ME. Recently, Thomas Hoenig, Vice Chairman of the
Federal Deposit Insurance Corporation (FDIC) came
to Iowa State University to present a lecture in the
College of Business. As you may recall, Hoenig was President of the
Kansas City Federal Reserve Bank from 1991 to 2011. As it turns out,
he is originally from Fort Madison, Iowa and received a Ph.D. in
economics from Iowa State University.
BF. I served on a local bank board for 28
years and I am familiar with Hoenig. He was with the Federal Reserve
for 38 years, beginning as an economist and then as a senior officer in banking
supervision during the 1980s banking and farm finance crisis. During the
1980s, Hoenig directed oversight for more than 1,000 banks and holding
companies with assets ranging from less than $100 million to $20 billion.
He demonstrated that he is a very capable, tough character. He did not
march to the drumbeat in the Greenspan era and stood firm on his point of view,
becoming somewhat controversial. So what has he been working on lately?
ME. Hoenig discussed how the banking system has
grown and consolidated since the 1980s and how fragile the leverage and financial
structure is for the largest financial institutions. The Dodd-Frank
Act was to end reliance on government-funded bailouts when the largest, most
complicated financial firms fail. How soon we forget, but in 2008 the
global financial system nearly sank into a collapse that could have rivaled the
Great Depression. Only through extraordinary government financial system
bailout efforts coordinated worldwide, did it become a Great Recession.
We recovered in five years, instead of ten years like the 1930s.
BF. As I recall, the Dodd-Frank Legislation that
Congress subsequently passed required the largest financial institutions to
have a well-developed restructuring plan or “Living Will” for resolving losses
and managing risks that could be implemented when necessary. Dodd-Frank
Act established bankruptcy for the largest financial institutions as the means
to reposition or restructure the failed firms. In doing so, it
attempted to assure a more resilient financial system without more government
bailouts.
ME. Correct. But Hoenig’s analysis presented at
his lecture raised red flags, suggesting that the financial structure of the
largest financial institutions are still highly leveraged and precarious in
that reserves are not sufficient enough to carry the institutions through
another similar global downturn. FDIC was created in 1933 in
response to the thousands of bank failures that occurred in the 1920s and early
1930s. As an independent agency, FDIC was created by Congress
to maintain stability and public confidence in the nation's banking
system.
BF. FDIC is one of several financial system
regulators with authority to conduct examinations of local banking
institutions. FDIC attempts to preserve and promote public
confidence by insuring depositors for at least $250,000 per insured bank.
FDIC has responsibility for identifying, monitoring and addressing risks
to the deposit insurance funds. Also FDIC is directed to limit the effect
on the economy and the financial system, when a bank or thrift institution
fails.
ME. In a Statement last August, Hoenig said
that all of the “Living Will” plans being developed by the large
institutions were deficient and failed to convincingly demonstrate how, in
failure, any of the firms could overcome obstacles to entering bankruptcy
without causing a financial crisis. “Despite the thousands of pages
of material these firms submitted,” Hoenig said, “the plans provided no
credible or clear path through bankruptcy that doesn't require unrealistic assumptions
and direct or indirect public support.”
BF. Well is it is true that the largest
financial institutions are generally more complicated and more interconnected
than they were prior to the crisis of 2008. They continue to combine
commercial banking, investment banking, and broker-dealer
activities. According to Hoenig’s statistics, the eight
largest U.S. banking firms have assets equivalent to 65 percent of GDP and the
average notional value of derivatives for the three largest U.S. banking firms
at year-end 2013 have increased 30 percent over their level at the start of the
crisis.
ME. Hoenig also claims there have been no
fundamental changes in the reliance of the largest financial institutions on
wholesale funding markets, bank-like money market funds, or other activities
that have proven to be major sources of volatility. And, when failure is
imminent, no firm has yet shown how it will access private sector “debtor in
possession” financing, which he considers to be a critical element in restructuring
a firm.
BF. Thank goodness for a
growing U.S. economy. The growing economy is providing
additional time for the largest banking institutions to lower their leverage,
increase their capital, and moderate the risks in their portfolio. We have
seen 4.6% and 3.5% growth in GDP during the second and third quarters of
2014. That exceeds the long run average of 3.27 % GDP growth from 1947 to
2014. Low interest rates and lower gas prices at the pump are helping to
stimulate the domestic economy.
ME. Yes but Hoenig, says that while the most
complicated large firms may have added some capital as a funding source, they
have only marginally strengthened their balance sheets to facilitate their
resolvability, should it be necessary. They remain excessively leveraged in his
opinion with ratios of nearly 22 to 1 on average. The remainder of the industry
that includes much smaller community and regional banks averages leverage
ratios closer to 12 to 1. Hoenig suggested a tangible capital ratio of 7 to
1 would be even better. That would be something like a 15 percent
capital reserve--long regarded as a conservative banking industry
standard. Hoenig’s point is that the margin for error in a possible
default for the largest financial firms is nearly half that of other commercial
banks that are far less important to the over soundness of the global financial
system.
BF. An added concern is that countries may begin
to protect their domestic creditors and stop outflows of funds during a
financial crisis. That would make the problem worse. In
theory, Dodd-Frank addressed the too big to fail institutions, but in practice,
it’s not the law but rather its implementation that determines its
effectiveness in the next downturn.