WASHINGTON — A growing chorus of regulators are urging policymakers, including President-elect Donald Trump and Congress, to be careful not to throw out important safeguards when they set about a deregulatory agenda next year.
Chief among them is Loretta Mester, the president of the Federal Reserve Bank of Cleveland, who argues that the system is better off than it was in the days leading up to the financial crisis, while acknowledging that regulators are already making needed changes to address concerns about compliance burden.
"The Federal Reserve and the other regulators are trying to rightsize the regulation to meet where the risks are," she said. "Some of the changes that have come most recently are about calibrating the regulation to [address] the type of risk that's out there. So, for example, community banks — there have been some changes in sort of how we're approaching stress testing there."
In a wide-ranging interview with American Banker — her second since heading the bank in 2014 — Mester talks about that as well as her views on reforming the Fed, capital levels, the future of the Basel committee and the effect of a Trump administration on financial services.
Following is an edited transcript.
Donald Trump's victory in the presidential election is on everyone's mind — what do you think the biggest effect of his administration will be on financial services?
LORETTA MESTER: It's a little premature to second-guess what's going to end up actually being passed in the new administration. And I think we have to recognize that the banking industry, as a result of some of the regulatory changes that have occurred since the financial crisis, is in a stronger position than it was.
A lot of good steps have been taken in terms of capital levels; I think that's improved the resiliency of the industry. I think that the liquidity requirements, as well as the capital requirements, are aimed at improving financial stability overall, and I think those are positive developments. The orderly liquidation authority — which was part of Dodd-Frank, and the idea that you want to be able to close banks when they get into trouble — I think is promising, as well as the living will process, which enables banks to sort of get a better handle of their own risk, and how they would unwind. So a suite of things — including the stress tests, which have gotten a lot of attention — have improved the regulatory structure.
So there's a lot of supposition about how everything would change, and I certainly don't think we should say that we've solved all problems. But I also think we should recognize that some of the benefits of having a more resilient financial system. Obviously, whatever regulatory regime we're under, the goals should be the efficient allocation of credit — because that's a very important part of our economy — to the most productive uses. But banks and other financial industries add value because they take risks and because they're supposed to monitor risk, [and] that leverage does create this potential for systemic problems. So it's this balancing act.
The leading alternative proposal to Dodd-Frank is some variation of exchanging a higher leverage capital requirement for the many various additional requirements of Dodd-Frank. Is that a good idea?
There's no doubt that higher capital was one of the components of Dodd-Frank, and I think an appropriate component. I also agree that the regulatory system is complex, but part of the regulatory complexity I think is a result of the fact that our financial system is complex. I think there is a trade-off between complexity and precisely right and simplicity and basically right, and you get benefits by some simplicity. I don't think you can replace all of the supervision and rules by just, say, imposing a leverage ratio, which is my understanding of some of the proposals that are out there. We tried that — in fact we tried that before Basel, and we figured out that didn't work, because banks were able to take on risks that weren't necessarily accounted for. Perhaps the swing went back to risk-based capital.
The U.S. always imposed a leverage ratio, and I have to say I was always in favor of that, because there's value in having both of those tools. But as soon as you have two, it does become more complex, and you have to realize that. The thing that we learned during the financial crisis was the liquidity issue, and having the right rules around making sure that banks maintain liquidity, so they can handle these kinds of liquidity shocks. So it's very appealing to say, "We want a simple system." But, again, you have to be a student of history and know how we got to where we are. That doesn't necessarily mean we have a perfect system, and it certainly doesn't mean we shouldn't always be thinking about the regulatory system, but I worry a little bit about us just saying: "There's a panacea out there. We do it, and we're done."
There are a number of proposals that would change the Fed's structure. Do any of those have merit?
If you look at the history of the institution, we had two attempts at a central bank before the Fed, and each of those only lasted 20 years — they didn't have a renewal of their charter. The Fed structure has been inexistence for over 100 years now, and I think it's [seen] reasonably good outcomes for the U.S. economy and for the public.
So I'm a defender of the system. And the designers of it in Congress were very ingenious — they came up with a structure that kind of balances Main Street and Wall Street interests. The 12 Federal Reserve banks overseen by the Board of Governors, it has this private/public sector structure. I think it's very important for us to have diverse views, so that we have all parts of the country represented when we go to Washington, for example at [Federal Open Market Committee] meetings. The Reserve banks are also involved in supervising and examining the banks in their districts. So I think the structure works quite well.
Now, the Fed has taken I think very good steps over time to try to improve our transparency, because [when] we say we're an independent central bank, what we mean is, we're independent within the government. So we're not independent from the government. And we are accountable to Congress and the American people. So one of the ways of being accountable is by being transparent and going out and explaining the rationale for our decisions. One of the reasons I give speeches is because I think it is incumbent on me to explain how I'm thinking about things, because I work for the American public and they need to understand where I'm coming from so they can hold me accountable. And I think that's true of the institution overall.
So I personally believe that the system is working very well. And I would be very concerned if changes were made that undermine that great balance we have between the public and private … regional/DC structure that we have.
The various proposals to ease capital or liquidity rules tend to rest on the proposition that doing so will result in a wave of investment. Are capital requirements keeping banks from lending?
Is there any level of capital that could prevent lending? I would say, yeah, obviously. So it's a calibration. I don't think capital requirements that are in place now are the main factor that's driving bank not to lend — in fact, in our district we talk to banks all the time and the bankers report that they're ready to lend. Some of the businesses just aren't there; they're not wanting to borrow from them, and there's a lot of competition for the borrowers that are there.
And there's uncertainty. The whole question about productivity growth being low, investment being low — there are different theories about why that is. But we have to remember though, that the Great Recession was a great recession — "great" meaning huge, and it was financially driven. And we know from history that those are usually much harder to climb out of.
I don't think you can just forget that. I think that colors [behavior]; people are much more cautious, saving rates are up, businesses are much more cautious. So I think that probably explains it more than capital. In fact, I think if you look at the banks that have higher capital going in 2008, they actually maintained their lending levels better than the ones that had less capital. So again, I don't think that at the levels we're talking about, either pre-crisis or now post-crisis, [capital levels] are the things that are restraining. A bank that knows it has the cushion is going to be a safer bank and is going to be able to take on risk, because it will have the wherewithal to move through ups and downs and shocks and things.
What do you think the increasing skepticism toward the Basel III accords — both in the EU and here in the U.S. — is going to mean for U.S. banks?
That may be what countries want to do. I think it would be very hard to step back from globalization. I think it would be very hard to balkanize ourselves. There have been a lot of innovations in financial markets — I'm not convinced that, even if you desired to do that (and I don't think it would be a very good idea) — that you could accomplish it. And I think you might be creating more problems than you think.
For example, if it's productive, people will find ways of doing it. So if you think about the so-called shadow banking sector, part of that was driven by innovation, but part of that was driven probably by regulatory arbitrage to some extent. That's why it's not a simple thing to think about what the best regulatory structure is, because you don't want to do something that then drives the risk into an area where you have less insight and less ability to monitor it. So a lot of these things don't kill the risk, you just move the risk somewhere else. That's why you need a balance of a bunch of different tools to be able to do this. Again, it may be the intention that you just only focus on yourself, but I just don't think that the world is likely to be able to sustain that.
What did you think of the conclusions in Minneapolis Fed President Neel Kashkari's final report last month on ending "too big to fail"?
One of his hallmarks is the higher capital levels, which [is] a very high capital level in his proposal — I think it's 23%. And there are various studies out there for what the right level of capital is. But the premise is that capital is a good thing, yes. But if you look at the cost estimates he has … it comes at a pretty high cost. That I think illustrates what the trade-offs are.
He also has this other part about imposing a tax on the nonregulated part of the financial sector, and I'm not quite sure how that would be implemented necessarily. And the Treasury secretary being the sole person who would make those determinations, I think would be difficult to implement as well.
I wouldn't want to tear up everything we put in place, which hasn't been in place for very long, and start all over again. I don't see the point of that.
Do you think fintech firms are going to make business easier or harder for banks?
We're all looking at that — bankers are looking at that. It's not a banking thing, but in payments we're sort of the convener and coordinator of a private-sector task force that's looking at ways of modernizing the payments system to make it faster and more secure. And there, fintech firms are big.
Technological change is driving changes in all industries, including finance. And all the firms we talk to certainly are looking at how they can capitalize on it, become a provider to it. I don't think it's going to be one of these situations where it drives banking out — I think banking is going to adapt to the technology that's available, so they'll be able to do their jobs better as well.
Markets have hit all-time highs since the election. Is that sustainable, or do you think that might be a sign of overheating?
I think the economy is at or a little above trend, which I put at 2%. I think the unemployment rate — what I view, from the standpoint of what monetary policy can do in terms of its maximum employment goal, is at maximum employment. I put the long-run unemployment rate at 5%. I think the unemployment rate will go below 5% at some point in the next couple of years before coming back toward 5%. So there will be continued improvement in labor markets. I think inflation is going to be moving back up to 2%.
In that context, I think interest rates — I think it make sense to make another step up in interest rates. I still think that gradual path make sense, given what I view as the likely outcome and developments in the economy. But again, we're not on any pre-set path for that. We're going to release new projections for both the economy and for appropriate monetary policy at the December FOMC meeting. A lot of people ask, "Well, what about the fiscal policy changes?"
The devil is in the details — we don't have a lot of facts yet about what the proposals will be, about the timing. And once we get more details we'll be able to do a better assessment about what the likely impact will be, and the timing of those impacts. So I think of that as being the economic environment in which monetary policy has to take into account, and we'll set policy appropriately after that. I don't think at the moment we are behind the curve, and I don't see huge imbalances in terms of the financial markets. I think the risks in the outlook are relatively balanced … but again we always have to be monitoring. We've had interest rates at very low levels for quite a while, and if we do delay too long, longer than is appropriate, I think the risk of both macroeconomic instability and financial instability will grow. So given where we are on our goals and where I project that we're going — that's why I favored at the last two meetings that we increase the Fed funds rate.
You've said before that one reason to raise rates is that a gradual increase would sustain, rather than stifle, the economy's growth. Why do you think that is?
Monetary policy affects the economy with, and this is a quote [from Milton Friedman], with "long and variable lags." And what that means is, if you wait until we're at our goals, you've probably waited too long. So if you really want to prolong our expansion — and that's what our mandate is, we want to basically have price stability and maximum employment — then it's prudent to move interest rates up when we've gotten where we are on this path toward our goals, and given how low interest rates are. So I think that, by being forward-looking and prudent, it makes sense to move rates up a little bit.
I'm not talking about making rates go up very, very quickly. In fact I think a gradual path is more likely if we do a move now. So this is not about curtailing the expansion it's about taking the necessary step to prolong the expansion. And I just think it's appropriate to do that at this point.