Is there an irony in your mind that the fact that who Obama brings onboard as his economic team -- [former Director of the National Economic Council Larry] Summers, [Chairman of the U.S. Commodity Futures Trading Commission Gary] Gensler is involved, Geithner -- were all in the Clinton White House, were there during the later years when they decided to deregulate derivatives, that these are the people that he relies on?
One of the things that's most striking is the extent to which in the wake of this crisis there hasn't been a fundamental rethinking of our financial system and its role in our economy. If you look at the arc of what happened, from the 1980s, 1990s through the eve of the crisis, what you see is a financial system and sector that is more and more dominant in our economy, that's taking more and more risks; in a sense, an economy that is more about money making money than capital being deployed to create goods and value and jobs for the American people.
In 1980, the financial sector represents 15 percent of the corporate profits in this country. By the mid-2000s, that has risen to over 30 percent. The amount of debt in the financial sector in 1978 is $3 trillion. By 2007 that soared to $36 trillion, very much an economy now being driven by the financial sector and by the risky practices it's undertaking.
You would think in the wake of this crisis we'd have a rethinking fundamentally. And I think one of the things that's most troubling is that here we are three years-plus after, and very little has changed. Now, Dodd-Frank [Wall Street Reform and Consumer Protection Act] has made a number of significant changes. But of course there is a fierce rearguard action by Wall Street, by its political allies, to inhibit its implementation. But here we are, three years later, and the over-the-counter derivatives market is still unregulated.
We don't know today the risks that we have in this country from the euro zone crisis. It could be that banks in this country have $100 billion of risk. It could be that it has a trillion dollars of risk. In many respects nothing has really changed in the credit rating agencies. If you look across the board, very little has changed in the nature and operation of Wall Street, and I think that is one of the more stunning aspects of this episode.
After all the hearings and all the attention spent on it all, the lessons we should draw from MF Global [derivatives broker]?
Well, it's really quite striking. Here we are again, three years after the crisis. And here is a major financial house that's leveraged 40-to-1, meaning for every dollar of capital, they're borrowing $40, the same kind of leverage ratios that brought down Bear and Lehman and would have brought down Goldman or Merrill or the others had they not been rescued by the United States government.
Now, if MF Global ends up being a small enough institution, where they rise and fall, fine. Of course, what's also striking is the extent to which it looks like, again, the regulatory system and their own internal checks missed what may be, you know, enormous sums of money not yet found.
Are we on the right track now?
I very much worry that we haven't learned the lessons that this crash should have taught us. The hedge fund, MF Global, that went bankrupt a few weeks ago, was leveraged to the tune of something like 40-to-1. A typical leverage ratio should be more like 15-to-1. They were betting on discounted southern European debt. It's precisely the kind of speculation that got us into this mess.
The fact that that kind of thing can happen, sure, that makes me nervous that lessons have not been learned.
I will say that they went down and the system did not. We do have to have a system where firms and banks can fail. It's actually a good thing. But in an era of this level of interconnectedness, yeah, I worry, I worry that we haven't learned the lessons.
We talked to a guy, who basically said the crisis has never stopped. It's been ongoing through '08 on up to now. As long as the "too big to fail" banks are out there, as long as things are the way they are, it's not over. We see it in the rumblings in the world right now. Agree?
We're in a postoperative phase here. The patient is able to get off the table, meaning the economy. We still have the patient on medication, that is, accommodative monetary policy. You talked about stress tests earlier. We're testing the patients to make sure that this patient can get up and walk, and later on run and move forward.
But there are still wires attached to the body, and medication is still being applied in terms of monetary accommodation, easy money at very low rates. At the right time, we will have to withdraw that. We're not there yet. …
We're much, much, closer, and so I think we're not out of the crisis from the standpoint of the totality of it, but it's most extreme and intense phase, we have managed to pass through. And now we just have to make sure that we don't get ourselves in that position again. First, that the patient's recovered and secondly, that we don't put the American economy at risk like it was put before, for whatever reasons it got there. …
Are we better off now having gone through this crisis? ... Is our banking system any safer?
Our banking system is far safer today than it was before. Capital is double what it was. Asset quality is better. Liquidity is much better. And there is much closer supervision and limits on risk-taking.
There is the huge problem outside the banking system, and that is particularly the housing market, where we really need a concerted effort, much more expansive than what we've done today. ...
Banks are healthier. Banks have higher capital levels. Banks have more liquidity. When do the benefits show up in the economy?
The one thing banks don't have is higher earnings, so it's going to take time for those earnings to start to improve. I think until then, it's going to be difficult for the banks to deal with the greater economic issues.
But there are ways. It's been widely reported about mortgage settlement negotiations with respect to servicing. This could put billions and billions of dollars into relief for homeowners.
I can't think of anything which would represent a nicer holiday present than getting that settlement wrapped up before year-end. Tens of thousands of homeowners would benefit if this can go into play. ...
What was your overview of what Dodd-Frank [Wall Street Reform and Consumer Protection Act] became? Is it too weak? Does it do enough? It still doesn't break up "too big to fail" banks.
Look, yes and no. I think Dodd-Frank does a lot of things good that needed to be done. Now, on addressing "too big to fail," no phrase is more misleading than "too big to fail," because it wasn't about big. If you took the biggest banks in America, if you took Bank of America and you said, "We are going to just break them up to make them smaller," you could break them into six pieces, and every one of those pieces would be bigger than Bear Stearns was.
That wasn't the problem. It wasn't just the size of people that made them dangerous. It was how connected they were and how much fear of contagion was there. So if they went down, would they take down their neighbors? Dodd-Frank does a lot of things to try to limit the ability of one bank to blow up its neighbors and thereby to take a bunch of people hostage when they get in trouble. And that part is very important.
Now, like all legislation, there's a whole bunch of other stuff in there, too. And I'm sure people will go back and argue about a lot of other things for years to come. But the idea that we ought to stick with the status quo, that got us into the worst financial crisis ever is almost criminally insane.
So we have a problem again. What does the federal government have to do?
Well, for all the rhetoric that there won't be bailouts again -- and Dodd-Frank has changed the law so as to not allow emergency loans to specific institutions -- it's hard to imagine that we won't face the same kind of dilemma as we did in 2008 unless we make fundamental changes, unless we perhaps break apart the largest banks in this country, unless we really do move away from a system that's crippled by too-big-to-fail“too big to fail” institutions in the critical moments.
Dodd-Frank is supposed to do a big piece. But again, a big rearguard action being waged by Wall Street and by political allies on the Hill who keep, for example, trying to strip away money from the Securities and Exchange Commission, strip away money from the Commodity Futures Trading Commission so they can't succeed, blocking appointments to key positions -- Wall Street, in the first quarter of 2011, after Dodd-Frank was signed, spent about $52 million on lobbying to try to thwart the implementation of that law and its regulations.
We've just come through another year and seen bonus pools up, lots of compensation for bankers. People are bitter. They're not seeing any results on Main Street, but yet the bankers seem to be doing just fine and making huge bonuses. And those bonuses don't do anything to quell the risky behavior of the past.
... The major point is that in large part due to the banking agencies, but also due in some part to self-discipline, these bonuses now are much more closely tied to risk, and in particular clawback arrangements, whereby if it turns out that the bonuses were earned and the work turns out after a year or two or three, to have been less profitable or actually incurred losses, there can be clawbacks of the bonuses.
There is much more attention being paid to the relationship between the risk incurred and the size of the bonus. I'm sure it is far from perfect, but I think there are major efforts being made.
Why not have a compensation system that gets rid of bonuses and just ties people's income to their performance?
The irony here is that's the way it largely used to be, and Congress in its infinite wisdom decided that if you did it that way, it would be subject to a much higher tax level. That really is what led to the bonus system being a far greater component of total compensation. ...
What did the report assert?
The issue is "too big to fail." We have five extremely large institutions that are bigger now than they were before the panic in 2008 and 2009; that they have grown in size, that now have 52 percent of all of the deposits in the United States, and we have had greater concentration of banking power than before all of this started and before Dodd-Frank [Wall Street Reform and Consumer Protection Act]. So the issue is really, how do we deal with "too big to fail?"
Why are they bigger? What happened? I thought this was what Dodd-Frank was about.
First of all, even before Dodd-Frank, in reaction to the emergency of the failure of institutions, they were blended into these larger institutions, assisted by government in doing so.
Dodd-Frank's stated purpose is to end "too big to fail." It's in the preamble of the legislation, and it sets out -- in 2,000 pages and 400-and-some-odd sections -- various ways to deal with financial reform. The focus is supposed to be on making sure the taxpayer never again bails out these very large and complex institutions, and the issue is whether or not it will succeed.
Now it set up some new supervisory bodies that deal with different capital requirements for these banks, and by that what they mean is having sufficient depth of capital that if they get into trouble, they can draw on that capital to protect their depositors and to protect the taxpayer from having to go in and bail them out. …
We know the crises will reoccur. This has happened since the Mississippi Bubble and the Great Tulip Mania, or the South Sea Bubble. This is the nature of economies. …
The question is will the taxpayer be held hostage once more if we have such concentration within so few hands? Again, five banks, 52 percent of all of the deposits in this country. Is that healthy or not?
Our thesis in the Dallas Fed [Federal Reserve] is that this is not healthy. … It gives them such enormity of scale and complexity that it is very hard for regulators to penetrate that complexity. And I would argue -- having been a former banker in the real world by the way, not just at the Federal Reserve -- it makes them extremely difficult to manage because of their size and their scope. And risk management techniques, as it is known in the business, has become very formulaic and mathematical.
The old rule of banking was "know your customer." You shouldn't make a loan unless you know your customer, and you shouldn't really take their deposit unless you know their needs. There is no way on earth that these large institutions can know you or me or their corporate customers as they really should.
And there is a last thing, which is it mucks up the process of what we do at the Federal Reserve. We operate monetary policy. The banking system is an important cylinder in that engine. We provide the fuel. All of the cylinders need to work to operate efficiently. When they're struggling with assets that are in trouble -- even when we cut rates as we have done, or add to the money supply, the base, significantly, as we have by buying all of these covering securities -- they don't put them to work as efficiently because they are worried about their own problems when they get into trouble.
So there are several reasons why one has to be concerned about "too big to fail." The question is does Dodd-Frank answer and solve the problem or not?
And remember, we had hundreds of banks fail during the savings and loan crisis. We were the epicenter of that crisis, so we have been through it before. We do believe that it is one thing to say these new capital requirements, these new bodies that have been structured to deal with evaluating whether or not they are capital adequate, it's idealistically and intellectually attractive, but it may well be impracticable.
A better solution, we would argue, at lesser cost ultimately on the taxpayer, is to have these institutions downsized so that not one of them can place our system at peril, or together they cannot place our system at peril should they fail.
And so I guess that's the answer to the question, are we safer?
Well, it's not clear. We don't know yet. One thing we do know is we now have, I use this analogy: It's not really survival of the fittest; it's survival of the fattest. We have five gargantuan, obese institutions. …
Our argument is that it's not healthy to have a few obese institutions. I'd rather have a system where everybody is slim and fit and ripped and able to work their way through the system, provide the capital that's necessary for our business, for our entrepreneurs, for the women and men that run corporate America and also private business, small and large, to do what they do best: take risk, provide the credit for them, let them grow, create more jobs and create more prosperity.
How does this end? What happens next?
I don't know how this ends. I think that we live in a new, complicated financial world, and I hope that people will continue to keep tabs on that and that we will focus more on disclosure in the future.
I think one useful thing is to look back to history, and to think about the 1920s. We like to think that we live in unique times, but during the 1920s, we had a tremendous amount of financial innovation. We didn't call it derivatives, but we did things like structured finance. We used offshore special purpose entities. We used things like swaps, and options. The world was enormously complicated.
And when we had the great crash, and we came out of it, we had a series of investigations that led to the securities laws. And they essentially created two pillars of regulation. One was required disclosure to tell companies: You need to tell us all of the relevant facts. I don't care if it's some fancy financial instrument or not. You have to tell us your assets, and liabilities, and risks. That was pillar number one.
And pillar number two was a robust anti-fraud regime, where if somebody lied to you about their risks, you could sue them. You could come after them after the fact.
My great worry is that over the decades since the 1930s, that we've eroded both of those principles, that now there isn't the right kind of disclosure, that the annual statements of companies have mushroomed, and become much bigger, but that they're meaningless now because the footnotes include complicated disclosure that satisfies a regulatory requirement, but doesn't really tell us what we need to know about the company. So that first pillar of disclosure has been knocked down.
And then at the same time, over the last several decades, this notion of shareholder rights, that you could sue Citigroup, that you could go after them after the fact, and hold them responsible, maybe criminally responsible, but certainly civilly responsible, that that pillar also has been knocked over.
And one of the most important parts of a common-law legal regime, like the regime that we have, is this kind of prediction about the future, that we need to have people who are thinking about committing fraud, or not telling us the truth, worry about future consequences.
Oliver Wendell Holmes said that the law's a prediction of what a judge will do. And we don't have very many people on Wall Street who are worried about what a judge will do in the future. They're not thinking about future consequences or reputation.
So I think my hope is that we will in the future put these two pillars back up, that we'll find a way to require better disclosure, that we'll find a way to have a more robust anti-fraud regime, that we'll learn the lessons that we learned from 1929.
But we haven't learned them yet. It took four years for us to learn the lessons from 1929. Maybe it'll take longer for us to learn the lessons of 2007 and 2008. Maybe we'll need another several crises to get us there. I don't know, but I think those are the two pillars that we need, and we don't have either of them in any kind of a meaningful way right now.
And so next, what did you do?
So the next thing is I learned about working groups and how working groups are organized. And I thought to myself, I just don't have time for that. I have three kids; I have a full-time job. But I would love to join someone else's working group and go to the meetings.
And pretty soon my friend, who, as I said, walks through Zuccotti Park every day, told me that there was an alternative banking working group being set up. So I went down to Zuccotti Park and I found the e-mail address of [director of diplomatic advisory group Independent Diplomat] Carne Ross, and I e-mailed him and said, "I'd love to be part of this group." So I --
He's the guy running the group?
Yeah, he started the group. And I went to the first meeting in his office. And it was really exciting, and there were quite a few people there, maybe 30 or 40 people, and a bunch of people on the phone, and we had a really exciting feeling. You know, here we are; we want to help this system; we want to fix it or create a new one, like, "Let's do this." You know, it was really cool.
And we met again the next week. It was even more popular by then. I think there were more like 60 people. And we had some really interesting people join it. A lot of the people were from the inside, so I realized I wasn't the only person -- and my friend who told me about it was also there -- that was in finance and wanted to change the system. We had quite a few people from the SEC [Securities and Exchange Commission], from banking, from hedge funds, all over the place. It was so large, in fact, the meeting, that Carne asked us to split into two groups at the end of the second meeting.
So we split into two groups. One of them, which Carne is still with, talks about reimagining the financial system, just starting a new system. And they're trying to work on opening a bank that sort of follows kind of a mission that they've written down, and an ethic.
And the other group, which I started facilitating in that second meeting, is talking about how the current system works and possible improvements to the current system -- reform, essentially. So to that end we do things -- we are trying to help the regulators do their job, become adversaries of Wall Street. One of the projects we're working on is submitting public comments to the Volcker Rule, [a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act]. So there's a subgroup called Occupy the SEC that's part of alternative banking.
And they're putting together a long letter to the SEC explaining what their comments are on the implementation the SEC is suggesting for the statute, which is written from the Volcker Rule. And I was actually on a call with the SEC last week about that. It was really fascinating.
One of the things I realized is that the SEC is filled with people that are probably not quants. They're closer to lawyers, I think, so they're very technically correct on a lot of things. But when I asked them about, "How is this risk section going to really expose proprietary trading so that the Vol…" To back up just a second, the goal of the Volcker Rule is to separate proprietary trading from banks that are supposed to be deposit holding banks and only engage in market making, not proprietary. So they're not supposed to take risky bets if they have people's money.
And, well, how do you tell? How can you figure out whether someone's taking risky bets? And one of the ideas in the Volcker Rule is we'll keep an eye on the risk numbers. If the risk numbers vary wildly, then it's a good chance that they're doing proprietary trading.
But the risk section of the Volcker Rule is really vague, really vague. And, you know, I worked in risk, so I explained to them: "... If I'm a bank, I can game this. I can game this requirement to make my risk numbers as small as I want for various reasons." And the SEC people -- there were 11 people on the call, and I mean, they were really nice, right; this is not a criticism of them as people, but their background, I mean, they just said, "Well, we'd really love if you could come up with better wording for that section."
And it just hit me. I was like, these people, they're not experts in this. We need people at the SEC who are experts, who have gamed the system in this way, and write down the regulations so that they couldn't even game that system."
Is there some truth to the fact that Washington is soft on Wall Street?
Oh, is Washington soft on Wall Street? I think yes. I do think that in 2009, the Dodd-Frank bill did make some important changes that Wall Street resisted. And the administration stood up, and the Democratic leadership in Congress stood up. But, you know, it's going to take some real work to change a culture that developed over 30 years. I mean, first of all, for 30 years, many regulators approached banks on the basis that they were not so much regulated entities as partners together, when, in fact, the job of public oversight is to exercise public oversight.
In fact, if you listen to some of the testimony given to us during the commission, regulators told us time and time again that they were urged not to be confrontational with banks. But in fact, in the end of the day, what we want are regulators who are. So that culture changes slowly.
Secondly, there is a real mismatch here. I mean, we have regulatory agencies that are understaffed, where pay is not what it needs to be to attract and keep people. What I saw -- and I really wasn't aware of this before I took this position -- but I was struck by the number of people who would work for a regulatory agency for three or four years, and then it was three or four years up and out to Wall Street.
And look, unless we have the political will to back our regulators and then give them the pay and the resources to do their job, it's going to be a mismatch. Look, Wall Street is like a greased pig. It moves fast. It's always looking for the new opening. Hard to catch. And unless you recognize that mismatch, you're going to continue to have Wall Street with victories at the expense of the American people.
The fact is that in the wake of this crisis, there has been very little rethinking of the practices on Wall Street. Why is that? Generally we learn, we grow from the consequences of our mistakes. But Wall Street was spared the consequences of their mistakes. They didn't really pay a price for those kind of practices in any real terms.
And the irony of the bailout is it may have saved the financial system, but it may have done great damage in terms of our ability to have Wall Street rethink what was right, what was wrong, what was sustainable, what was not.
We still haven't seen results in the economy even though the banks have been given billions of dollars to loan. We still have banks that are too big to fail, that are systematically risky institutions. What progress have we made?
There has been progress in raising bank capital levels and requiring that they rely more on long-term funding, so they are more stable from that standpoint. ...
Europe hasn't done much of anything to stabilize their banks.
But we're tied to this banking system. It's all one banking system.
We are. That is true. ... I have done as much as I can -- and probably made myself unpopular with a lot of people in Europe -- to try to bring more public attention to that. Because I don't think the problem with regulatory capture is much worse in Europe in that there is just no separation between the big banks and their regulators. It is a very close relationship and one that I wish the political leadership in Europe would look more closely at, because I think that's a real problem.
But we have made progress. I think the lending standards are better. The Fed did finally move ahead, at least with the high-risk mortgages, and have lending standards across the board.
But we still have "too big to fail."
But there has been progress there too. There are tools to resolve these institutions now. There's been internal planning at the FDIC to be able to put them in a resolution should one of them get into trouble. They are now required to do plans to show how they can be disassembled. ...
... But we still have a system that looks to me [like] we could be back where we were in 2008.
That it could change on a dime? You're right. We absolutely could be.
I think the lack of tangible progress is frustrating to people. I'm not going to say what's happened is near enough. It's not near enough. But in fairness to the regulators, capital is much higher. Liquidity, the funding of banks is much more stable. I think there has been significant improvement there.
We need to be vigilant. They're backsliding already on their funding structure and funding with long-term debt, but there have been improvements there.
So let's go to the basics.
"Too big to fail." Number one, what does it mean? And why is it the danger that you define?
Well, "too big to fail" means an institution that, if it falls, essentially sets off a domino effect. And the fact is that leading into this crisis, we had a set of very large institutions that were woven together, interconnected very closely, so that if one of those major institutions fell, it ran the risk of creating ripples throughout the whole system, through its derivatives contracts, through the repo lending, which is that massive overnight lending market. So these institutions were very woven together and very concentrated in terms of these assets and power within the financial system.
Now, where we are today? In worse shape. Ten biggest banks in this country control 77 percent of the banking assets in this country today. Fewer banks that are even bigger, and I think that presents a real challenge for this country going forward.
Can banks be reformed?
Oh, yeah. Banks were reformed after the Great Depression. They absolutely were. Glass-Steagall really did it. It was a political-will issue, and it continues to be. We can absolutely reform banks. We just have to care enough about it, and we have to trust that the world won't collapse in the meantime. But, I mean, we can also set that up.
What I keep saying is, we can't set up a perfect system, but we have to compare what we can set up to what already exists. And what already exists is dysfunctional. What we have is a bunch of "too big to fail" banks that are insolvent, currently. They're zombie banks. And same thing for Europe. Europe is a mess. And the question isn't, "Are we going to create something perfect?" The question is, "Are we going to create something better than this?" It's actually pretty low bar, so I think it's definitely achievable.
What kinds of things are you doing with your alternative banking group?
So one of the things we're working on is a Move Your Money app. So the idea is to make it really easy for people to move money from their big banks to credit unions. It's a great idea to do that, but there's a pretty big obstacle for most people, that they don't know credit unions that they're eligible for.
Credit unions have something they call the field of membership where you have to work someplace or live someplace or be a part of some union to actually be a member of their credit union. So the idea of the app is you will enter information into the app and it will give you a list of credit unions -- their locations, the ATMs nearby and their services, to make it easier for people to do that.
What did you think when the MF Global fund came down?
Sadly, I wasn't surprised. I mean, one of the things I'm working on now on Occupy Wall Street is this idea that we have not made progress in fixing the system. I eventually left the risk company in disgust essentially that, you know, here I am working hard as a researcher at risk, but no one cares. It's not changing the system.
No one cares about good risk if no one's reading the risk reports. And I just -- I lost faith altogether in regulators fixing the system. I didn't see it happening. Let's say it that way. And this was at the beginning of 2011.
And then later, in 2011, I kind of had a change of heart in the sense that I didn't think I could trust the system to change itself. But I realized that these sort of techniques I learned, the statistical and modeling techniques I learned from finance, were still really powerful techniques and should be opened up; that it's treated something like a guild.
People, the quants at D. E. Shaw and at other hedge funds, they've developed a pretty incredible set of techniques to try to measure these very small signals in the market. And they hide these techniques. And I thought to myself, well, at the very least, I can expose these techniques, because you can use them to detect other things, too.
One of the ideas I had when I first started was to use them to help my friend figure out when his blood glucose level was low so he needed to take insulin. So, you know, that kind of thing, I was like, "Well, ... [the] same techniques would work in other ways." So I started my blog to sort of open up some of these techniques, but also to -- the other goal of the blog was to sort of object to and point out contradictions in the financial system and point out corruptions in the way that finance worked.
But some will argue that we missed the opportunity, the only opportunity you're going to get unless there's another disaster to change the system more dramatically.
When they say that we missed the opportunity to change the system more dramatically, I'm not sure I agree with that. We live in a dynamic system, changes every day. Whether there's a war or there's an energy crisis or there is discussions on education and immigration, there's going to be a political campaign and debates coming. Every day our industry changes based on the workings around us. You can read the front page of the newspaper. My guess is 75 percent of the stories impact our industry in some way.
So, to me, we're always in a changing history. If people think that, well, the administration missed their chance to change the industry in a more hardened fashion, I don't agree with that. I think that they looked at the industry and said, "OK, what are the real problems that this industry needs to rectify most quickly?" And I think that those were leverage, i.e., real capital, the equity; those were making sure we understand what's on our balance sheet -- so, whether it's the Level 3 assets or the derivatives -- and making sure we had the right transparency, and making sure we were servicing our clients the appropriate way.
I think that we understand that's the direction we're going, and as we continue to go that way I think our industry will be better for it. So I don't think it's an idea of we need to all of a sudden have a 180-degree turn of our industry. Our industry does a lot of great things. Our industry got in a situation where we were highly levered at a time where there was not a lot of liquidity, and we had to change. And, unfortunately for our industry, part of the change was the action of more government involvement using their capital. And once you use government capital, that's a major change for our industry. And our hope is that the regulations move quickly, we will abide by them, and then we're back in business as quickly as we can get. ...
A lot of people argue throughout this process there were opportunities to leverage power, to change the system somewhat, to make a system where the banks were not so much in control because they were so big and you had to deal with them. What were your concerns back then? What are your concerns now about that issue?
I think the main way that we wanted to deal with the long-run health of the banks and this question of "We never want to go through what we went through in the fall of 2008," the focus turned to financial regulatory reform. And that's a case where the administration was incredibly aggressive, and this very much wrote the giant report about "Here's what we're thinking about financial regulatory reform; here's our proposed plan for what should be in it"; that that was the right way to deal with the structural issues [of] too big to fail, and how do we make sure we don't have another crisis and all of that.
And I think that was incredibly important legislation. I think it was fundamentally good legislation. The decision that was made was not to say every bank has to be little, because there are certainly issues of international competitiveness. And you also want a very strong banking system, and you want it here in the United States. You don't want it to all go to the Cayman Islands or someplace where it isn't regulated.
So how do you get a financial system that works for the economy, that's safe, that doesn't ever need government bailouts again? And that's, I think, what the Dodd-Frank [Wall Street Reform and Consumer Protection Act] financial regulatory reform bill is designed to do. And the big way in which it does that is fundamentally with capital requirements. So it changes the regulatory structure. It makes sure that one person, the Federal Reserve, is watching all of those big financially important institutions, including things that hadn't been in the regulatory net, like the AIGs of the world are now in that net very firmly.
But it basically said the best way to make a financial system stable is to make them have a lot of skin in the game, so to have big capital requirements so that if there is a run, if there are losses, there's a lot of investor capital there to take the loss, that it's not immediately the government has to be in there. And I think that is the fundamental logic behind it, and I think it's good logic.
Let's move on to MF Global. What happened?
I don't know that it should be surprising to people that there are these hidden bets based on different financial variables within financial institutions. They're there right now. They're going to continue to be there. The bets at MF Global actually were disclosed. They were disclosed in a footnote.
This is not new. We've been down this road before. It's exactly like Enron disclosing its risks in footnote 16 of its 2000 financial statements. MF Global told the world that it had derivatives exposure to European sovereign governments. But people weren't able to understand the extent of its exposure from those disclosures, and it didn't appear on MF Global's balance sheet. …
What exactly was Jon Corzine embedding? I don't quite understand why European sovereign debt would be something that would save his company. How did the deal work?
So we don't know all of the details about MF Global's contracts because people haven't seen them yet. But in general, people understand that MF Global's bets were that European governments would be solvent, would be able to pay their debts. …
So what MF Global was doing is really no different from buying the debt of European governments. It's just that instead of directly buying the debt, they were entering into swaps that were based on the debt. So it's a kind of synthetic way of getting exposure to the government of Italy, the government of Spain. …
And one of the consequences to doing it in a side bet instead of buying the bonds themselves is that that bet doesn't appear on the balance sheet. It doesn't show up as an asset, or a liability. It shows up as a footnote because it's a swap. Economically, it's exactly the same as buying the actual asset. From the perspective of disclosure, it's very different.
What does it reveal though about the risks that still exist in the system?
I think MF Global illustrates that there are so many risks embedded in the system everywhere, in places that will surprise us, that we might least expect. There are trillions and trillions of dollars of swaps based on all kinds of variables that aren't very well described, that aren't regulated, that aren't disclosed.
And any time we see a big move in some financial variable, we should know that we're going to see an explosion somewhere else in the financial universe. It's like the old adage about the butterfly flapping it's wings, except that now instead of the ripple effects having some sort of environmental impact, they have a financial impact in all kinds of surprising ways. …
I think one of the most important things that has to happen if we want to protect ourselves from future financial catastrophes is that we have to have a lot better disclosure about these risks. It's fine if companies want to take on risks associated with the governments of Italy and Spain. Go ahead and do that. But tell us that you're doing it in some kind of a precise way so that we can know whether or not we want to be involved.
Unfortunately, right now, the way derivatives work, there isn't that kind of disclosure. …
What is the worst possible consequence? What’s the worst case scenario?
I just want to say, in many respects, the financial crisis never ended. It never ended. People seem to think about this financial crisis as one in which there was a run up to September, 2008, a bailout, and then the crisis passed. But, in fact, those clouds are still hanging over the global economy. And they're still filled with risk.
This crisis really never ended. There was a period of reckless lending, securities activity that extended over a number of years. And the overhang of that is still there. And it still hasn’t washed out of the system completely. Now, up until now, who has been asked to bear the brunt of that, have really been not the financial sector, but it’s been homeowners and workers. And, by the way, in the U.S. and in Europe. So you look at Europe, every effort [is] being made to protect the lenders, potentially driving countries like Greece and Spain into a depression. Here in the U.S. every effort [is] being made to protect lenders, at the same time that homeowners are drowning under a mountain of debt in this country. …
How is this possible when Obama was considered such a reform kind of guy, a guy who was a president for the people? The expectations for him were much different. Why do you think this administration got caught in basically coddling with banks and bailing out the banks, and not bailing out Main Street?
Well, they inherited the bank bailout, and it was already in place. The real question is, in the wake of the bank bailout, why hasn't there been the kind of hard pivot to remaking the financial industry? And I think that's still a very troubling question. There needs to be. And we're seeing the president articulate more and more concerns about income inequality, about the damage done by recklessness to the economy. And my hope is that it takes hold, that beyond rhetoric it becomes real policy.
Again, I don't believe reform is too late, because the fact is, the country is still hurting deeply. I mean, we've got the lowest ratio of wages to GDP since the Great Depression, 24 million people out of work; the foreclosure disaster continues each and every day. So therefore, in many respects, the political ballast for real reform still exists today, even though a lot of revisionists would want to wish away the truth of what happened in the crisis, and although Wall Street has more power than it had clearly in the wake of the meltdown of September of 2008.
Do you trust the banks to operate over-the-counter derivatives in a responsible fashion?
You don't think we need more regulation of derivatives? ...
I think we need tons of regulation of derivatives, but I think an over-the-counter market which is --
That means, to people listening to this conversation, an unregulated, non-transparent --
No, it's not. It never was unregulated.
Well, it's not easily regulated by the regulators. The regulators oversee the banks, but they don't have good visibility.
I think it's relatively straightforward to protect what's best about the over-the-counter derivative market while satisfying all the public policy objectives and the safety and soundness objectives.
For example, banks or any participant in a derivative market can be obliged to record their transaction with, for example, the DTCC [Depository Trust & Clearing Corp.], which is a good old industry consortium, central clearinghouse, regulated and regulatory entity.
So the SEC or the CFTC [U.S. Commodity Futures Trading Commission], when they want to review every trade that's been done in the OTC derivative market, can get it in one place, and they can see where all the risks are concentrated.
There's always a debate around whether big participants in this market are advantaged relative to small participants. So the reason in equity markets that every trade has got to be done on a recognized exchange and made public virtually immediately is because regulators have not wanted to disadvantage the mom-and-pa day trader, saver, IRA holder versus the big institutions that could get some inside information. And that's a very legitimate objective, particularly in equity markets.
When you get into the credit derivative market or the interest rate derivative market, the ma-and-pa [customers] don't trade in those markets. They don't have access to those markets. They shouldn't have access to those markets, and therefore do they need protection in terms of immediate transparency? No. They absolutely don't need that protection.
But we need protection against somebody like AIG taking a lot of one-way bets and then not being able to pay up when the time came that they needed to.
So we still don't have a regulator looking in on that kind of trading activity to know whether or not there's somebody sitting out there with a lot of one-way bets that gives them a lot of exposure.
First of all, I think the movement to central clearing is different than the movement toward exchange trading. So central clearing makes a lot more sense ... because it concentrates the information. And the AIG one-way bet? If all of their bets are with a clearinghouse, the clearinghouse knows exactly.
But why are we sitting here four years down the road and this could happen again?
... Probably the only thing I could imagine that would be worse than the position that we're in right now, which is that four years later we've made relatively little progress, is if policy-makers had been given the right to do whatever they wanted in the six months after it first became clear what the problem was, because the things that they would have done, we'd be regretting terrifically today.
... Obama and Geithner's plans didn't break up the megabanks, even the banks that were in real trouble like [Citibank]. Why do you think they went that direction? ...
I think there was some concern that a more radical approach to the banking system could have been taken, and that the breaking up the banks would have been the meat-ax approach as opposed to the scalpel.
In my view, that would have been a mistake. ... You don't try and regulate a financial system with a meat-ax; you do use a scalpel, you do change the regulation. You just don't say that banks are too big and break them up. ...
In fact, in large part due to Geithner but also to some key senators, we now deal with this a much more effective way, through a resolution scheme which lets a big bank fail. So we really have a situation where too big to fail, I believe, has been eliminated, or very close to it.
People say nobody knows how the resolution authority works either, especially because all banks are international at this point, and who knows if you try to do something here in the States how that would affect a percentage of the bank that's in another country. In reality, do you think we are safer?
We are definitely safer for any number of reasons: because of this resolution regime, because of living wills, because of various new standards.
But you do point out the single biggest flaw in any resolution scheme, which is the largest banks have, depending on the institution, a substantial international aspect. ... You're never going to have a single resolution scheme globally, but what you need to do is to make them compatible.
There are actually some relatively simple steps that would solve 75, 80 percent of the problem, such as international agreement as to which law, whose resolution scheme governs. That's something which a number of people have been urging and I regard as at a very highest level of priority.
The way they dealt with -- we talk a lot with Democrats as well as Republicans about the pressure that they did or did not bring on the banks. Would it have changed the dynamics of the relationship with the banks if they had taken some harsher sort of decisions and tactics?
Well, to this day, we have not held those responsible for the decisions that they made and for the position that they put this country in, our economy, we -- first of all, they need to be held responsible, and then ultimately -- you know, I'm offended by the fact that the executives in so many examples even walked away with the bonuses ultimately, that [ranking member on the House Financial Services Committee Rep.] Barney Frank [D-Mass.] and Secretary [of the Treasury Tim] Geithner, they were working behind the scenes to make sure that those executives still got the bonuses. And you tell that to hardworking Americans all across this country, you know, they have a right to be offended, to be frustrated by what they saw happen.
Those banks needed to be held accountable. And I believe that if they would have been -- if we would have handled that differently, if they would have been forced to accept the situation in which they found themselves, and the decisions that they had made that found themselves, they would have had to make -- they would have, first of all, had to make different decisions. And I also believe that maybe it would have resulted in there being a change in the banking structure so we don't have just a small number of banks that are controlling so much of the banking in America. I'm a big believer in our independent and our community banks. And one of the unfortunate realities of where we find ourselves today is that independent community banks are being -- you know, the heavy hand of the federal government now has come down on them. And these are the guys, these are the bankers that are in the communities, know the communities, have the relationships, know when it's appropriate to take a risk. And I'm very concerned about their future over the next three to five years. How do they survive? And at the same time, the big banks are continuing to -- you know, they have the relationships. They have the money to handle the new regulations or come down here and try to get a change here or there that would protect their interest.
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University’s Rutherfurd Living History Program. Learn more...