Stress Test Page 10
I did come of age professionally at a time when financial innovation and the freer flow of capital across borders were widely seen as good things. As a young international negotiator, I pushed for open markets for the U.S. financial industry, even though I sometimes had misgivings that we were pushing too hard. I greatly admired Rubin, Summers, and Greenspan, and I shared their general approval of markets and financial innovation. But the common broad-brush caricature of that trio as unswerving free-market ideologues is unfair. For example, during the Clinton years, they all pushed for stricter regulation of the mortgage giants Fannie Mae and Freddie Mac, the “government-sponsored enterprises” (GSEs) that were exploiting their implicit federal backstop to load up on low-priced leverage. Fannie and Freddie had immense bipartisan influence in Congress, so reform didn’t happen, but it should have.
Greenspan did have an almost theological belief that markets were rational and efficient, as well as a deep skepticism that government supervision and regulation could make them safer. But he was a strong supporter of our financial rescues in the emerging-market crises. Rubin, the only member of the trio who had made a living in the markets, had much less faith in their inherent wisdom and rationality. He consistently expressed concern about excessive leverage, although he was also skeptical of government’s ability to do much about it. Larry’s view of the world fell somewhere in between, probably closer to Greenspan’s at the time. I didn’t have the strength of any of their convictions, but by disposition, my view was closer to Rubin’s. My formative exposure to finance was the emerging-market crises, which were not attractive advertisements for free-market fundamentalism.
My responsibilities at Treasury in the 1990s covered international issues, so I was mostly a bystander during the Clinton administration’s debates over financial regulation, and I didn’t have strong views about them at the time. I played no role in the noble but futile efforts to rein in Fannie and Freddie. I also had no involvement in the central battle of the time, the bipartisan effort to formally end the Depression-era “Glass-Steagall” legal boundaries between commercial banking and other financial activities, boundaries that had already been substantially eroded by changes in regulation and financial innovations. But I did play a peripheral role—and not a very distinguished one—in the debate over derivatives, the financial instruments such as swaps, options, and other contracts that derive their value from some underlying price or rate.
In 1998, Brooksley Born, the chairwoman of the Commodity Futures Trading Commission, floated the idea of regulating privately traded “over-the-counter” derivatives, customized deals that were not posted on public exchanges. She didn’t unveil any specific plans, but she did suggest that swaps—including foreign exchange swaps, which cut across my international portfolio—ought to be regulated as futures contracts by the CFTC. I didn’t know much about the issue, but all the other U.S. regulators and my Treasury colleagues were deeply concerned that her plan could create dangerous legal uncertainties about trillions of dollars of existing derivatives contracts. The air was thick with warnings that Born’s ideas would create financial chaos.
The popular narrative of Born’s crusade has been boiled down to a morality play, pitting a heroic Born against nefarious financial Goliaths. But the reality was less black-and-white. In many ways, the battle was more about turf and interests than substance or ideology. The Fed and other regulators fought the CFTC; the New York banks that dominated the derivatives business fought the Chicago exchanges that hoped to expand their market share; and the lobbies for the various business interests fought one another on Capitol Hill. Even Born was not proposing to ban derivatives. She just thought they should be regulated as futures by the CFTC and traded on the Chicago exchanges. My biases were with the Fed, mostly because of the quality of the Fed officials I had worked with during the earlier crises. The CFTC did not have a sterling reputation for market sophistication, and was widely perceived as captured by Chicago.
But Born’s motives were noble, and her concerns about the lack of regulatory oversight of the derivatives market were prescient. She just didn’t have a concrete or plausible plan. I remember she began one meeting at the CFTC by pulling out a yellow pad and reading from dozens of pages of handwritten notes about our messy securities laws. She clearly felt strongly about the cause of reform, but her proposals for reform were mostly impenetrable.
With limited knowledge, I found myself sympathetic to the substantive case that Larry, Greenspan, and the New York faction of the derivatives industry were making against Born’s proposals. They saw derivatives as valuable tools for hedging and distributing risks—airlines, for example, use derivatives to protect themselves from future increases in fuel prices—and more specialized over-the-counter derivatives as particularly valuable for specific businesses facing specific risks. They argued that firms already had good incentives to manage derivatives carefully, and that government interference in private transactions could stifle innovation in a dynamic industry. During one discussion in Rubin’s small conference room, I invoked the lazy argument that regulating the over-the-counter market might drive derivatives offshore. I must have sounded like a bank lobbyist, and Rubin shot me a derisive look.
“That’s the weakest argument you can ever make against reform,” he said.
Rubin had run a financial institution with a large business in derivatives, and while he recognized their benefits, he thought their complexity combined with their tendency to increase leverage could make them extremely dangerous. He was nervous about institutions taking on derivatives risks they didn’t understand. But he didn’t think much of Born’s proposals, either. Her credibility suffered from the weakness of the CFTC’s credibility. And the fears about legal uncertainty, while surely exaggerated by the CFTC’s turf-conscious rivals as well as bankers who reflexively oppose new regulations, were real. When Born released a concept paper, Treasury, the Securities and Exchange Commission, and the Fed all opposed her approach to reform.
Born’s ideas had no chance in an anti-regulatory Republican Congress anyway. Still, her instinct that derivatives were falling through the regulatory cracks absolutely had merit. We shouldn’t have been so dismissive of the general concern about derivatives just because we had issues with her remedies. Treasury did favor mandatory “clearing” of futures contracts, but Greenspan objected, and the idea went nowhere at the time. Overall, the bipartisan legislation that President Clinton eventually signed was an unfortunate missed opportunity, and in some respects, it weakened the already limited oversight of derivatives. By the time I got to the New York Fed in late 2003, the derivatives business would be much bigger, much more complex, and near the top of any sensible list of concerns about the financial system.
IT’S FAIR to say that I had not been a vocal critic of the financial system before I started my new job. I wasn’t a staunch defender of the financial system, either, and I had seen how its failures could cause significant pain. But the New York Fed president is often viewed as a servant of the financial establishment, in part because the optics of the institution’s governance are awful.
Like the Fed’s other eleven reserve banks, the New York Fed is technically “owned” by the banks in its region. By law, three of the nine directors on the New York Fed board must be representatives of those banks; they also elect three of the other directors, ostensibly to represent the public, with the Federal Reserve Board in Washington appointing the final three directors. But the directors have no involvement in regulation or supervision or emergency lending, and only an advisory role on monetary policy; unlike the shareholders of a normal corporation, the New York Fed’s bank shareholders do not control its operations. However, the board does select the president and set the president’s compensation, subject to the approval of Washington. So the New York Fed has always been vulnerable to perceptions of capture by the big banks. And I made some changes to the board that unfortunately made those bad optics even worse.
The board that I in
herited had an interesting mix of talent, but it was a bit weak on financial experience. I thought we needed a stronger board with more leaders of the major New York companies, to better reflect the composition of our changing financial system. So I recruited some prominent financiers to join it, including Lehman Brothers CEO Dick Fuld; JPMorgan Chase CEO Jamie Dimon; former Goldman Sachs Chairman Steve Friedman, who was still on the firm’s board of directors; and General Electric CEO Jeff Immelt, who also oversaw his company’s financing arm, GE Capital. I basically restored the New York Fed board to its historic roots as an elite roster of the local financial establishment. But Paul Volcker, whom I consulted often for advice, presciently warned me that I was exposing the Fed to too much “reputational risk.” I would end up having to ask Fuld to resign from the board on the eve of Lehman’s collapse. Friedman later resigned after public disclosures that he had bought Goldman stock during the crisis; though he had complied with Fed rules, his actions caused an uproar.
Volcker was a towering figure in the financial community and a thundering critic of modern Wall Street, especially investment banks such as Lehman and Goldman. He didn’t like the conflicts of interest, the mind-boggling compensation, the elevation of risky trading of newfangled products over careful and conservative banking. He would later quip that there hadn’t been a useful financial innovation since the ATM. I took his discomfort seriously, but I didn’t have the strength of his convictions. I had never worked in banking, so I had no basis for comparison to the past. I didn’t see the financial sector as either irretrievably broken or inherently wise. I saw it as an inherently risky business, a collection of profit-maximizing individuals with profit-maximizing shareholders, providing generally valuable economic services. I was rarely shocked by reports of rapacious behavior. I took it as a given.
I rarely socialized with Wall Street executives—I did run into Volcker once at a lavish celebration of Peterson’s Blackstone Group, and he whispered, only half-jokingly: “You shouldn’t be here!”—but I talked to them regularly to get their perspectives on the markets and the economy. That was an important part of my job. I thought some of them seemed very capable, others less so. I also thought they had pretty good incentives to try to keep their firms from self-destructing, but I knew we couldn’t leave the stability of the system in their hands.
At one early meeting, several senior bankers complained to me that new capital rules would hinder their ability to take on leverage. I said I understood why they might find that a problem, but they didn’t get to set the rules that determined how much risk they could take.
“That’s our job,” I told them.
Obviously, we didn’t do that job well enough.
MY FIRST inclination and my most important decision at the New York Fed was to increase the attention we paid to systemic risk.
We had many other responsibilities competing for our time and resources, and we were careful to give them the attention they required. We managed the nation’s large-value payments system, the Treasury auction process that financed the government, and a substantial portion of the Fed’s cash distribution business. And we shared responsibility for enforcing consumer protection and anti-money-laundering laws. Seven months after I arrived, we slapped a hefty fine on Citigroup after an affiliate took advantage of unsophisticated borrowers and then misled the Fed during the subsequent investigation; Volcker called to say he was pleasantly surprised.
I did not get very involved with the emerging concerns about the subprime mortgage market. Ned Gramlich, a Fed governor in Washington, was already leading a process to examine excesses and abuses in the mortgage business serving lower-income Americans. I was impressed by Gramlich’s work, and those issues seemed to be getting a fair amount of attention from the Fed in Washington. I didn’t want us to be like kid soccer players, all swarming around the ball. I wanted us to focus on the systemic vulnerabilities that were getting less attention—starting with our own banks, but looking outside them as well.
Inside the New York Fed, I convened a series of “risk breakfasts” to bring together staff from the organization’s disconnected silos—supervision, markets, payment systems, international, research, and more—to share information about potential dangers to the system. We set up a more formal Financial Risk Committee that reviewed detailed analyses of systemic threats. We also conducted “horizontal risk reviews” of all the institutions we supervised directly, to get a sense of how the different banks managed different risks, and to try to promote more conservative approaches across the industry. The idea was to identify best practices, highlight them, and push banks to imitate their most forward-thinking competitors.
I spent much of my time trying to understand whether banks under our supervision had enough capital—the cushion that could help them absorb losses, retain confidence, and remain solvent in a crisis. Generally, capital represents the money a bank would have left over if it sold all its assets and paid all its liabilities, the liquidation value of the company. It’s a measure of conservatism, the flip side of leverage; the heavier an institution’s reliance on borrowing to finance its operations, the lower its capital levels. In a crisis, capital serves as a shock absorber, a first line of defense against losses. A well-capitalized bank can take hits without creditors questioning its ability to meet its obligations. It’s like a down payment for a homeowner with a mortgage, a life jacket keeping the borrower above water even if the home loses value.
So in those early months at the Fed, I began asking questions about capital: Do our banks really have enough? How can we be sure? Our banks were holding capital equivalent to 13 percent of their “risk-weighted assets,” well above the required 8 percent. But I kept pestering my staff: Are we confident we know how to measure the risk in those assets? Why was the requirement only 8 percent? Would those capital levels still be adequate if the world looked darker? What if the world looked darker than it has looked in recent history?
The banks themselves were confident they had more than enough capital. As part of our horizontal risk reviews, we asked them to conduct internal “stress tests” to model the impact of losses from recessions and other potential shocks; not one bank produced a scenario that significantly dented its capital. The worst outcome considered in their internal tests didn’t even eat through a quarter’s worth of earnings. Their overconfidence was perhaps understandable at the time. Default rates were low, the economy was growing, and they were making a lot of money. In that environment, prudence would have been an expensive strategy. And leverage was the great multiplier, a source of greater potential profits, but also greater risk.
For example, if you were a shareholder in a bank or an investment bank that had $100 worth of assets financed by $10 of shareholder capital, a 10:1 leverage ratio, you’d double your money if the assets rose in value to $110. But if your bank had that same $100 in assets with only $5 in capital, a 20:1 leverage ratio, the same $10 increase in value would triple your investment. Of course, if the asset value instead decreased $6, from $100 to $94, the bank with only $5 in capital would be insolvent; leverage dramatically increases “wipeout risk.” But in those days, the financial community didn’t expect asset values to decrease. A financial CEO who was unusually cautious about leverage during the boom probably would have been fired before the bust. Many bank executives didn’t even want to think about truly extreme events.
But even when the Fed’s own bank supervisors and economists analyzed the system, they thought there was plenty of capital in the banks to absorb a substantial increase in losses. These public servants had good incentives to be tough, because a crisis would fall to us to clean up, and they were a talented, experienced, thoughtful group. Even so, they had a hard time coming up with economic scenarios that would generate losses large enough to seriously impair bank capital. One internal Fed analysis calculated that losses in consumer portfolios would have to be four times as large as in any recent downturn—essentially Great Depression levels—to deplete bank capital to
dangerous levels. By existing regulatory standards, the banks under the Fed umbrella seemed well capitalized. Compared to the more leveraged investment banks as well as Fannie Mae and Freddie Mac, they seemed very well capitalized. At the time, trying to force our commercial banks to raise more capital (and dilute the holdings of their existing shareholders) so that they could survive a Great Depression would have seemed arbitrary and unnecessary, like imposing a thirty-mile-an-hour speed limit on an expressway. And it would have driven more risk into nonbanks.
Still, since we had no way of knowing what the future would bring, and I had vivid memories of the crises of the previous decade, I wanted us to examine the darkest possible scenarios, the seemingly implausible “tail risks.” In meeting after meeting, I argued that regulators and risk managers alike needed to set aside assumptions about the implausibility of a major shock and study the impact of that shock if it somehow happened. This provoked a fair amount of skepticism internally, and derision outside the Fed. In that apparently benign state of the world, many bank executives thought it was totally unreasonable to expect them to prepare for a deep recession, much less a depression.
I tried to lean against the prevailing winds of complacency—not only behind closed doors, but in public. In one speech to a group of bankers two years after I arrived in New York, I emphasized “the need to improve stress testing and scenario analyses,” citing a half dozen analytical problems we were seeing “even at the most sophisticated institutions.” In another speech, I noted that banks seemed reluctant to address “the effects of the failure of a major counterparty,” as well as “the risk of a major shock to market liquidity.” That was unsettling, I suggested in my typically impenetrable prose, in part because the banks and their counterparties had gotten much bigger: “The greater concentration in the financial system means the systemic consequences of the failure of a major firm could be more acute.”