SAN FRANCISCO — Among central bankers, few can match John C. Williams' insight into the tech sector.
As president of the Federal Reserve Bank of San Francisco, Williams is at the epicenter of the tech industry's foray into financial products, with marketplace lenders like SoFi and Lending Club headquartered nearby.
Williams shares many of the banking industry's concerns about fintech. While he sees promise in alternative lending products, he also sees perils, including the potential to leave low- and middle-income borrowers behind or make it easier to engage in predatory lending.
"I do worry that some of these online financial products allow you to do predatory lending or other scams at massive scale," he said.
In a sit-down interview with American Banker at his office here, Williams spoke about fintech's impact on the banking industry, as well as calls to break up the biggest institutions, banks' culture and stability since the financial crisis and the possibilities for another recession.
Following is an edited transcript of the interview.
Banks are very concerned about competition from marketplace lenders. Should they be? Do those lenders need more regulatory oversight?
JOHN C. WILLIAMS: I think that everybody should be concerned, if you're in a business, about competitors — that's good, it's healthy. Capitalism is all about competition and innovation, and let the better product, let the better service win out. I think a lot of bankers may have gotten used to a higher [return on equity] and a stable business model and some threats from disruptive or other competition is I think a good motivator to do what you do even better.
I think what we want to make sure is that it's a level playing field, though — that community banks and other bankers, if they're facing competition from fintech or shadow banking, that the same rules apply across [business models], based on what the activities are.
A lot of our regulation is based on real problems that needed to be addressed through regulatory or legal ways. I'm thinking of things like redlining way back, or underprivileged communities not getting credit — that was a problem in our society and there were laws written to try and better address that.
I worry about that with fintech, to make sure that, if we're going to bring technology in — whether online lenders or crowdfunding or things like that — that we remember the lessons from the past and demand of them that they extend credit to all parts of our community and not create a ZIP code-based lending algorithms, where if you live in Atherton [median income $250,000-plus] you get a loan, but if you live in East Palo Alto [median income $56,713] you don't. That kind of thing really does bother me, not because people are bad but because they maybe haven't thought about it. We should have expectations as a society that our financial system is serving all people and not leaving people out.
The second [concern] is consumer compliance. I do worry that some of these online financial products allows you to do predatory lending or other scams at massive scale. I'm not anti-tech, but I want to make sure that consumers are appropriately protected in the same way that we expect that consumers are protected when they deal with banks or other lenders.
The last is that, a lot of fintech tends to need to do what everybody needs to do. If you want to lend money, if you want to have liquidity, you grow very strong connections with banks. That's good. But as fintech companies become more and more enmeshed with the banking system, with that comes safety and soundness [compliance], AML, BSA, all that. The thing I think we need to message to the fintech world is that there are reasons we have these laws. These aren't just because regulators are mean, grumpy people that like to tell people, "No." There are social issues, social problems, that needed to be dealt with and those same laws and issues are going to apply in fintech.
What do you make of the campaign rhetoric around Wall Street and breaking up the biggest banks?
I won't talk about politics here, but when I think about banking regulation, it's really important to look at what were the real causes of the crisis and what caused the government and the Fed to have to take the dramatic actions that we did to try to forestall a much worse economic downturn.
My view is, the steps that have been taken, both on the part of the regulators but also from changes in the law — the stress tests, other changes — were badly needed. I think they will make a more resilient financial system and a more resilient banking system. There are still some steps with resolution of SIFIs and all that, but to my mind this is the right way to approach this.
It's a balanced approach — it recognizes that we want a financial system that provides credit to the economy, it helps small businesses grow, it keeps our economy strong, but at the same time it's not a financial system that takes on excessive risks.
What we saw after the fact was that [firms] didn't even understand the risks they were taking. One of the biggest shocks to me was how much we learned about the inadequacy of operational issues at a lot of banks — that they didn't understand the risks, they didn't have good [management information systems] to manage the information that they had. A lot of banks had just underinvested for years in that back-office, backroom stuff that really helps you to control risk, to understand what's happening. That was true at smaller banks up to the biggest banks in the world.
In the end, I think those are the tools that will help us have a resilient, effective, successful financial and banking system. I'm old enough to remember when we broke up AT&T, and they reformed into huge phone companies again. Some of these answers that sound good, like "Break up the banks," don't really tackle the important issues.
Do you think bank culture has changed since the crisis?
When I talk to community bankers who survived the crisis, bank culture has not changed. Community bankers, regional bankers, bankers who have been in the business a long time, they are the ones who survived. They're the ones who didn't make all the bad decisions. So that hasn't changed.
Where I worry about bank culture is when there is more of a culture of traders and investment bank culture, which I think in commercial banking adds a lot more risk to that kind of enterprise. What worries me the most is all these anti-money-laundering and [Bank Secrecy Act] failures at the biggest banks in the world. They pay huge fees, they clearly have not had adequate control over this, and when you read the stories, it sounds like [the bankers think], "Well, this sounds like a profitable business, so let's not ask questions." That's what worries me, is the kind of culture that doesn't worry as much about reputation, about the long-term health of the organization.
I think the events of the last eight years have taught a lot of leaders in banks that reputation, which has always been highly valuable, is something that you can lose quickly when you find out that people are doing things that aren't consistent with your vision and your mission. That leads to a lot of public recognition of that, and obviously huge fines. Hopefully the lesson learned is to recognize that the long-run health and reputation actually matters a lot more than short-term gains. That's still a question mark, though, how much that has stuck.
How would you rate the banking sector's resilience in the context of greater-than-expected losses in the energy sector?
There are two stories there, and they're both important ones. For the vast majority of banks — and especially the biggest banks — the resilience, the level of capital, liquidity, everything about the institutions, both quantitatively in terms of capital, but also the risk management — all those things are in much better shape than they were. So I think we've learned lessons from the crisis, I think the banking system is much better prepared for whatever the next thing is. The oil crisis was one little mini case of that — can you take those losses when a bunch of loans you made to an industry are going sour? So I actually feel this is a nice little test case of this better resilience of our banking system.
The second story is, we have a lot of banks in our district who were downgraded in terms of our assessment of their safety and soundness [after the crisis]. A lot of banks in our district ended up closing, whether being merged or going through a resolution. And one of the things you still see is, of the banks who were hit hardest — and I'm thinking of community banks — they are still struggling to get back to full strength. So there are definitely still parts of our district and this country where the community bank sector is still damaged enough from the housing crash that they're still not providing the credit to local businesses, local community in the way that we need.
One of the things that's still holding back our economy is the lending from community banks — throughout the country but especially in areas that were hard-hit. Those areas where community banks went under or are just trying to stay alive are areas of the economy that are not getting credit that easily. It's not easy for other banks to step in and immediately start providing the credit that the local banks were doing. It's not a big headline, it's not about the biggest banks, it's not about financial stability, but it is about the long-term damage that came out of the financial crisis and the effects it had on a lot of banks.
Economic reports suggest there are wide variations in types of lending activity from region to region. How do you make sense of that, and does it matter?
Your observation is dead on. I see that. These markets can be very idiosyncratic — the [San Francisco] Bay Area is driven by what could be broadly called "tech," but the whole innovative sector that's going on is driving commercial real estate prices, construction rents through the roof. And one of the things you have to do is stop breathing this air, go out in the rest of the country and other parts of my district where … prices are still depressed and there are other parts of the country where it's this mixed bag.
One of the things that's very healthy is I meet with my colleagues from the different Federal Reserve Banks at the [Federal Open Market Committee] and I might say, "Commercial real estate is really hot in San Francisco, L.A., Seattle for these reasons," and then one of my colleagues will say, "That's really interesting to see, because we're seeing the exact opposite." So we just organically will often have this comparison on what is really a national trend versus what is unique to a specific market.
One of our economists here [Robert Valletta] has done some careful studies over the years about … the dispersion index of economic activity across sectors, across regions: Has that changed over time? Is it unusual or a problem? He showed that there's always this [effect]. We have a very dynamic economy. We have an economy that typically has regions that are booming and sectors that are booming and others that are stagnating or even shrinking. That's kind of normal for the U.S. economy. And if you look at a standard dispersion measure, that doesn't have any obvious upward trend or downward trend. My guess, not having seen any recent analysis on this, is that the same thing would be true.
How important is the next interest rate hike, relative to everything else happening in the global economy? Do we in the media make too much of it?
As a group, when I read a lot of the business section in newspapers, it's mostly about businesses — what is Apple doing, or what is Samsung doing, or whoever. I think the vast majority of reporters put the Fed right where it should be, that is, not the most important story for the U.S. economy. But if you're going to a press conference and asking about the Fed, it's not surprising to me that the focus should be on the policy decisions and the thinking around those.
I think if I had my [way] — and I don't speak for my colleagues, but I think many would agree with this — if we could have the conversation be less about the individual meetings and more about the path for policy over the next few years, I think that would be much more constructive. One of the advantages of the dot plots is that it allows us to talk not about individual tactical decisions at meetings, but really talk about where we see policy over the next few years. That's what's going to affect bond rates. That's what's going to affect financial conditions. If we were going to move in meeting X or meeting Y, it has virtually no effect — if it's the same total move — on the economy. What does matter is if interest rates two years from now are going to be higher than they are today, and how much higher.
How well-founded are market concerns of a slowdown or recession in 2016?
I don't see any signs whatsoever that there is more likelihood of a recession this year than there would be in any year. Recessions happen once every so often, so I don't want to say there couldn't be something, because things can happen. But when you look at past recessions, usually there's a factor or a group of factors that contribute to [the downturn]. In the past, it's often been an upward movement in oil prices, or we had the tech meltdown, or the housing bubble. So there are imbalances or risks in the economy that are growing and then they come to a head and the economy takes a hit. Right now when I look at those risk factors — household debt, where asset markets are, where business investment is, home construction, all these things that are typically correlated or connected to imbalances in the economy that lead to recessions or inflation — none of those are even blinking yellow, really.
Why hasn't the drop in oil prices been a boon to the economy?
Two things. One is that oil production has once again grown to be a significant factor — we're a bigger producer of oil today than we were five or 10 years ago. So that changes how it affects the economy. Jobs in drilling, extraction, all of the ancillary jobs — that whole industry grew rapidly when prices were high and got hammered when they came down.
The second is, the dynamic in the [hydraulic fracturing, or "fracking"] industry is very different than in the rest of the oil industry. Normally, when you're looking at big oil, if you're thinking about deep-water drilling, they're thinking about 10-year, 20-year investments and extraction. All of those decisions are based on long-term views of where things are going to be. Those tend to be, in economics parlance, "stickier" — if the decision makes sense based on our view of the next 20 years, then there's not much that's going to happen today that's going to change my view. And once you start drilling, the marginal cost of pulling that oil out is very low.
With fracking, it's the exact opposite. You only need a few months to start, you start pulling it out right away, and you're done in a couple years. So all the dynamics are more like your Econ 101 textbook: Price down? Close. Price up? Do more. That's something that has really changed to affect the economy. Basically we saw us lose a lot more jobs, a lot more GDP, a lot more losses to the banking industry down the road because this dynamic is quite different. We kind of knew that, but maybe our modeling of that took a little while to [catch up].
You might say, why don't we see the economy booming even more? I think these headwinds from abroad, the drop in net exports, other factors have been slowing the economy. I don't think it's that lower gas prices haven't been helping; I think it has. It just kind of loses the headlines when GDP is only growing at 2%. We are getting the benefit. That's why consumer spending is growing at more like 3%, car sales are near all-time highs.
Does the oil glut and the fact that it took everybody by surprise mean the Fed needs to rethink the way it predicts oil prices?
I have to admit, our own view here when we look at oil prices is [that] we've given up on trying to predict where they'll go because it's very hard to model the future of oil prices based on past experience. In our own forecasting exercises we tend to follow the futures curve, but we also have done an analysis that shows that the futures curve is no better at predicting oil prices than just taking the spot price and assuming it will stay the random walk.
There's really no good model of predicting oil prices, at least from a macro forecaster's point of view. So we, like [with] many things, plead ignorance and say, assuming oil prices follow what the futures markets indicate they will, what's our forecast? And then we do the risk analysis: what happens instead if oil falls to $20 [per barrel], to $60, that kind of stuff. It's the risk scenarios that, I think, are more informative.
Headline unemployment continues to decline and yet wages remain stagnant and there is persistent slack in the labor market. Why is that?
Normally, if you were to plot various measures of slack in the labor market — like the unemployment rate, various surveys of whether it's easier of harder to get a job from the Conference Board, is it hard or easy to fill a job — they all move together. When the economy is strong, they all say the economy is strong; when the economy is weak, they all say the economy is weak. What happened during the recession is very unusual, in that some of these indicators really did get out of alignment with each other. They all moved in the same direction, but they didn't move in the same proportionality.
The number of people who were part time for economic reasons rose a lot more than you would expect for an unemployment rate than went from 5 to 10 [percent] and now back to, essentially, 5. The part time for economic reasons [metric], with the depth of the recession, the length of the recession, and the very gradual recovery — there was just a more than proportional effect. There was a larger increase in the number of people who dropped out of the labor force but who still wanted a job than you would normally get in a recession. In every recession that number goes up it just went up more than you would expect from the unemployment rate. A lot of economists looked at why [that is] and in my own experience, you want to kind of average over those. If the standard employment rate is telling you that things are better than the other [metrics are], then maybe there's more slack than the unemployment rate is saying.
The good news is all these other indicators have improved a lot. My own prediction is that over the next few months is that more and more of the new jobs are going to be taken not by people who are unemployed officially, but people who are either out of the labor force or people who go from part-time work to full time work. As the unemployment rate gets lower and lower, employers are going to have to be pulling workers in form these margins.
In terms of wages at a superficial level, we're not seeing an acceleration of wages. Our economists have been scratching their head about that and wondering why that's happening. The simple [explanation] is that, we should be looking to real wages relative to productivity, so both adjusting for inflation and productivity. Inflation has been very low for the last several years, there's no question about that. Overall inflation has been very low. So if you look at wage growth of 2.2% and if inflation was only 1%, that's real wage growth. And productivity growth has been horrible. Last year it was about 0.5%. Inflation was below 1%. So that would tell you that wages would only grow about 1.5%, even in a strong labor market. It actually grew a little faster than that.