Sheila Bair was chair of the Federal Deposit Insurance Corporation from 2006-2011, a period in which the U.S. faced the worst financial crisis since the Great Depression. She is author of several books, including her latest, "Bullies of Wall Street."
As we observe the fifth anniversary of the Dodd-Frank financial reform law, some of Wall Street’s most influential voices are warning of the possibility for another financial crisis, and they want you to know in advance that it isn’t going to be their fault. Rather, according to this new narrative, the problem is those pesky government regulators and their misguided efforts to de-lever and de-risk the financial system.
The opening volley in this latest line of attack against financial reform was laid out in Jamie Dimon’s annual letter to JPMorgan Chase (JPM) shareholders. Not coincidentally, Dimon and others are taking aim at the reforms they seem to dislike the most: tougher capital rules which require banks to fund themselves with more common equity and less debt; and liquidity rules, which require banks to keep minimum levels of low-risk, easily-sellable assets on hand.
Dimon and others argue that big banks will be unwilling to “stand against the tide” and be a source of strength to the economy during the next crisis because of all these new liquidity and capital constraints. For instance, Dimon points out that during a crisis, there is a “flight to quality” resulting in steep investor demand for safe assets like U.S. government securities. However, he argues, banks will be unwilling to sell such securities to investors because government rules now require that they hold on to them to meet new liquidity standards.
He also notes that during a crisis, investors pour more money into FDIC-insured deposits, and draw down on credit lines to increase readily-accessible cash. But he says banks will refuse to allow this because the bigger their balance sheets, the more capital they will have to hold. Similarly, he says, banks will refuse to make new loans or otherwise make credit available because it will increase their capital requirements.
To support his argument, he points to significant decreases in big dealer banks’ bond holdings as evidence that they are poorly positioned to meet customer demand for safe assets during times of market stress. As proof, he references the extreme volatility that occurred in the Treasury market in October 2014. To be sure, big banks’ bond inventories have dropped since the crisis, but it is far from clear that is due to regulation. More likely, it is a result of their unattractiveness as an investment given their low yields, combined with a significant reduction in supply caused by aggressive central bank buying here and abroad.
Changes in market structure are also playing a role, as new players have entered the Treasury market. Indeed, a recent report by the U.S. government found no conclusive evidence that regulation was responsible for last year’s volatility. It did, however, note the growing role of “principal trading firms” aka high-frequency traders (whose trading, I might add, is supported by the big banks through their prime broker operations) in the Treasury market.
While Dimon complains about regulation being too tough, it is difficult to see how loosening the rules would help. If anything, they need to be tougher. For example, the new “supplemental leverage ratio” requires big banks to maintain equity capital funding of 5%, still permitting 95% of their funding to come from debt. How would the problems Dimon identifies be addressed if that requirement was loosened to say 3% or 2%? Would that put the banks in a better position to accept new deposits, keep credit lines open, facilitate customer trading, and make new loans during economic turmoil? On the contrary, with razor-thin capital margins, and sudden and unexpected losses on their own investments and loans, they would be struggling to stay solvent and maintain access to credit themselves. They would hardly be in a position to “stand against the tide.”
In fact, this is just what happened during the 2008 financial crisis. Going into the crisis, many big banks were over-levered and exposed to trillions in opaque, illiquid mortgage securities and derivatives instruments. This created widespread (and justifiable) concerns about their solvency, causing their own creditors to retrench en masse. Banks could not roll-over the short-term loans on which they heavily relied for funding, forcing the government to throw trillions of capital investments, loans, and loan guarantees at them to keep the financial system functioning. Even with this support, the country suffered a severe credit contraction, contributing to one of the worst recessions in our nation’s history.
Dimon boasts that his $2.4 trillion bank rolled over $260 billion in loans and credit during 2008 and 2009. A more interesting figure would be the volume of credit lines JPMorgan reduced or pulled, and loans it did not renew during those two years.
Indeed, as the chart to the left shows, for the industry as a whole, outstanding loans and available credit lines fell precipitously during the crisis and did not really begin to recover—albeit tepidly—until early 2013. Unused credit lines dropped by a whopping $2.6 trillion from the second quarter of 2007 to the second quarter of 2010. The damage to the real economy was profound. However, thanks to the bailouts, the banks were just fine.
Dimon has a better point in his critique of the liquidity rules (which, like a lot of reforms, are still only half-done). I would agree that the basic premise of these rules -- that big banks would be taking steep haircuts on so-called liquid assets to raise cash during a crisis -- is highly questionable. But the answer is to change and strengthen the rules, not weaken them. For instance, banks could be required to retain a greater proportion of their funding from stable, long-term debt, and have to maintain a liquidity buffer at the Fed that could be drawn down during a crisis.
It should be acknowledged that Dimon managed his bank well during the crisis. The banks are lucky to have him as their spokesperson. But that is part of the problem. He tends to view the need for regulation through the lens of a well-run institution, though even mighty JPMorgan is subject to missteps, as we saw with the London Whale debacle.
Given big banks’ implicit and explicit government benefits, they have strong incentives to take outsized risks on the government’s dime. They need a firm regulatory hand. If we want to make sure big banks can “stand against the tide” and be a source of strength for the economy, we first need to make sure that the banks are stable themselves. What Dimon is really asking of the government is to loosen the regulatory shackles and trust them to do the right thing. How could any regulator who lived through the 2008 financial crisis want to go down that road again?
Wall Street has persistently tried to escape accountability for its role in the 2008 crisis by blaming it all on government efforts to expand homeownership. This current finger pointing at regulation as the cause of system instability smacks of the same reluctance to accept responsibility for their own behavior.
If government was to blame for the last crisis, it was because regulators listened to Wall Street nonsense about enlightened self-regulation, that there was no need for mortgage standards, that they could be trusted to set their own capital rules, and that the derivatives markets needed no government oversight. If government is to blame for the next crisis, it will not be because they were too tough on the industry, but because they were, once again, too timid in the face of fierce industry lobbying which has left financial reform at best, half-done.