ST. LOUIS — It's not uncommon these days for regulators to acknowledge that the pendulum of supervision has swung too far, particularly for community banks.
But James Bullard, the president of the Federal Reserve Bank of St. Louis, is willing to go even further, suggesting that it was a mistake for smaller institutions to face most of the new requirements of the Dodd-Frank Act, including internally-run stress tests and the Volcker Rule.
“I've not seen any evidence that, for smaller banks, the system that we had [prior to the financial crisis] didn't work,” Bullard said in an interview with American Banker. “It was a big shock, but we were able to handle that under the previous framework. You bring in things like Volcker for small banks, or some of the other more onerous requirements, even stress testing, it's just not so clear what the utility of that is for very small institutions.”
Bullard, who joined the Fed bank as an economist in 1990 and was installed as president of the St. Louis Fed in April 2008, had a front-row seat for the financial crisis, and is hardly anti-regulation.
But in an expansive interview with American Banker, he discusses the problems facing smaller institutions as well as cybersecurity at the Fed and what happens as fintech firms become bigger players in banking.
Below is an edited transcript of the interview: (To listen to it in its entirety, click here for the podcast.)
American Banker: You just wrapped up your community banking conference here today. There seems to be near-universal agreement that bank regulations should be lighter for smaller institutions. Do the banks you supervise have an equally universal vision of what an appropriate level of regulation should look like?
James Bullard: The community banks in this district do feel that the regulatory burden is too high, and that a lot of regulation rained down on their industry after the financial crisis, even though the roots of the financial crisis were in much larger institutions that were outside, for the most part, the banking system. There's a sense of unfairness about it, which is developing into a more serious consideration that may be harming the community bank business model itself.
Just to give you a number on this, for community banks under $1 billion — according to our survey for this conference — they thought that their compliance costs were about 9% of expenses, whereas for somewhat larger banks from $1 billion to 10 billion in assets, they thought their compliance costs were 3% of expenses. That's quite a large difference. This is a very serious issue and one that is maybe getting more urgency.
As a baseline, the pre-crisis regulatory environment for smaller banks was fine. It actually worked well for smaller banks. I don't think there was anything wrong with the ... pre-Dodd-Frank framework during the crisis. Obviously for very large institutions and for nonbank financials, that's where we had a lot of work to do, and that was clearly the intent of Dodd-Frank. But because we haven't been able to delineate how we're going to give regulatory relief to smaller institutions, we're ended up with an un-level playing field in the banking industry.
I've not seen any evidence that, for smaller banks, the system that we had didn't work. It was a lot of work, it was a big shock, but we were able to handle that under the previous framework. You bring in things like Volcker for small banks, or some of the other more onerous requirements, even stress testing, it's just not so clear what the utility of that is for very small institutions.
One of the papers presented at the conference found a correlation between lighter supervision and heightened risk-taking. Should supervisors give small banks more room to run when it comes to risk?
We certainly don't want them to take on too much risk, and a lot of it is in the pricing of the risk — are they properly pricing the risk that they're taking on? That's not always emphasized in the current framework. It's inherent in the business that you're taking a calculated risk when you make a loan and you want that to be done in an appropriate way and that's what our rules and regulations are there for. I'm not saying there should be no rules or regulations, but the pre-Dodd-Frank [framework] worked fine for small banks.
Besides regulation, what factors are standing in the way of community bank profitability? What can be done to address those factors?
They're picking up a lot of costs, I think this compliance cost number illustrates that. The industry has a longstanding issue about being carved up and a lot of the lending has gone out of the industry into other non-banking entities. That's something that often does not get addressed. You have nationwide mortgage lenders and nationwide consumer loan lenders and so on, so there's an evolution of the industry and trends in the industry that have been going on for a long time that probably are eroding profitability.
Speaking of that, a few fintech firms applied for industrial loan company charters earlier this year. What would a more widespread expansion of tech companies into the banking world mean for the banks you supervise and the public more generally?
The biggest issue facing the U.S. financial sector today is financial technology — fintech. When you have a heavily regulated industry like banking, there are a lot of incentives to develop products and services that are very close to the ones that are offered inside the regulatory umbrella, but offer them outside in a deregulated environment at lower cost and possibly with more convenience and then take over the market. This is a process that we've seen play out in many markets over the years, that's kind of how innovation works.
The ability of fintech firms to do what they need to do by getting the right information on potential borrowers is likely to radically change lending in the U.S. I'll give you one example that I know of from Square. So Square is a payments processor or front-end for payments. But the difference between them and a bank is that they're seeing every single sale that the small business is making. So after a while, they have quite a bit of data on that small business, and they're seeing it transaction-by-transaction. And they can make an automated offer of a loan based on that transactions data, and the owner of the business can simply click on the button and get the loan on the spot.
That kind of thing is going on today, and is a very different process from the traditional small business trying to get a loan from the bank. Usually the small business goes into the bank and the bank doesn't quite know what is going on with the business — they might know the character of the person but may not know the details.
But with Square, they've got all the information right in front of them, and they don't even have to meet the person — they just automatically make a loan offer. That is probably the future of lending, and I'm sure it's happening in many other areas, consumer loans and so on, where if you have enough information on the borrower ... you can just have your artificial intelligence system make the loan. And in addition, Square can get paid back by docking transaction-by-transaction account of the user.
My concern is that we've erected all this regulation around a certain industry and that's creating tremendous potential for disruption along this line, and if it's not Square, it's some other company, because billions of dollars are being thrust at fintech and at the possibility of gaining large profits through this.
Fed Gov. Jerome Powell said recently that he thought bank capital is roughly where it needs to be, but of course there are other voices that think it is either too high or too low. Do you think bank capital levels or ratios need to change?
There's not too much scope to go further at this point. There is a little bit of concern. Sometimes you hear the argument for large banks that they're holding more regulatory capital than their global competitors. I would be a little bit concerned about global competition for the U.S. financial sector. But I'm not sure I would go far enough to want to reduce capital requirements just because someone else isn't holding up their end of the international regulatory framework. I guess we're good for today.
The massive Equifax data breach has raised concerns about cybersecurity — how do you assess whether a bank is adequately prepared for a cyber threat?
This is one of the areas where we've really beefed up a lot. We do expect our regulated entities to have an appropriate cybersecurity program in place, and that program has to evolve and change as threats evolve and change. Something that's good one year might not be so good two years later.
We've had to cajole many of our supervised institutions to get serious about this issue, and make sure that they're pressing this as hard as they can. Also, I might mention that, from the Fed's perspective, our own systems, I'm actually the head of the Information Technology Oversight Committee for the 12 reserve banks — that's about a $1.4 billion spend for the Federal Reserve System.
One of our top concerns there is that we maintain top-notch cybersecurity, so I know from that experience that to get up the maturity curve and to do everything that needs to be done... to put all that together and to maintain productivity and to maintain visibility, all of that is pretty hard and involves some changes every day. The Fed is under constant threat by ... ordinary hackers, but also state-sponsored organizations, and so we do try to have top-notch systems in place.
At some point we probably would get compromised in some way, so we try to have resiliency programs in place to handle that situation as well. So that's a lot of work to get all that to work, but we've tried to be as good as we can be. I don't think we're military-grade, but we're high-grade. We also have risk-based systems where we put extra security around our highest-risk assets.
The FOMC seemed pretty confident about an additional 25 basis point rate hike in December. What would make the committee change its mind?
I don't think the committee has come to a decision, and we'll have to decide that at the December meeting. As things stand right now, we have very low inflation ratings so far this year below what was expected. When we started the year, inflation looked like it was poised to move toward 2%; instead inflation has moved back down, and now the year-over-year core inflation rate is about 1.4%. In some sense we will not have made hardly any progress toward our inflation goal over the last couple of years, because a couple of years ago we were also below [target].
Given that environment, I would think it would be hard to raise the policy rate in December unless we can cite some other data, such as fast GDP growth or particularly strong labor markets.
The question is, what would we be able to cite in December? Hardly any progress against our inflation target, and kind of hazy readings on the economy. I think that's what we'll be looking at. So I'd be leaning against, at this point, trying to forge ahead with additional rate increase at that meeting.
The Fed announced last month that it will start drawing down its balance sheet. Do you see the Fed returning to more traditional monetary policy operations, or continuing to rely on paying interest on excess reserves as a primary monetary policy tool?
No. The interest on excess reserves is a cornerstone of the current Fed policy, and it would be hard for us to extract ourselves at this point.
Under [former Fed Chair Ben] Bernanke, we really committed to using the interest on excess reserves as a primary tool of monetary policy because reserves were superabundant, and if you didn't use it at this point you wouldn't be able to move the policy rate off zero. So that, combined with our reverse repo program and our rather thin federal funds market, those rates together describe the thrust of monetary policy, and that's the way it's going to have to be done, at least for now.
It has worked pretty well, since we lifted off in December of 2015 and continued with three more rate increases starting in December of 2016, so I think for the foreseeable future, that will be the operating regime.
At some point in the far more distant future we could reconsider our operating procedures, possibly consider a corridor system or a system that didn't rely on [IOER], but to get to that kind of system, you would have to get away from the world of superabundant reserves somehow, presumably with a much lower balance sheet than we have today. We're shrinking the balance sheet, but we're shrinking it slowly, so it's going to be quite a while before we're in that environment.
The Fed is sometimes criticized for not being appropriately transparent in its operations and processes. Do you think those criticism have any merit? Can the Fed be more transparent than it is?
We could do a lot more to push the transparency agenda forward. As you know, I've been an advocate of having each meeting be ex ante identical — have a press conference at every meeting. That would provide more communication from the chair, in particular to global financial markets but in addition it would give the committee the option to move at any meeting where they thought it was appropriate ... as opposed to now, where markets aren't really expecting us to do anything at the non-press conference meetings.
We could improve on that dimension, I think we could also provide a monetary policy report, which I think would ... also follow an international standard. Other central banks release monetary policy reports, and there's no reason we couldn't as well. We could put a reasonable forecast in that, and replace the dot-plot, that I think is confusing to people and is only partial information.
I think also on regulatory matters, we could be more transparent. I think there's long been a bifurcation in the way we communicate in monetary policy, which has trended toward more transparency, and the way we communicate on regulatory matters, which is I think more legalistic and more hidden from public view and less well understood by participants in the markets. I think we could do more to forward the transparency agenda on the regulatory side.
Do you think the Fed’s independence, either in monetary or regulatory policy, is in danger?
I do worry about it. I think that the Fed is an important institution for the U.S., and I think if it was co-opted by the political process, that it would be a much less effective institution than it is.
The way we do it now is we delegate to an independent agency, and that allows the politicians to complain about policy, which I think is fine, or present their own views about what policy should be doing, but leave the actual decision in the hands of a committee that's pretty big and by and large does represent the whole country, and by and large is very technocratic and comes to pretty good decision in the end.
I think that process works pretty well, and to mess that up with a lot of politicization I think would be a mistake and probably lead to worse policy, and everyone would be less happy with the outcomes if we went in that direction.