right. You have to have a center. I understand that. We did. Even with Paul Volcker and Bill Taylor, you had it. With Greenspan, you had it. However, you have to also be open to and expect from the regions reliable performance and accountability. When you take their authority away, they become less involved.
When I was a head of supervision at the Federal Reserve Bank of Kansas City, the president of the bank then, Roger Guffey, could make a phone call or he could meet with a CEO and it would have an impact. You don't see that as much anymore. You might have it in a casual way, but not in, what I'll call an official way. I think that's unfortunate.
Steph: Of course, after Greenspan's time came to an end, then Ben Bernanke becomes the Fed Chair. How would you say supervision changed after that? Then, of course, you have the crisis and Dan Tarullo becomes a key person. What was happening?
Tom: I think that was part of the increased centralization. When Dan Tarullo became the head of the committee, the board's committee on bank supervision, he really did want to centralize it. He was very honest about it. That left him more in charge and left the board staff more in charge and the banks less so. You lost that direct communication- -from the region. I think that's unfortunate. Similarly, when I later joined the FDIC, it also had become more centralized than it had been when I was at the Federal Reserve Bank. I think these trends weakened supervision. We had crisis back then. We have crisis today. I think we're less able to deal with it today than we were then. Today, we tend to look more quickly to bailing out institutions.
Steph: Then, of course, since then, we've had Janet Yellen as chair, and now it's Powell. It seems the supervision process has not really changed much. Let's say going forward, I think now is a key time to talk about reform to make things better. What would you suggest?
Tom: Let me back up just a little bit. One of the things that I think happened was Paul Volcker really wanted bank supervision to be more important at the Federal Reserve and more important generally among the agencies. He really was behind the movement to have a new position on the Board of Governors called the Vice Chair for Supervision. While Dan Tarullo was the head of the committee, I don't think he became vice chair. Randy Quarles and Michael Barr are the first and second Vice Chairs over supevison.
Paul Volcker's goal was to strengthen the importance of supervision within the Federal Reserve, not just monetary policy. What it did is it concentrated the responsibility in one individual rather than the Board of Governors broadly. You really don't often have briefings from the regions on important matters or differences of opinion with the board any longer. It's all channeled through the board staff, to the vice chair. That's where it's taken care of.
Now, on major policies, the vice chair still has to get approval from the full board. While they receive briefing documents and staff updates, the board members are less well briefed on supervisory matters, supervisory issues and regulatory issues. That advantage has been lost. Going forward, I think that vice chair should report periodically to the full board on important issues and individual instituions, have the staff, including leadership from the reserve banks or the regions, come in and brief the Board of Governors.
Unless they already do it, I would also would suggest that the FDIC and OCC (Office of the Comptroller of the Currency), when major issues arise, that they have their regional staff come in and brief their boards and leadership- -and not just have it funneled through the staff to the head of that agencies. That would, I think, improve the knowledge base of the decision makers and, I think, improve the consequences and accountability for the decisions they make.
Steph: Of course, it would also maybe give the actual examiners more of an impetus to be aggressive in monitoring what's happening.
Tom: That's a very good point. I think one of the things that happens is that the examiners, like anyone, look to leadership for how you should do things. When I was involved, when individuals like Bill Taylor would be involved, he would say, "You do a good job, you examine, but you have to be able to explain yourself to management as to why you're raising these issues." It can't be just say, "I said so." You have to say why, explicitly.
You have to explain to management, what violation of law are at issue? What underwriting standard of your own policy have you violated that have weakened your credits and exposed you to risk? What investment policy have you failed to deliver on that has weakened your investment portfolio, leaving you exposed? For example, when interest rates were extremely low, everyone was concerned about what that would do to the investment portfolio and government securities values in the longer run.
Think about it. When the Fed increased interest rates, given the experience, it should have been immediately passed on to those banks, get your loan agreements with the Federal Reserve in place because if you have a liquidity problem, you want to be prepared for it. I didn't see any letters come out on that, and I think that is where the lack of information from the examiners, the lack of knowledge of what the condition of things were, I think hurt the ability for the regulators to react to the crisis that was developing. It's still a risk today.
Steph: One last question. Do you think you could recreate what Volcker created or would you have to do it differently?
Tom: I think you could recreate it. It would take leadership at each of the agencies, and there will be new leadership. It would take the vice chair of the Fed for supervision saying, "Here's what we would like-- We want the banks involved. We're delegating to them the responsibility and accountability for making sure banks in their region are run well, and that there are conversations if there are issues with the president, not just with the head of supervision." There's nothing wrong with doing that.
Now, ultimately, the Federal Reserve Board is responsible. Ultimately, the head of the OCC is responsible. Ultimately, the FDIC board is responsible. If they have good staff and they empower that staff and they hold them accountable, you will get information more quickly. You can't shoot the messenger. When the bad information comes in, you have to say, "How do we correct this?" Not, "It's all your fault”.
Steph: Thanks, Tom. This has been great. Now that we have it on record, I no longer have to trouble you with repeating it again.
Tom: Thank you very much for the opportunity. I do hope that the agencies think about how they can do things better, not just different. Thank you.
[00:24:39] [END OF AUDIO]
