WASHINGTON — With the regulatory reform debate taking a leap forward this week, Thomas Hoenig, the president and chief executive of the Federal Reserve Bank of Kansas City, is advocating a more clear-cut world for financial services and those who supervise it.
"If I were heading regulatory reform, it would be under rules that are simple, understandable and enforceable," he said in an interview last week. "I don't like to think of it as going back to the good old days. I think of it as going back to prudence."
An example: strict loan-to-value ratios, enforced by examiners.
"If an examiner goes into an institution, whether it's the largest institution in this country or the smallest institution, and they have underwriting standards that have loan-to-value ratios at 100% or 90% or 125%, they are written up," he said.
"There is no negotiation."
Another: a ceiling on leverage.
"If I look to the past, prudence tells me that a leverage ratio that is 34 to 1, or actually 20 to 1 is too high, that the margin of error is so slim against the capital available to absorb the losses, that it is unacceptable," he said. "We have standards that were long based on a maximum of 12 to 1 or 13 to 1. Let's put that out there."
The Obama administration plans to roll out its prescription for revamping oversight on Wednesday. In addition to establishing the Fed as a systemic risk regulator and tightening supervision of nonbank institutions, the White House is also likely to broaden the Federal Deposit Insurance Corp.'s authority to take over and unwind troubled companies.
Hoenig agrees the resolution process is due for an overhaul. Reforms should minimize the risk of government intervention by putting shareholders on the hook for both current and future losses. The whole point is to prevent shareholders from being rewarded if the stock price rises after a government rescue, as it did in the case of Citigroup Inc., where shares now top $3.30 but were barely over $1 in March.
Under Hoenig's plan, if losses on writedowns and loan workouts prove greater than total equity, all shareholders would be wiped out. But, importantly, if losses did not overwhelm total equity, shareholders would still take a hit, because the government would exercise warrants. For instance, if a firm has $100 in total equity and experiences a $90 loss, the government would exercise 90% of its warrants, leaving shareholders with just 10% of their investment.
"We need to develop an orderly resolution process that allows these institutions to be accountable for their errors in judgment so the economy itself can renew," he said. Otherwise, "you create an oligarchy of financial power that is not good for an economy."
In an era where so many firms — ranging from American International Group Inc. to Citi — have been saved because they are considered vital to the overall economy, Hoenig looks back with envy at how regulators managed the failure of Continental Illinois in 1984 and says shareholders should shoulder some of the resolution costs.
"It was the seventh-largest institution in the country, had international influence and in a sense, I wish we'd have used that as a guide and modified or even improved it," he said. "You didn't just wipe out the stockholders at once. You put them in a position that all future losses as you put them into receivership were charged against them."
Hoenig envisions selling off the bad assets and private investors stepping up with capital.
"All bank holding companies would be subject to this approach," he said. "Then you could have a mechanism where the Treasury, the Federal Reserve and the FDIC come together on any other financial institution and make a judgment as to whether this is an institution that is systemically important but needs to fail and you take this bankruptcy approach to those institutions."
Hoenig is not opposed to returning to the days before the Gramm-Leach-Bliley Act of 1999 and a wall between commercial and investment banking.
"There would be some value in that," he said. The issue is "the amount of risk you can take on when you have a role in the payment system."
Still, he knows repealing Gramm-Leach-Bliley is politically unfeasible, and even colleagues at the Fed say resurrecting old barriers is not helpful.
As Fed Gov. Daniel Tarullo said in a speech last week, "Reform by nostalgia is not usually an effective approach, since it tends to forget the problems of the past and deny how much has changed."
Since the financial crisis emerged in August 2007, the Fed has introduced nearly a dozen separate lending programs to help financial institutions with liquidity. Hoenig is increasingly eager to phase out those programs.
"We really do need to think about how we would wind down, what the time frame is," he said.
Though Hoenig is not a voting member of the Fed's policymaking committee, which meets next week, he is worried the liquidity programs could fuel inflation.
"You have all this stimulus coming forward and a great deal of liquidity, and therefore, unless we are sensitive to that and think about withdrawing it in a timely fashion, we can be fairly confident that inflation will be the outcome."
Hoenig acknowledged the central bank will face political pressure to not take away the proverbial punch bowl too soon.
"I've always encountered resistance to a rate increase," he said. "There will be a lot of hesitancy to withdraw this when the time comes to do so. That's why you have an independent central bank."
Hoenig applauded early signs of optimism in the industry but said challenges remain, including exposure to commercial real estate.
"There's a greater degree of calmness. I think that's good … but we are hardly out of the woods yet, and I think we shouldn't forget that as we plan for the future."