How Do You Break up a Superbank?

... June 2009, the president is going to announce a package of reforms that eventually becomes the Dodd-Frank [Wall Street Reform and Consumer Protection] Act. Coming up to that point, you believe the FDIC is going to have resolution authority.

Yes.

What happened there?

We got blindsided.

Again?

It was the story of my life.

Actually, the president asked me to come to a meeting with him and Tim and Larry to talk about the AIG bonuses. This was probably a couple months before. There was all this adverse publicity about these huge bonuses being paid out.

What was the president saying in the meeting?

He was clearly upset. He was really concerned that this had happened. ...

I think the whole country was upset about that.

Yeah, and rightfully so. So I told him at that meeting, "You need resolution authority for non-banks like AIG because with our resolution authority, we can repudiate these employment contracts. ... You can fire them. You can pay what you want to pay. You can figure out who you need to keep and who you don't, but you have no legal obligation to give them their jobs or pay them their bonuses."

The president liked that, and I think that was really the start of serious decisions about including resolution authority as part of the package of reforms that the White House would request.

Where were Geithner and Summers on that?

They were agreeing, and the early iterations of the white paper had basically an FDIC resolution mechanism in it.

It got changed. We didn't see the final draft until that meeting. We got it basically when the press got it.

In June?

Yeah, and I was flabbergasted when I saw it was not the FDIC process. It was a bailout process.

I was being put on the spot. I was asked to appear with all the regulators at a big press conference unveiling this thing. I had not seen it beforehand. I didn't agree with what was in it.

What was in it that upset you?

First of all, it didn't make the FDIC the resolution entity. Basically the Treasury Department would run it and decide who was going to be the resolver and all that. And I didn't really care for the non-banks, but for the banks and the bank holding company, it was really important for us to get that.

Because what good does it do me to have Citibank if somebody else has got the Citi holding company? It doesn't. They're all intertwined. So that was a problem.

But it was more. We had pushed for very tight prohibitions on bailouts. We didn't want any more one-off bailouts, and that language was lost. And there was a lot of flexibility to do what we thought were essentially bailouts in capital investments and all the things that we think in retrospect would have been better to do something else.

So they got unhappy with me. Tim got unhappy with me. I didn't say anything at that point, but when Barney Frank asked me to testify later about the bill, I gave him my honest views.

I thought there was too much flexibility for bailout authority, and both the House and the Senate ended up rewriting the resolution authority to make it more aligned with what we had suggested. So we ended up winning that battle.

But I was just blindsided. The president didn't know. The president thought that everybody had seen this thing and signed off on it. I talked to Rahm Emanuel afterwards. They had no idea that Treasury hadn't shown it to us until that meeting. ...

As far as you could tell, the president understood the issues?

That's right. I think he wanted to end bailouts. He wanted a bankruptcy-like resolution process that would impose accountability. I think that's what he wanted. I don't think that's what he got in the white paper that was unveiled that day.

But you'd have to get into the weeds to really pick up on how the thing had been restructured to really allow continued bailouts, which was unfortunate. It was not what the president wanted. ...

So then you have Lehman Brothers coming in the fall. Are you getting any closer to getting any real information on or analysis put forward?

No. ...

Why should you be consulted?

Because we had expertise in resolving financial institutions. And we have resolved institutions with cross-border operations. There were a couple during the crisis that were resolved.

One of the things we always do very early on is we notify the foreign regulator that we have a troubled institution, that it may have to go into an FDIC resolution, that we may have to sell it very quickly. And we find out in advance, what are your regulatory requirements to approve mergers and acquisitions? And we walk them through it and we make sure they're comfortable when we get to that point where the institution actually has to be sold.

How many people worked under you at the FDIC?

About 8,200.

You had procedures and methods in place.

We did.

You drilled these things.

Right.

You do simulations.

We did.

You're sitting there like a firehouse ready to take down a bank and do it in an orderly fashion?

Right. That's exactly what we do.

So the United States gets into a financial crisis with a couple of Wall Street banks that are teetering, with some big commercial banks that are teetering. And you're not consulted?

Not with the investment banks, no, and a very poor consultation with the commercial banks.

As the commercial banks started getting into trouble, we were given a very short timeframes. In one situation with Wachovia, ... were told on Friday by the primary regulator that they were stable. And the next day, we were told that they were going to fail if something didn't happen.

So even with commercial banks we were given very short timeframes, and I think that also limited our ability to pursue different options other than bailouts.

Why are you not consulted?

Because I don't think regulators work as well together as they should. I think a lot of it is turf. I think a lot of it was fear. I think they know our process is a harsh one, and I think there was some desire to protect these big banks and their shareholders and creditors, especially their bondholders. I think that was absolutely part of it. ...

Do you think that a bank holding company the size of Citigroup could be taken apart?

It is far more difficult than people imagine.

You're on the FDIC's resolution committee.

... One of the efforts being made by the FDIC through the whole so-called living will process -- and hopefully our committee has some input into this -- would be to make it easier to take apart a major bank if it runs into very deep trouble.

The single-biggest flaw, in my view, which was exemplified by the 2008 crisis is there was no game plan. There was no break-the-glass-in-case-of-fire little pamphlet which said here's how we're going to do it. ...

Every decision was ad hoc, under extraordinary time pressure, and the best people in the world are going to make less than optimal decisions in those cases. ...

But are we safe if we can't figure out a way to take down a big bank if we remain with this "too big to fail" problem?

... We've got to end too big to fail, and the way to deal with that is to have multiple options and to have them analyzed in advance.

Personally I think the best way would probably be to go through a recapitalization arrangement. Go to the creditors and say, "If we will turn your debt into equity, will you come in?"

It will not be done as a living bank. The bank will be failed. The company will be failed. It will be taken into resolution. The bad parts will be left behind. The good parts will be available for recapitalization.

It gives the creditors the opportunity to take their chances on the bad bank, or to turn their interest into equity in the good bank. And you would go what I would call a stack, so subordinated debt comes first, long-term debt second, and that will almost certainly be enough.

There could also be the option of bringing in private equity, new forms of capital for this institution.

You have to have the option of selling pieces, but all of this all these options need to be available and thought through ahead of time. This is a critical problem, and it's critical I think for reasons not fully understood. ...

Why is untenable to treat them like utilities, require double the kind of capital requirements that are now going to be in place?

... The difference is utilities are almost all monopolies, and utilities also are not in the risk-taking business.

Banks are in the risk-taking business; that's what banking is all about. Banks take at least three major types of risk. They take credit risk. If they're not willing to take credit risk, we don't have a well-functioning economy. They take counterparty risk, as money has to move from party to party. And they take what I would call asset liability risk, because most funders are short and most uses of capital are long, so banks have to bridge that.

There's a difference, obviously, between excessive, undue risk on one hand, and appropriate risk on the other. But one argument that I always use when this question comes up is would you want a bank never to have a bad loan? I would say if you have such a bank, that bank would not be making a lot of good loans. ...

... 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.

Were there opportunities that we missed to accomplish this, especially when the banks were on the ropes, basically, because they were on the taxpayer dollar?

Well, it's easy to be armchair quarterbacks after the fact. But when you are in the midst of battle, when you're in the midst of a crisis, I think it's very hard to structure an entire system. Instead, you are putting out the fires.

But what we now have to do is rebuild the ecosystem of banking and make sure that we do have the firebreaks along the way. And rather than just fight those fires one after another as they come up, make sure they won't spread and burn down the entire economy.

But when you look back, the value of history, too, is to look back and say there were these moments.

I think the moment is now, because we are, as I said earlier, the system is liquid. Before, liquidity had disappeared. That's not the time to act. Secondly, the economy is strengthening. So we may not be quite strong enough. We argue at the Dallas Fed that one of the reasons we are not strong enough is because we're sort of being held to the sludge that's around the pistons that is the "too big to fail" institutions. But I'd rather do it now under conditions where liquidity is abundant. And I think now is the time to act. …

We've talked to executives from some of these banks, from Wells Fargo and some of these other "too big to fail" institutions. They say they were never really in trouble during the crisis, that they could have survived without government help. … Were they actually in trouble during the crisis? Were the largest five institutions, would they have survived without help from the government?

Well, the question is about would the five or more have survived without help from the government. There were different degrees of health, and I'll let them speak for themselves. I hear them saying that some felt compelled by virtue of the pressure put on them by the secretary of the Treasury, and by the New York Fed to participate. And the reason for that was to eliminate the stigma that might be associated. And indeed, some of these banks are better operated, have less risk than others. But in the end, they all decided to participate, that's a fact. …

So how do you do that? … Let's say we pass through the moment where we're really terrified and the crisis is over, and we've saved the banks. Then what should we have done? What could we do? How do we skinny them down?

A very tough question to answer. There are probably several approaches. First, is there is a time to do this? Certainly I would submit, do it at a time … when you're flush with liquidity, which we are now.

And when did we get flush? Have we been flush a year?

We've got them flush for well over a year. And by the way, it's in large part because of the actions we've taken at the Federal Reserve. We bought a significant amount of government treasuries. When we buy a bond, we pay somebody for it. And so we have some $680 billion in mortgage-backed securities, and then we have not quite $2 trillion in U.S. Treasurys, and we've been moving further out the yield curve. As you know, that means we've been buying things at longer maturities.

When we buy things, we pay for them; that just puts money out. When we sell them, we'll take money back in. This is the way to control what's called the "zero bound," when we cut rates to zero. And so through cutting rates to zero, through being active in purchasing securities, and also because people have restructured their balance sheets -- they have been tight with money, they have not been out there employing and expanding but have been saving whatever cash flow they have -- a combination of all of those factors has made for a very liquid system. …

The second thing would be, of course, if we had a more robust economy. And the economy is gaining some steam. As you know, I argue that what's preventing the economy from gaining steam is not only the fact that we have these "too big to fails" that are clogging up the system, but very, very importantly, we have a dysfunctional fiscal policy and a Congress that just can't get their act together. And until they make clear what the tax policy is going to be, what their spending policy is going to be, what kind of regulation is going to affect business, businesses are going to hedge against expansion and wait to see what happens.

But as we go through the process of recovery, I think that's the time to let the marketplace -- there are whole industries that are built, very clever people that are good at taking companies apart, finding value to all of the pieces, building new structures out of that. And frankly, I don't care how large or successful or how rich they become in the process. What I am duty bound as a central bank official to protect is the American taxpayer, and the sanctity of those that deposit money in institutions.

And so if these parts are peeled off -- and again there are whole industries that are devoted to being experts in this, that take away the risk of the taxpayer being put at a point of exposure once again -- I would be happy in the process. And I don't think you have to have government dictates to tell you to do that. The private sector could work this out very, very efficiently.

And so you are really saying that in order to bring them down, the market will take care of it eventually. This is not a role of the government. This is not something that Dodd-Frank or anything else is going to have anything really to do with.

I think Dodd-Frank is going to perhaps assist the process. We'll see. They have to have living wills, for example, basically which is you write out how to dissolve this company without dinging the taxpayer. It probably reads easier than it is to do.

We're going to continue at the Federal Reserve … to insist that they are able to survive stress tests and also meet capital standards which are internationalized. …

... Let's talk about Dodd-Frank [Wall Street Reform and Consumer Protection Act]. ... Geithner and Summers are the ones that wrote the original legislation, as opposed to delegating it to Congress, like they did with the stimulus and healthcare. Why is that? And is this bill that was put forward aggressive enough? ...

It's very clear that the Dodd-Frank bill, which was stronger in some ways than the administration's original proposal, does not go far enough, and I think there's almost unanimity among the economics profession on this.

Two issues: One is the "too big to fail" banks. They're still too big to fail. They're even bigger, because part of the process of dealing with the crisis was to consolidate the banks. ...

The second issue is the non-transparent derivatives. [Sen.] Blanche Lincoln's [D-Ark.] committee regulates derivatives, reported out a bill that said that no FDIC-insured institution should be engaged in writing these derivatives. Makes absolute sense. Why should taxpayers be involved in this gambling instrument?

We're not clear whether derivatives ought to be viewed as insurance or gambling. If it's insurance, it should be regulated by state regulators; if it's gambling, it should be regulated by gambling authorities. But neither are banking.

Geithner and Bernanke opposed. Very interesting. Two of the regional presidents of the Fed said this was absolutely essential, wrote a very strong letter.

Bernanke and Geithner won, or to put it more accurately, the American people lost and the New York banks, the derivative-writing banks won, and we are now in a situation where we don't know our exposure to a lot of the risks. ...

They say there's now an ability to, in an organized fashion, dissemble a "too big to fail" bank, that's in the bill. ...

There was what was called resolution authority and living wills, plans for an orderly dissolution.

Two problems with that: One is that the living will describes what you would do in normal times, but in crises, your plan to sell off this asset or that asset or dissolve may not work because there's no buyer on the other side. The markets can actually just disappear. So what does it mean to have a living will when the markets can go into paralysis exactly when you need them?

Even more important was we didn't use the full legal authority before the crisis. The Fed had authority to regulate mortgages, didn't use that authority. The banks scared the American people. They put a gun at their head and said if you don't give us money, we're going to collapse and you'll be sorry, and America blinked. The banks, I think, would do it again.

So even though there's authority to resolve and almost a commitment to resolve, none of us are really sure that it will actually happen if the banks are really too big to fail. ...

Would Congress and would America allow them to bail out the banks again? Is there the political will in this country to allow them to do that again?

... I think there probably isn't. ...

One of the people we talked to was [Financial Crisis Inquiry Commission Chair] Phil Angelides, who did the report that looked into it all. The majority view of the commission was that it failed in some important ways. ... That there was not a real rethinking of the financial markets, that we missed an opportunity. There were a lot of things that were missing. ...

Oh, sure. Look, the regulatory agencies still have an awful lot of work to do to work out the details of what Congress passed. Congress said derivatives that can be cleared have to be cleared; derivatives that can trade on an exchange have to trade on an exchange. CFTC [U.S. Commodity Futures Trading Commission], you go work out the details.

Those details ... are incredibly complicated, and they have a lot of work to do to make sure that those are done right. But it was necessary for Congress to pass the law that gave them the authority to do it.

Same with resolution authority. I think resolution authority is remarkably complicated. I'm not in these discussions anymore, but my sense is they still have an awful lot of work to do to make sure that it's a workable authority.

... Maybe one of the biggest failures is that "too big to fail" banks have not been dealt with. That can was kicked down the alley, and the result is that we are still in a situation where, if we have another crisis, the government is going to be again needing to bail out these companies.

I think that's an easy thing to say. I don't think any of us could know that right now. No one knows what future crises are going to look like.

The "too big to fail" problem is complicated, it's challenging, and defining what's too big to fail is equally challenging. ... But saying it's hard doesn't mean it doesn't have to be dealt with. My sense is there's an awful lot in Dodd-Frank that did deal with this. ...