When he retired on Sept. 30, Tom Hoenig had clocked 38 years with the Federal Reserve System, the last 20 as president of the Federal Reserve Bank of Kansas City.
There's always something bittersweet when a long, respected tenure comes to a close. There are toasts to the successes and well wishes for the future, but also an appraisal of what didn't get accomplished, of what more there is to do.
In his years at the Fed, Hoenig always lived up to his plainspoken Midwestern image, and since the financial crisis he had ratcheted up his opposition to easy monetary policy and the notion of too big to fail. In the last weeks of his tenure, he ruminated on the Fed's monitoring of the banking system. Its approach changed significantly as a result of the crisis, but Hoenig still finds it wanting.
"This is at least the sixth time we have enhanced supervision in my career," he says. "We need to learn from our mistakes. We need to make supervision simpler, easier to understand and enforce."
He offers a similar prescription for banks—especially those that might be seen as SIFIs, or systemically important financial institutions. He would like to see, as he puts it, "less SI and more FI."
The policy of too big to fail, he says, subsidized the largest institutions and led to a misallocation of resources. It "encouraged ever-larger institutions," he says, "without capitalism being able to cleanse those that were not successful. We need to rethink that model."
The Dodd-Frank Act gave the government new powers to liquidate failed institutions, and big firms will be required to map out in a living will how they could be unwound. But does any of that make these institutions easier to supervise? Does it make the system any safer?
Hoenig argues an adamant no. He proposes something of a return to Glass-Steagall, with a twist of Gramm-Leach-Bliley. Hoenig would put trading, dealing and brokerage exclusively in the purview of investment banks, while commercial banks would be limited to lending, deposit taking, asset management and (here's the nod to Gramm-Leach-Bliley) securities underwriting.
In Hoenig's model, only commercial banks would have deposit insurance and access to the payments systems. "Those roles are protected and therefore subsidized, and should be separated" from higher-risk pursuits, which should "not be brought in as part of the safety net."
Of course, none of this would bulletproof the commercial banking business. Even in this last go-around, the bulk of the losses at most banks were caused not by trading but by lousy credit decisions. "Lending is very risky," Hoenig acknowledges. "That's why you need to concentrate on it. When you are doing everything, and you have this trading over here where you get your return on equity, and you have your lending over there, you are not paying attention to it, and you get into trouble."
Hoenig also proposes some fundamental changes to the shadow banking system. For one, he would like to see money market funds revalued daily, so that investors aren't shocked as they were in the fall of 2008 when the Reserve Primary Fund broke the proverbial buck. He also wants to rein in the repo market, by undoing a change to bankruptcy law that in 2005 made it easier for creditors to make claims on real estate-related securities backing certain kinds of short-term loans. Reversing the change would make mortgage-backed debt less attractive collateral for repos. The result, says Kansas City Fed economist Chuck Morris, Hoenig's chief collaborator on this proposal and others, would be a direct dent in the notion of too big to fail. "It would limit the amount of interconnectedness by limiting the amount they could all lend to each other very short term," he says.
Hoenig and Morris don't want to neuter the U.S. financial system. But they question the idea that the system is made stronger by the size or diversity of its banks. "Diversity that actually reduces risk is a very rare thing," Hoenig says. "Often it just concentrates risk."
To illustrate, he points to the vehicles banks created to move assets off their balance sheets, generally as a means to lower their regulatory capital requirements. When the bank lines backing these units got called, trouble ensued.
"Diversity is actually going into activities where one is procyclical and the other is countercyclical, so that you have something that leaves you whole," Hoenig says. "When it's all procyclical and you are just doing more of it, it all collapses in on you, and that's what we just finished doing."
Fair enough. But don't we need big banks that can go head-to-head with rival institutions abroad? "Look at [foreign banks] today and tell me it's better," Hoenig counters. "Are they more competitive? Are they taking market share away from us, or are they in trouble up to their eyebrows and Europe is suffering? You always can compete best from a position of strength." Emphasizing the point, Hoenig firmly presses his hand to the table. "Size, secondary. Strength, primary."
