I really appreciate the opportunity to be with you today and to speak to the Council of Institutional Investors. As a reminder, my remarks reflect my own views and not necessarily those of others in the Federal Reserve System or of the Federal Open Market Committee. I also thank you for allowing us to record and replay my remarks, which is important for transparency.
I am excited to join you today because of who CII is—long-term investors who work on behalf of millions of Americans to secure their economic futures. With $4 trillion of assets under management, you are important stakeholders in our financial system.
While there are other large players in our economy and capital markets, few combine that scale with such a long-term perspective. You don’t have the luxury of looking out only one or two quarters or even one or two years; you make decisions that will affect your members many years in the future and even over decades. It is your unique combination of scale and long investment horizon that is motivating me to speak with you today.
I know from my own experience in government and in the private sector that CII, and many of your members, are active leaders in driving positive changes in our economy and society. Take corporate governance as one example. You have long advocated for strong governance practices because, as you say, “CII believes effective corporate governance and disclosure serve the best long-term interests of companies, shareowners and other stakeholders. Effective corporate governance helps companies achieve strategic goals and manage risks by ensuring that shareowners can hold directors to account as their representatives.”
Another example is climate change. Several leading pension plans actively promote environmental sustainability by investing in companies that are aligned with their goals and principles.
It seems to me that you take on issues that (1) are in your members’ long-term interest, (2) your scale and your role in our economy position you to help drive meaningful change, and (3) are the right things to do for society as a whole.
I want to speak with you today about another issue that I think meets that three-part test and on which I believe you should focus your policy agenda; that is, capital markets and banking regulation. I know this is not a new issue for you, as many of you have identified financial market stability as important to your ability to deliver for your members. However, I am going to argue today that you should elevate this issue to the forefront of your agenda because large, unacceptable risks remain, and you are uniquely situated to drive change. Your members and all Americans deserve better than the financial system we have today.
Earlier in my career, I worked at the U.S. Treasury Department and oversaw the Troubled Assets Relief Program (TARP) in the Bush and Obama administrations. I confess that the experience of battling the global financial crisis is burned into me. In the worst moments of the crisis, we didn’t know if our financial system, our banking system, and our broader economy would pull through. Looking back, I realize that our programs—Treasury’s, the Fed’s and Congress’ fiscal programs—were effective in stabilizing the crisis, but I also know that we got lucky. We didn’t know for sure that our programs would work. We were taking our best shot. It could have been much worse.
We saw that fragile capital markets and a fragile banking system can inflict enormous damage on the broader economy and on Main Street—on everyday Americans living their lives far away from Wall Street. These are your members. Think back to 2008. What was happening to your pension plans? What was happening to their funding status? For most, it was a catastrophe in the making and, even with the massive government intervention, many plans haven’t recovered. The most recent data from the Federal Reserve1 show that before the financial crisis, state and local pensions were about 66 percent funded. That fell to 48 percent in the crisis and most recently had only recovered to around 52 percent. Beyond the pressures on pension plans, think about the hardships your members faced. Even with massive government intervention, millions of Americans lost their jobs. Many lost their homes. Many who were responsible and bought homes they could afford lost those homes after they lost their jobs. The financial crisis was deeply unfair in who paid the price for the risks that had built up in the financial sector.
Following the financial crisis and Great Recession, Congress passed the Dodd-Frank Act, and new regulations were put in place to increase the resilience of the banking sector. That act and the reforms that followed were based on a fundamental design principle: Keep the basic architecture of our financial system unchanged. Just strengthen the existing structure, but don’t be so aggressive that it leads to major changes. As a result, large banks were forced to increase their capital levels modestly and fund themselves with longer-term liabilities. Stress tests were introduced. But the basic architecture and the main players didn’t change.
Did the reforms work? The largest banks in America do have higher capital levels than they had before the crisis and do fund themselves with less short-term borrowing. But the 10 largest bank holding companies in America are around 45 percent larger than they were going into 2008, having grown from roughly $9 trillion to nearly $13 trillion in assets.2 While banks often complain that regulations are hurting their competitiveness, the data show that is simply not true.
When I joined the Minneapolis Fed in 2016, we embarked on a review of the issue of banks being too big to fail to assess the reforms that had been implemented and whether more were needed. Our analysis, and that of many other independent researchers and academics since, confirms that large banks in America today are still too big to fail, and their capital levels are not high enough to balance the benefits society gains from their scale with the risks they pose to the economy.3 This analysis shows clearly that large banks should fund themselves with equity of at least 24 percent of risk-weighted assets—up from around 13 percent today. That would maximize the benefit to society and protect taxpayers because, at those levels, banks could cover their own losses.
Banks make all sorts of arguments against higher capital requirements that are easily refuted. First, they say they will be at a competitive disadvantage if other countries don’t follow suit. But that has already proven to be false because U.S. banks are outcompeting European banks that have even more lax regulations.
Next, they say the U.S. economy benefits from their large economies of scale and that will be lost if they are forced to issue more equity, because they might choose to break themselves up to get around the higher capital requirements. If, in fact, they have such economies of scale, then they should be able to afford higher capital levels than small banks. Perversely, large banks have, on average, much lower levels of capital than small banks even though small banks don’t pose a systemic risk to the economy. It’s the exact opposite of the way it should be.
Finally, their favorite line is that lending will be curtailed if they have to fund themselves with more equity. But up until COVID-19 hit, they were buying back billions of dollars of their stock each year. In fact, combined, the eight largest global banks headquartered in the United States bought back more than $110 billion of stock in 2019 alone.4 If capital was constraining lending, why were they buying back their stock? It is nonsense.
Large banks will never address these risks on their own. Their management teams have a fiduciary duty to their shareholders, which are you and your members, to maximize shareholder value. And the shareholder value-maximizing business strategy is for banks to expose the taxpayers to as much risk as possible and then count on the government to bail them out in bad times. More specifically, they are charged to run with as little equity as possible—that is how you maximize earnings per share. Large bank CEOs would not be doing their jobs for shareholders if they didn’t fight back against regulations that could protect taxpayers and make the financial system safer. This is not hyperbole. This is the reality of our economic system and why they are willing to make silly arguments that are so easily refuted. There are some risks in society like this—we call them externalities—which the private sector simply cannot address on its own, and that is why strong government regulation is necessary to address those risks.
Congress considered financial system reform when it wrote the Dodd-Frank Act, and it chose not to be aggressive in reforming our financial system. Why not? I have asked that question of numerous members of Congress on both sides of the aisle. They respond simply that financial firms have enormous influence on Capitol Hill. Strong regulation is the textbook response to externalities such as pollution or too-big-to-fail risks. However, that response fails if the regulated entities have too much political power. And, unfortunately, that appears to be the position we are in today.
Before COVID-19, the good news, or so I thought, was that we had time. Prior to the Great Recession, the last time the United States had a systemic financial crisis was during the Great Depression. So I thought, if these massive shocks happen only every 80 years, then we could take our time to reform the system. And then COVID-19 hit us. Much to my surprise and horror, in March of this year, the financial system faced another systemic collapse as fear gripped markets and investors shunned most securities in favor of cash. Facing this crisis, the Federal Reserve stepped up forcefully to backstop the financial system, pumping trillions of dollars into markets and directly supporting money markets, municipal bond markets, mortgage markets, corporate bond markets, and the Treasury market. In 2020, the Fed acted much faster and more aggressively than it did in 2008. I fully support the Fed’s actions in responding to the COVID-19 crisis, but I just can’t believe that it happened again, only 12 years later. And I keep asking myself, what kind of absurd financial system do we have that requires the central bank to bail it out every decade? How can it possibly be this fragile?
So far, this financial crisis has been focused on funding markets, such as commercial paper and money markets, rather than large banks. You might not realize it, but the banks got a lot of help. How have the tens of millions of Americans who lost their jobs because of COVID-19 been able to make their credit card payments, car payments, and rent and mortgage payments? Most have been able to make these payments because Congress acted so quickly and aggressively to send money to people, including the $1,200 one-time checks many Americans received and the extra $600 a week in unemployment benefits. Bank losses would have been much, much larger if the American people didn’t have this extra money to make payments on their loans. I applaud Congress’ bold actions to support people affected by the COVID-19 crisis, but we need to be clear that families weren’t the only beneficiaries. This was also a banking bailout.
In my mind, the funding markets that almost collapsed in March raise important and complex policy questions. Unlike addressing the risks of too-big-to-fail banks, where the solution is clear and straightforward—force them to fund themselves with more equity—the solution to fragile funding markets is less obvious but also important. Fundamentally, I wonder why we allow firms, financial or otherwise, to fund themselves overnight? What societal value is there in such a system that proves so fragile when risks emerge? The primary value I see is that it allows firms to eke out a few extra basis points of earnings in good times and then requires the central bank to backstop it when risks emerge. This is the definition of privatized profits and socialized losses. That strikes me as an absurd system for the country. We need to carefully study what happened in these markets in 2008 and again in 2020 to develop effective solutions. In my view, we can’t keep doing what we’ve been doing.
I am not suggesting that we could eliminate all financial crises if we aggressively addressed these flaws in our banking and financial system. Crises have happened throughout financial history and no doubt will continue to happen in the future. I do believe that with smart, aggressive regulation, the American economy could thrive on an efficient, competitive, and innovative financial system that was more resilient against shocks—one that required taxpayers to step in far less often and at lower cost.
So why am I coming to you? Because you are uniquely positioned to drive much-needed reforms in the banking sector and the broader financial markets that have proven so fragile.
First, you are large-bank shareholders. Bank management will argue they are just doing their jobs, simply trying to maximize shareholder value for you. But you are in a position to recognize that maximizing the value of one sector of your portfolio that then puts the rest of your portfolio at risk doesn’t make sense. You are in a better position than most to understand the spillovers of these financial system risks. And you can demand change as shareholders.
Second, you are huge players in the capital markets, which means you are important customers of large banks. If the largest pension plans in America got together and said we aren’t going to trade with banks that do not have at least 24 percent equity, they would increase their capital levels. Banks are hard to change—but they know they have to listen to their clients, because the marketplace is competitive. And if they don’t listen to you, some of their competitors will. Don’t underestimate your potential influence as major capital markets clients of large banks to demand and drive change.
Third, the bailouts worked in 2008, and they worked again, so far, in 2020. Will they work next time? Will there be political will to backstop the financial system the next time there is a massive shock, such as a real estate bust or another pandemic? I don’t know. Will there even be the political will to continue to support Americans who’ve lost their jobs because of COVID-19? I hope so. Is betting on successful future bailouts a sensible risk for your members? I would argue the answer is a resounding no.
I am here today to ask you to put meaningful banking and financial system reform at the front of your agenda. I believe your members and the American people deserve a resilient financial system that doesn’t require a bailout every decade or so. Fixing this system is absolutely in your members’ long-term interest. Your scale and your role in the capital markets uniquely position you to help drive meaningful change. And it is clearly the right thing to do for society. We at the Minneapolis Fed would be pleased to work with you to share what we’ve learned, examine these recent episodes, and advance solutions that will finally address these risks.
2 Minneapolis Fed calculations based on data from the FR Y-9C (Consolidated Financial Statements for Holding Companies).
3 See The Minneapolis Plan to End Too Big to Fail (pp. 16-17) for citations to six analyses finding net benefits to higher equity levels. Former Fed Chair Janet Yellen also summarized some of this same material and noted that “this research points to benefits from capital requirements in excess of those adopted.”
4 Minneapolis Fed calculation based on data from Bloomberg Finance L.P.