Rep. Scott Garrett, R-N.J., Chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises for the House Financial Services Committee, is giving the opening keynote address at American Banker's Regulatory Symposium in Washington today. Following is a transcript of his speech.
I want to discuss today two issues that I believe should be top priorities of the next Congress and the House Financial Services Committee. The first, which the actions by the Fed continue to reinforce the need, is Federal Reserve Reform. The second is finally ending Too-Big-To-Fail (TBTF) in our banking system. You thought I was going to say GSE reform? Yes, that too, but we'll save that discussion for another day. Rob only gave me 30 minutes.
Federal Reserve Reform
A growing number of my colleagues, on both sides of the aisle, are very concerned with the radical and unprecedented actions being taken by the Fed. The President's harmful economic policies aren't making it any easier. However, the terrible job market and President's poor performance do not excuse Mr. Bernanke's radical and unprecedented actions.
The Fed is consistently getting deeper and deeper into fiscal-type waters. As you know, fiscal matters are the domain of the Congress. So I find it interesting when I read various Fed apologists opining with their concerns of Congress threatening the Fed's independence. I would argue that any additional scrutiny they are receiving has been brought upon by themselves and by their extreme actions.
When the Fed uses arcane and questionable emergency authority, there will be additional scrutiny. When the Fed abuses their typical open market operations to manipulate the rate curve, there will be additional concern. When the Fed expands its balance sheet to $3 trillion, elected representatives will ask questions. We would not be doing our job if we did not.
One area that has received a lot of attention is Congressman Ron Paul's bill to allow the Government Accountability Office (GAO) to audit the Fed's monetary policy decisions. That is fine and I support the legislation, but I don't need a GAO audit completed for me to second guess their continued unprecedented interventions in the market.
When a significant part of the performance of our equity markets hinges on a periodic announcement or speech by a Fed member, it is pretty clear that we have a problem. Market participants should be more concerned about market-based metrics and less concerned about reading the tea-leaves of Federal Open Market Committee (FOMC) minutes.
One of the original rationales behind ensuring independence for the Fed was so that Members of Congress, who are running for reelection every two years, don't attempt to pressure the Fed to have artificially low rates that provide a benefit for the short term while risking potential runaway inflation over the long term.
Now, the exact opposite is happening. The Fed is taking such extreme steps that Congress and the American people are saying please stop! There are huge potential risks that are being created by these actions.
The Fed and their defenders claim that their independence is being eroded by others' actions but I claim the exact opposite. I believe the Fed's own actions are eroding its independence. I will provide three specific examples and a policy solution for each one that will re-establish the Fed's cherished independence.
First, Mr. Bernanke's initial four-year term as Chairman expired at the beginning of 2010. After President Obama was sworn in January of 2009, there was much speculation about whether he would reappoint Mr. Bernanke. The first big legislative initiative that Congress considered was the President's failed $800 billion stimulus plan.
To curry favor with the Administration and Democrats in Congress, Bernanke wound up publicly supporting the bill. His support was touted on the floor during consideration. I am sure that supporting one of the President's largest economic policies in his first term didn't hurt when it came time for the President to make a decision about re-nomination.
The policy solution to this problem is quite easy. The law should be changed to only allow an individual to serve a single term as Federal Reserve Chairman. This will ensure we don't have any repeats of the stimulus debacle and Chairmen seeking re-nomination publicly supporting various fiscal policies out of self interest.
Second, the Fed's supervisory role greatly compromises its independence in regard to its monetary policy role. How can the Fed independently make appropriate monetary policy decisions, which have an extraordinary impact on the large financial institutions they regulate, without considering how those monetary decisions will financially impact those same institutions?
Let me provide one very real example on how this can become a problem. Right now, large commercial banks are holding billions of dollars of long-term mortgages at very low rates. These mortgages are being financed by short term deposits.
It is impractical to believe, even though some might, that rates will stay this low for the next thirty years. At some point rates will have to go up and when they do, the value of these mortgages will go down creating potential major safety-and-soundness repercussions with some of these financial institutions. The Fed, knowing this, could possibly be swayed on their monetary policy decisions because of their supervisory function. This is a significant threat to the Fed's independence as it relates to monetary policy.
The solution to this is very similar to what Republicans put into their Dodd-Frank alternative and what Chairman Dodd had originally supported at the beginning of the debate. We should remove the Fed's supervisory function and place all of the prudential regulatory authority in the hands of a consolidated financial regulator. The Fed would then have its independence strengthened and be able to focus on their core mission of conducting monetary policy.
The third and final threat I see to the independence of the Fed is its emergency lending authority through Section 13(3). Dodd-Frank attempted to limit this authority by prohibiting the Fed from using this power to bailout or lend to any specific institution. That is a good start however there is a loophole big enough to drive a multi-billion dollar bailout through, literally.
To get around this restriction, all the Fed has to do is create a lending facility under this section and make the facility available to all firms in a specific industry. For instance, if it can't bailout one investment bank with the authority, all they have to do is make the bailout available to all investment banks in order to bailout the one.
The policy solution to this problem is to severely curtail this authority. If the Fed is not able to use arcane and questionable authority to bailout as many TBTF banks, then it will be treading in fiscal waters less and be better positioned to conduct monetary policy independently.
Speaking of bank bailouts, let me move to the other topic I wanted to address today: ending TBTF. One of the worst parts of the myriad of bailouts that occurred during the financial crisis is the tremendous amount of moral hazard they created in the financial system. The bailouts reinforced the notion that investors, creditors, counterparties and other market participants had regarding the big U.S. banks.
I find it odd that Treasury continues to send out press releases today highlighting how much money TARP made but then also touts how the government is reducing its exposure the financial institutions it bailed out. If the bailouts made so much money, shouldn't they recommend making TARP permanent? Shouldn't they be proposing to expand it? Of course not.
What they aren't saying in their press releases is how much moral hazard has been put into the system and how costly this will ultimately be for the taxpayers. Some claim that this isn't an issue because Dodd-Frank ended TBTF. How they do this with a straight face is not clear.
Let me be very clear, Dodd-Frank did not end TBTF. In fact, it made the problem far worse by having the government create a list of all of the TBTF institutions. All investors and creditors will now know exactly who is TBTF and where their money will be protected regardless of what happens to the firm.
Dodd-Frank creates a system where the government specifically identifies who is TBTF and then adds additional regulations on the firms such as increased capital and leverage constraints. If a firm does happen to get into trouble, there is a resolution mechanism created called Orderly Liquidation Authority (OLA).
This process of unwinding a firm allows for a large amount of regulatory discretion regarding when and which firm to place in the resolution process and which creditors should suffer losses and which should be made whole.
There is no doubt that since the passage of Dodd-Frank, TBTF banks have gotten bigger. Their share of the marketplace has increased and their funding costs have dropped compared to their competitors.
Even many democrats admit that Dodd-Frank has not fixed TBTF. Representative Maxine Waters, the current Ranking Member on the Capital Markets Subcommittee and potential head Democratic member for the full Financial Services Committee, stated that one of her top goals will be to actually end TBTF. Former Senator from Delaware, Ted Kaufman, has been outspoken on his belief in the failure of Dodd-Frank to resolve TBTF.
All of this begs two questions. One, why did they support the bill? And two, the more pertinent question, what is the proper solution? I will let the respective members address the first question but I thought I would walk through some of the potential answers to the second and discuss the positives and negatives to each one. I won't necessarily be picking a side today but I do believe it is essential to lay the ground work now so that we can move to end the TBTF doctrine next Congress.
First, I will begin with the solution that is very popular in many circles on Capitol Hill right now: reinstating Glass-Steagall. This would reestablish a formal separation between commercial banking from investment banking.
The most common refrain on this is that it served the country well for seventy years and that when Gramm-Leach-Bliley was passed, it allowed for the creation of huge megabanks which are now TBTF. The idea is that, stand-alone commercial banks with deposit insurance can go back to doing the everyday dry business of making loans to consumers and investment banks can go continue participating in the securities markets and making risky trades without a taxpayer safety net.
While I can understand some of the appeal to this solution, we have to remember that Lehman Brothers, Bear Stearns, AIG, Fannie Mae and Freddie Mac all did not have a commercial bank affiliate with deposits. So even if Glass-Steagall were fully reinstated how would the failures of these firms be any different? It's also important to remember that those organizations went down primarily because of their overexposure to U.S. mortgages, which is a major component of what commercial banks would be limited to under this model.
A concern about this approach is what type of effect it will have on U.S. financial markets and international competitiveness. If European or Canadian banks are not limited in the same manner, what will be the impact here? Former Senator Phil Gramm has stated, "if you want your grandfather's banks, you'll have to restore your grandfather's economy." This is something we need to really think about.
Another potential solution that some call "Glass-Steagall Light," is what is referred to as "ring-fencing." Ring-fencing is the concept laid out in the Vickers Report and is the model that the U.K. has adopted for its banks.
There are a variety of ways to structure a ring-fence option. The overall goal is to prevent the parent from using subsidized funding through an insured depository affiliate to fund its capital markets activities while still allowing the parent to recognize the benefits associated from the increased economies of scale.
Critics of this proposal insist that no matter how strong and clear you make the ring-fence, ultimately if the parent runs into trouble it will be able to comingle the assets and funds in order to stave off collapse.
A third option is what appears to be a fairly simplistic and elegant solution: require all financial institutions to just hold more capital and have less leverage. This is being done currently under requirements in Dodd-Frank and the Basel III agreements. It is obvious that, during the run-up to the crisis, capital requirements were way too low and leverage limits were way too high.
I think there is agreement that these components need to be part of whatever final solution there is but it is hard to see these two requirements being the only components of a final solution. As memories of the crisis begin to fade, will these requirements always stay as robust? There are many types of capital, some better at absorbing losses than other, how much and what kind of capital is the appropriate amount? If these limits were so off the mark last time, how can we assure we get them right this time?
Fourth, a number of people suggest simply breaking up the big banks. They argue they are too big, too sophisticated and too interconnected to operate so Congress should pass a law that would forcibly break them up. Some have argued that this would actually be a positive for shareholders, that there is more value in these entities broken apart than stacked together.
While there might be some rhetorical populist appeal in this suggestion, there is a little thing called the U.S. Constitution that has to be considered. If there is an anti-trust issue here, then the courts should address it, but I don't know how appropriate or constitutional it is for the government to go around breaking up private banks.
A fifth option that has gotten much consideration, except from the press it seems, is to create a new chapter in the Bankruptcy Code to handle large, interconnected financial firms. This is actually what House Republicans included in their alternative to Dodd-Frank.
The rationale is that we should remove the political considerations from unwinding failing financial institutions and have those firms go through a similar nonbiased process that all other companies go through. One of the concerns is the time that it takes to unwind a large financial institution and whether the bankruptcy process can handle the speed that is needed. Supporters argue those concerns can be addressed by having a special chapter of the code for these firms with judges that have additional expertise and the resources to resolve them.
Recently, former Federal Reserve Governor, Kevin Warsh, gave a speech discussing the merits of an expedited bankruptcy process as an alternative. He states,
"A new chapter of the Bankruptcy Code - applicable to all financial institutions - would bring much needed credibility to the murky issues involving the government's support for large financial firms. A Chapter 14 amendment to the code would go some distance to remind creditors and counterparties that the government has fine and effective and well-understood options to unwind a financial firm and, in the long-run, promote financial stability."
He even suggests that this option could be combined with the current Orderly Liquidation Authority option, as long as the bankruptcy option is "understood as the prevailing, dominant option." Also, this appears to be more politically viable than some of the others.
The final option I want to discuss dovetails somewhat into the enhanced bankruptcy option. It is the concept of bail-in. A bail-in would usually take place prior to a bankruptcy and would convert a predetermined class of bonds into equity.
The idea is that when an institution is suffering severe losses and needs more equity capital so they don't default on their debt obligations, this type of swap would help build the capital base while also reducing the institution's debt burden.
For such a concept to work, many difficult questions would need to be answered first such as: When does the swap happen? Who makes the decision? How would the bonds price in the market?
Regardless of the disagreement over which of these options would best protect taxpayers and end TBTF, there should be complete agreement that the TBTF doctrine is alive and well and Congress must act to finally end it.
The main objective is to ensure greater market discipline exists for all financial institutions including their management, their shareholders, their creditors and their counterparties. Otherwise, the moral hazard that was greatly increased by the bailouts of the financial crisis will only get worse. Time is running out to put the genie back in the bottle.