“The regulatory system in the US is way too complex and fragmented”

February 2014

Conversation with William Isaac, former chairman, FDIC on – the Volcker Rule – too-big-to-fail banks – recent regulatory failures

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Here is the transcript of the video.

Emmanuel Daniel (ED): I’m very pleased to speak with Bill Isaac, who was in his time the chairman of the US Federal Deposit Insurance Corporation (FDIC), in an earlier period when the US economy and bank failures occurred. We’d like to revisit some of his decisions, and what you were thinking at that time.

I was very happy to read your book Senseless Panic, How Washington Failed America. Do you see a trend in the way that the banking industry has been evolving over time, in that today’s problems are not really the same as the problems that you faced in your day, but a evolution of it?

When you were chairman of the FDIC, your average American bank was essentially local. How would you profile the institutions that you regulated and what you see today?

1. Evolution of US bank regulation

William Issac (WI): Well, first of all, I think – I think that the average American bank today is still local. We have a handful of banks that are very, very big that are very global and very complicated. But that’s not the typical bank in the US. I’d say the top ten at the most, and probably even the top six that you can say are – are truly global in scope and – and fairly complex entities. The rest of the banking systems isn’t all that changed from – from what we were doing within the ‘80s.

ED: Right. So from 1978 to 1984, this was at the tail end of the oil crisis. Paul Volcker was the US Fed chairman at the time, and he was fighting inflation.

WI: I was fighting Volcker. I say that in jest. Paul Volcker is a good friend. We did have our battles but I have enormous respect for him and we are very good friends.

ED: Well, what were the battles on?

WI: One type of battle we might have is when we were dealing with a particular failure, he might have a different view than I had on how to handle it. The most notorious example of that is the Penn Square Bank, which was a small Oklahoma bank. In 1982 it went down in surprise and it had sold off a lot of loans to the major banks and a lot of very bad loans to the major banks. There were those who felt that we shouldn’t let Penn Square Bank fail, that we needed to bail it out.

ED: That’s the systemic failure that’s been happening again and again, in a different way right up to today.

WI: It was felt there would be a contagion effect and I think Paul would’ve wanted to handle that transaction differently than I did. I wanted to impose some discipline and let it fail. And in the end we let it fail.

The other type of disagreement we would have from time to time was – it was a period of deregulation, particularly deregulation of interest rates. I wanted to move a little faster on deregulation than he did in terms of getting the rates deregulated. I don’t know who was right and who was wrong on that but we did have some disagreement on that. But it was always about substance, about policy. It was – it was never personal. He might’ve had a view that was somewhat different than mine.

ED: Right. There’s deregulation on interest rates, there’s also deregulation on interstate banking.

WI: That hadn’t come yet. That came when the Congress passed a law – I’m trying to think. Yeah, I think that was in the late ‘80s after I had left the FDIC. We started to deregulate geographically and allow banks to – to go across state lines.

ED: Right. So when it comes to liberalisation of a banking system where you liberalise interest rates, you float money market, funds and so on. Do you think that there should be some checks and balances in place before you embark on that liberalisation journey?

WI: In an ideal world, we would’ve deregulated much more slowly than we did. The conditions in the marketplace forced us to deregulate fast, much faster than we otherwise would have. When Paul was chairman of the Fed, he was trying to fight a very serious problem – inflation. So he raised interest rates from probably a 7 or 8% level on prime rate to 21.5%. Most people don’t recall that today, but we went to 21.5% on interest rates in short order. Well, what happened was that people started taking their money out of their bank accounts and putting it anywhere else because banks were limited by law on rate of interest they can pay on their deposits. And so the money was just hemorrhaging from the banking system and the thrift institutions. We really had to go fast on deregulating their interest rates so they could keep the money.

But by allowing interest rates to go up, we created another problem, which we would like to have been able to balance better, and that is that because most of these institutions had loaned money to you and me at fixed rates, now they’re able to pay much more for their deposits. And so they were hemorrhaging red ink. They were losing a lot of money. The entire thrift industry was negative in terms of its earnings.

ED: The banking industry never really solved this problem of matching funds, right? Do you think that we’ve improved? Do you think that they have got new vehicles by which they can manage this mismatch?

WI: We’ve improved a lot. Banks are pretty good, for the most part, at being able to match their their assets and their liabilities and not take huge interest rate risk. But keep in mind that for roughly 50 years, from the Great Depression when we imposed interest rate controls on banks, they weren’t allowed to compete on interest rates.

ED: Right.

WI: They could count on having relatively stable money at a low price that was pretty much fixed. So the bank could go out and make longer term loans and investments at fixed rates. And that’s what they spent the previous 50 years doing. But all of a sudden, when the prime rate went to 21.5%, all those rules were out. And so overnight they had to start paying up for their deposits significantly. They couldn’t adjust their assets because those were long term commitments they had made to government bonds, to housing loans, to commercial loans and the like. Those rates were not adjustable. So it was really a serious, serious time.

ED: So you had chairmans and CEOs come into your office and, you know, ask you to help them deal with the issue. What were some of the ways in which they wanted help at that point in time, given the fact that they weren’t able to match their rates that they’re supposed to meet?

WI: Well, we needed to deregulate interest rates so they could at least go out and pay for the deposits that they needed. Because if they didn’t have that they had no liquidity, and you can’t run a bank, you know, without liquidity. You’ve got to have the cash to pay your bills and to pay your depositors and so forth. So that was the immediate thing that we needed to do. That was an emergency.

Then once those rates – they’re allowed to pay up for deposits, they’re losing money, many of them. And what they asked for, basically, was time. “Give us time. Don’t fail us too soon. Give us as much time as you can so that we can let these assets mature and run off and reinvest it at higher rates and earn more money.”

ED: But they weren’t given that timein many cases.

WI: We did the best we could do. For example, the Savings Bank Industry, which the FDIC regulated, it was basically a thrift industry like an S&L, but it was called a savings bank. We gave them time. As much as we could. We said that we would allow them to stay in business on less than desirable capital as long as they behaved. That they didn’t go out and bid up for deposits needlessly. That they didn’t take on riskier activities. We would allow them to in business until their book capital reached zero.

ED: How would you describe the working relationship between the US Fed and the FDIC, uh, at that point in time?

WI: I think we were very coordinated, not that we didn’t have disagreements. I was probably pushing faster on the deregulation of interest rate front than Paul Volcker, I believe that the Fed and the FDIC were very closely coordinated, and we were strong allies. Particularly it showed up when we handled the failure of Continental Illinois, which was the seventh largest bank in the country.

ED: Right. Now, let’s fast forward to 2009 and the responses from 2009, the Volcker Rule. Do you think that that’s now tying the hands of the banks to be able to give them the tools they need to manage the cost of funds issue.

2. Banks’ risky investment activities

WI: I’m a proponent of the Volcker Rule. I endorsed it immediately when Paul told me what he was up to. I’m not a fan at all of what the regulators have done to implement it. I think they’ve made a serious mistake.

Our mutual Dick Kovacevich, the former chairman of Wells Fargo, and I have written a couple of articles on this subject. We believe that there are two kinds of investment banking activities. One doesn’t really have a place in the banking system. One major activity in investment banks is to underwrite securities. That is something that we believe it would be appropriate for commercial banks. It’s a relatively riskless activity for me to take your securities and underwrite them and sell them into the market. It’s less risky than making a loan to your company because when I make a loan to your company, I tend to keep it on my books and take a lot of risk over the years. So just underwriting your securities and selling them gets me some good fee income, and it has relatively low risk. The other thing investment banks do that should be curtailed, not eliminated but curtailed in the banking industry is trading, actively trading securities, commodities, and other things.

That is a highly risky activity that doesn’t really belong in the banking system in a material way. Now, there are some things that banks do in that area that as long as it’s not oversized in relationship to the bank, we think that it’s useful. You do trades because you’re trying to hedge your books, sometimes you’re trying to help customers.

So what Dick and I have suggested is that you allow banks to earn as much as 10% of their income from trading activities but not more. On top of that, maybe not in the US, but many banks outside the US have a universal banking model. Both on the proprietary front in applying servicing there is the fee element, and also it’s a very important component of being competitive.

ED: Right. On one hand, the idea is not to go into trading as a gambling activity. At the same time, it’s a call part of running a banking business today. Is it the job of the regulator to sort of draw a line and say this is where you don’t cross?

WI: The regulators have actually drawn the line even tighter than I’m suggesting, which is to say “You can’t do it, period”. When we were dealing with winding down Glass-Steagall in the 1990s, the Fed adopted a rule very similar to what I just described.

They allowed some of that trading activity to take place in the banking system, but they put a limit on it. They said it can’t be over X% of your revenues. And so, uh, there is a precedent for it. It did work, it’s something that the Fed did on the way to phasing out Glass-Steagall altogether.

If we had stayed there and not eliminated Glass-Steagall in its entirety, we wouldn’t be talking about these problems today. So I think there is a precedent to it. I do think it would work. I don’t have any problem with banks making bets and trading, but they should not be something that could threaten the bank.

You are limited to say 10%; you could say it’s 12%. You could say it’s 15%. You could say it’s 5%, but, we chose 10%. If you limit your trading activities to a certain percentage of the revenue, it’s something that cannot bring down the bank. It’s just not big enough. That’s something that makes me a lot more comfortable.

ED: The funny thing about the US is that now, investment banks that used to have the right to trade as much as they want, have reincorporated themselves as commercial banks. So they’ve sort of tied their own hands behind their own backs. How do you think that’s going to play out? How do you think they are behaving, the Goldman Sachs of the world?

WI: Well, different people are going to make different choices. But in terms of the trading activities, I’m not concerned about that particularly in terms of the marketplace because hedge funds and others are already filling that void. They’re, you know, unregulated firms.

ED: Which is a natural consequence here. It just moves to the shadow side of the industry.

WI: Right. But there you have private capital at risk. Private funding is at risk, and you don’t have the safety net. So firms will be allowed to fail if they’re not banks.

ED: Why is it okay for firms outside the banking industry to fail in that way on the commercial basis, and why should banks be protected?

WI: Well, I think that we’ve decided a long time ago that banks are essential to the proper functioning of the economy and that banks can’t function well if depositors and other providers of funds to them don’t have some confidence that the government is in there ensuring deposits and properly supervising and regulating the banks.

During the 1920s, the stock market crashed, and – and there was a panic throughout the country. And people were withdrawing their deposits from banks, and we wound up having 1/3 of the banking system, 10,000 out of 30,000 banks, failed.

ED: How do you deal with banks that will be too big, too important to fail?

WI: I think you have to define fail, and that’s what we’re not doing today. As you know, Continental Illinois, our seventh largest bank in the country got into trouble when I was chairman. Well, many people would say we bailed it out. I would say we didn’t. I would say it failed. What we did is we assured all depositors that we would take care of them, so the FDIC put capital in the bank. The Fed agreed to continue funding the bank, and the FDIC agreed to take over some of the problem loans.

The price of that was we eliminated the stock. We, in effect, nationalised the bank. A few years later after I left the FDIC, it was sold back into the private sector. I would consider that a failure, and I think it was handled in the best way we could at that time. That’s what I think we ought to be doing with these large banks that get into trouble.

We ought to require that they issue a lot more long-term debt as part of their balance sheet whether it’s secured, subordinated, or senior. They ought to be required to issue maybe 12% or so of their balance sheet in the form of long-term, unsecured debt. Those creditors are going to be risk averse because they don’t get any benefit from excessive risk taking and big profits. All they want is their money back with interest.

Those are sophisticated investors, and they’re going to be risk averse. They will keep those banks in line. It will impose discipline on them. If the bank gets into trouble, regulators such as the FDIC have to deal with it, that long-term debt can be forced to convert into equity.

I’m in favor of relatively high capital in banks, tangible equity capital. I would suggest somewhere around 8% of tangible equity. So now, when you take the 12% long-term debt and the 8% tangible equity, you’ve got a 20% cushion. It’s hard for me to imagine a large bank could and cost the FDIC more than 20%.

ED: The rules seem to be, you know, fluctuating or moving from one extreme to the other. What do you think went wrong with equity as a form of discipline?

WI: In the form of equity, I can’t do anything about your behavior. All I can do is sell my stock if I don’t like it. I can’t declare in the event of default. I have no control over you unless all of the equity holders got together and kicked out management. But that doesn’t happen very often. So I think the bond holders are a more effective source of discipline along with regulators doing their job, which I think they failed.

You started this question asking should we have too big to fail banks, or should we do away with too big to fail banks through the mechanism I just described. But the most important thing to know – and this is why I got so frustrated watching the crisis in 2008, 2009 – is when serious problems develop in the financial system, the most important responsibility of a regulator, including the depositor is to not let it get out of control.

WI: Don’t create a panic. During the 1980s we handled 3,000 bank and thrift failures compared to only 400 in 2008 to 2010. We handled 3,000 bank and thrift failures. And as we did that, we didn’t create a panic because we had a plan. We knew how to deal with it.

ED: Do you think there was something fundamentally different between the balance sheet of a, you know, 1982, ’84 bank and a 2008 bank because the 2008 scenario wasn’t a banking panic. It was the market’s panic. It was the Lehman Brothers of the world not being able to meet their obligations. And then it found its way to Main Street.

WI: I think we’ve had plenty of problems on Wall Street. I remember Merrill Lynch almost failed in the 1990s. Other investment banking firms and hedge funds got in trouble in the ‘80s and ‘90s. So I don’t think that I would agree with you though this time around, it started on Wall Street. But because it was mishandled, it became a Main Street problem.

ED: It didn’t have to become a Main Street problem because in a way, regulators overreacted on on the situation on Main Street by calling into question the ability of Main Street banks to hold up the share price for example.

WI: I would agree. I think the regulators did overreact, and more importantly though when they were dealing with the Wall Street problem, they were schizophrenic about it. They had no plan, and they made different decisions within the same month that sent very conflicting signals.

First Bear Stearns gets in trouble, and they bail it out. And then Lehman comes along, and everybody was thinking it would be bailed out because they bailed out Bear Stearns. They let it fail, and the markets really didn’t know how to deal with that. What are the rules now? Almost the same time that happens, AIG gets in trouble, and they bail it out with $80 billion. And then they’ve been telling us for months and months that Fannie and Freddie were fine.

Right around that same time, they shut them down and put them in a conservatorship. And then WaMu was put into JP Morgan Chase, and Wachovia was put into Wells Fargo. So people rightly said what are the rules? Who’s gonna fail next, and how is the government going to handle it? That’s why my book is entitled Senseless Panic: How Washington Failed America. You have to have a plan. When we handled the Penn Square Bank failure in 1982, and we had this big argument about how we should handle it, we knew or thought that if we handled it as a failure, which we did, that Seattle First might come at us. The big bank out on the West Coast, Seattle First, might come at us. It did in 1983, a year later. We thought Continental Illinois might come at us, and it did two years later in 1984. Seattle First and Continental did not surprise us. In fact when we were arguing that weekend, we said, “You must bail out Penn Square because if you don’t, Seafirst and Continental are going to come at us.” And my response at that time, two years in advance of Continental was, “We will stop the contagion there. We’re not stopping it here. Those banks are going to pay the price for these investments they made and bad loans coming out of Penn Square.” So we were prepared for what was going to come next. I got to sense in this recent episode in 2008, 2009 they didn’t have a clue what was going to be the consequence of their actions.

ED: Washington Mutual’s big problem was that they couldn’t support the kind of lending it was doing. I can see the connection between Wall Street and Main Street very selectively. Wherever these two elements cross each other, markets and banking, that’s where the problem arose.

It appears that the regulators didn’t separate the two stories and insisted on dealing with it as one problem.

WI: Well, two things. One is, that in both cases in the 1980s when everything was coming down, uh, and in 2008, 2009 when it looked like everything was coming down, the primary issue for somebody, a public policy maker or somebody who’s running these agencies and trying to deal with the crisis, the common problem no matter what the balance sheets look like is in either case there’s a lot of leverage.

Banks were very leveraged in 1980s. They’re very leveraged in the 1990s and the ‘70s. Banks operate in a highly leveraged way. We allow that. Of paramount importance is to make sure that the markets don’t panic. And so they had a problem. Their number one problem should have been in 2008, 2009, to do whatever it takes to maintain stability.

That was what was guiding us in the ‘80s. We wanted to maintain stability. You can argue with me later about whether Continental was a good transaction or not. I don’t have time to argue about it right now. What I have time to do right now is make sure that I don’t create a bigger problem. I need to resolve this in a way that maintains stability. So that’s one thing I’d say the two errors are the same. The other thing I would note is you asked about the balance sheets. They’re huge.

ED: Way beyond what you saw in the 1980s?

WI: Way more leverage than there ever should be. Some of them were 30, 40 to 1 and that’s just way too high, and that was a flat out mistake on the part of management of those institutions and a flat out mistake on the part of the regulators that allowed it. There was way too much leverage, and there was way too much dependence on highly volatile funding.

ED: Let me ask you this. How do you see current attempts by BIS, for example, to use leverage ratios as a mechanism to manage that? They want to see liquidity ratios. They want to see net stable funding. What is your sense of these mechanisms to control and manage commercial banks?

WI: I’ve always been a fan of a leverage ratio. I think the Basel Committee has got it too low. I think the 3% ratio, whether it’s on all the balance sheet or part of the balance sheet is way too low. The US has it at 5% for the holding company and 6% for banks. I believe that that is as low as anyone would dare go and still be confident in the banking system. I think the US really ought to take that up higher, no matter what Basel does, you know?

ED: At a price to the banks, relevance to the economy, and ability to lend?

WI: I believe that it’s important when you do it. If I have any reservations about what’s going on in the US right now, it is we are doing too much all at once. I think that’s one of the things retarding economy growth in the US and thus the rest of the world.

I believe that it’s extremely important for bank supervision and regulation to be counter-cyclical, not pro-cyclical. The time to be forcing banks to increase their capital, their liquidity, and their reserves is a period like 2003, 2004, 2005 when things were overheating.

That’s when a bank regulator should step in and slow down the banks, rein them in, and just take some of the steam out of the economy. It would have made the landing, if there was one, a whole lot softer than if you let them continue to go until the markets explode.

When you’re in a period, like we’ve been in since 2008, where there’s little to no growth in most of the developed countries of the world, that’s a time to be allowing banks and encouraging banks to lend more. If I have any concern about increasing capital and liquidity ratios and everything, it’s timing. Let’s do it once we get the economy going again. Their timing is not what it could be.

3. Better regulation and supervision moving forward

ED: In the 1980s, you had the commercial banking industry to deal with almost exclusively, and you could have focused on that. Going forward, as a result of all the regulation that’s coming into banking, as you mentioned, non-banks are taking on a lot of these activities.

You’ve got the hedge funds, mutual funds in the market now. So these are types of institutions that can take on what banks would have done if they weren’t regulated and the way they’re regulated today. Do you think that some of these institutions should also be brought into some form of a regulation?

WI: That’s the debate that’s going on right now in the US, and I presume in other countries; as well as how big should we make this safety net. If their deposits are being ensured, if they have access to the Fed window, then I think we have to regulate them properly.

ED: So anyone with access to the Fed window is to be a regulated institution?

WI: I believe so, and anybody that’s got FDIC insurance on as liability should be regulated. If you have institutions that are outside that safety net, I would hesitate to expand the safety net. If they fail, let the market deal with it.

I think the market will deal with it a lot more effectively than we might think. They wouldn’t be the first non-banking firms to fail. But what happens is when you create a safety net, access to the Fed window, insured deposits and the like, what comes with that is regulation and supervision by the government. And what happens is creditors start to relax. The government’s on the job. It’s examining these people. If they were doing anything wrong, they’d be reined in. If they fail, we’ve got the Fed and the FDIC to pick up the pieces.

What I worry about is if we say, okay, well, that big hedge fund out there. Now, it’s going to be regulated like a bank. That gives the people who have money or investments in that hedge fund a reason to relax and say okay. The government’s on top of it.

The government’s not on top of it. It can’t be on top of it. We are going to run into problems, and that’s one of the reason why Dick Kovacevich and I have been advocating forcing banks to go to the long-term debt markets and have a balance sheet that is 20% tangible equity, capital, plus long-term debt.

I don’t believe the regulators can do this job alone. I think it takes a combination of strong discipline in the market, hence our proposals on capital and long-term funding.

I want to make one other point and that is that the regulatory system in the US is way too complex, way too fragmented. Dodd-Frank did almost everything, much of which wasn’t relevant to the crisis and wouldn’t have prevented it.

But one thing that was related to the current crisis that needs to be taken care of is we have to make sense out of our regulatory system in the US. We can’t have all these regulators in charge of the financial system not talking to each other, not coordinated. We have a regulatory system in the US that nobody would have ever designed on purpose. Even though we’ve recognised its weaknesses, we haven’t fixed it. I’ve seen three major banking crisis during my career. I would say that three major banking crisis in the US in the space of one person’s career is at least two if not three too many. And yet, you don’t fix the regulatory system that’s supposed to be overseeing that, and preventing that from happening? That’s unfinished business in the US that we need to get to.

ED: This desire to see more bondholders in all of the banking. You would look at it differently, if interest rates were higher, in the sense that the bond market will be less attractive as a form of raising capital. That’s one.

The other thing is that you said simplifying regulation. Even in your own book, you had a conversation with Dick Kovacevich. He, on the other hand, thinks that simplifying regulation is not the thing to do because he thinks that one regulator is too simplistic. He wants to see checks and balances between regulators themselves.

WI: I haven’t advocated one regulator. I advocate fewer regulators working together more efficiently and effectively whilst being more independent and tougher. I agree with Dick. I do not believe one regulator is the answer. I believe we should have checks and balances in the system.

ED: In terms of bond holding versus equity, would you look at it differently, if the markets were more equity-friendly and not bond-market friendly?

WI: If the bond market isn’t friendly, it’s probably due to the fact that the economy is overheating and they’re concerned about inflation and therefore the interest rates go up. Or, they’re very concerned about asset quality. In either case, I believe that it’s important to slow banks down, because they’re going to have to pay more for the bond for higher interest rates. Therefore, they’re going to be less enthusiastic about issuing it. Therefore, they’re going to have to curtail growth. That’s probably exactly what is needed at that time.

ED: We’ve seen this shift from, too much shareholder responsibility, to an age where the shareholder is almost irrelevant. It’s now between management and the regulator. In fact, the shareholder gets punished when the management does something wrong. I’m thinking how would that be different if you said that the shareholder should be more of a bondholder rather than an equity holder?

WI: We’re always going to have shareholders. I’m saying shareholders because once they make their investment they have no control. The bondholders are going to have to be the ones to apply discipline. They’re going to charge a higher interest rate if you’re less creditworthy. And they may declare default. They’re available to be converted into equity in the event that the institution is teetering on the edge of failure.

But you brought up an important point and that is these days, regulators are coming after the large banks for sure, and asking them for millions and billions of dollars, none of which is addressing the problem. The company didn’t do anything wrong, it’s just a legal fiction. The people who were involved in the company may or may not have done something wrong. If they have done something wrong, go after them. Whether it’s a fine or whether it’s jail, go after the people because the company didn’t do anything. A company doesn’t exist. It can’t act negligibly. It can’t act willfully. It can’t do good things. It can’t do bad things. A company’s just a legal fiction. You must address the people and go after them.

All they’re doing when they levy these big fines against these institutions is they’re hurting innocent shareholders who’ve had nothing to do with the wrongdoing, they just happened to make the wrong investment. They have nothing to do with the wrongdoing.

You’re also hurting the economy because you’re taking large amounts of capital out of the banking system that can be leveraged eight to one in loans if it it were left in the banking system. So I don’t understand the rationale behind what they’re doing.

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