Top Fed Official Says Megabanks Need To Shrink Or Crises Will Keep Occurring

Top Fed Official Says Megabanks Need To Shrink Or Crises Will Keep Occurring

The U.S. financial system is tilted in favor of the biggest banks, compromising the "very foundation of the economic system" and putting the nation at risk of continued crises, a top Federal Reserve official said Wednesday.

Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City and the current longest-serving regional Fed chief, has been an outspoken advocate on behalf of community and regional banks. Megabanks, he's long argued, benefit from the kinds of implicit and explicit government guarantees that hurt their smaller competitors, distorting the market and crippling Main Street.

"If we stray from our core principles of fairness or ignore the rule of law, we distort the playing field and inevitably cultivate a crisis," Hoenig said during a speech at a U.S. Chamber of Commerce summit in Washington. "When the markets are no longer competitive, firms become a monopoly or an oligopoly and it matters more who you know than what you know. Then, the economy loses its ability to innovate and succeed. When the market perceives an unfair advantage of some over others, the very foundation of the economic system is compromised.

"The protected will act as if they are protected, they will retain their status independent of performance, and the public will suffer.

"As a nation, we have violated the central tenants of any successful system," Hoenig said. "We have seen the formation of a powerful group of financial firms. We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences. We must correct these violations. We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law."

The seeds of this problem were sown during successful attempts to deregulate the financial system, explained Hoenig.

"Although this new era of finance was widely supported, a critical ingredient was missing on the road to expansion and innovation: a framework that would limit dangerous excesses or the development of perverse incentives," said Hoenig. "Undoubtedly, the most important omission was a way to deal with the larger firms that were using the new growth opportunities to become 'too big to fail.'

"The growth of large institutions has distorted the framework of the financial system in ways other than just TBTF. Larger and more complex institutions have become more difficult to regulate and supervise. In some cases, regulators did not have the resources or authority to keep up with a growing and innovative financial system, particularly during a period when some regulatory rules were being replaced with a risk-focused supervisory system. It has been very difficult for examiners to get large banks to tighten their operations, especially when the banks were generating tremendous profits.

"These large institutions wield considerable influence," Hoenig said. "Looking back, one sees that the crisis was inevitable, if for no other reason than that these TBTF firms would push the boundaries until there was a crisis."

But Hoenig, one of the most outspoken federal regulators on the unfair imbalance between Main Street banks and Wall Street firms, warned of the consequences more than a decade ago.

"In a 1999 speech on financial megamergers, I concluded that, 'To the extent these institutions become 'too big to fail,'' and ... uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial system," he said. "More than a decade later, the only thing I can change about this statement is that the government guarantees are no longer just implicit. Actions during the financial crisis have made this protection quite explicit."

"This framework has failed to serve us well," he said. "During the recent financial crisis, losses quickly depleted the capital of these large, over-leveraged companies. As expected, these firms were rescued using government funds from the Troubled Asset Relief Program (TARP). The result was an immediate reduction in lending to Main Street, as the financial institutions tried to rebuild their capital. Although these institutions have raised substantial amounts of new capital, much of it has been used to repay the TARP funds instead of supporting new lending."

Small banks, on the other hand, continued to lend. "In 2009, 45 percent of banks with assets under $1 billion increased their business lending," Hoenig noted.

Hoenig explained how Too Big To Fail helps the nation's biggest financial firms.

"TBTF status provides a direct cost advantage to these firms. Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity. As of year-end, the top 20 banking firms held Tier 1 common equity equal to only 5.1 percent of their assets. In contrast, other banking institutions held 6.7 percent equity.

"If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both.

"Stated another way, almost one-quarter of the assets held by these large institutions are supported by less equity capital," he said.

But giant financial firms don't just get a break when it comes to raising equity capital, the most expensive form of funding. They also get a break when issuing debt, Hoenig said.

"Furthermore, TBTF reduces the cost of the debt that these firms issue. Due to their implied government support, ratings agencies explicitly increase the debt ratings of the largest banking organizations above the intrinsic rating that would be assigned based on the bank's condition and the amount of leverage. Not only do these firms get to use more debt, but the debt is cheaper," he said.

That debt allows TBTF firms to increase their leverage to levels their smaller brethren would never be able to reach.

But Hoenig has not been impressed with Washington's progress towards fundamental financial reform.

"While calling for action myself, I have been uneasy with what I have seen so far. The attempts to address capital markets and their role as the 'Financial Foundation for Main Street' appear to place a much higher value on rhetoric than on substance and necessary reform," he said.

"We will not have a healthy financial system now or in the future without making fundamental changes that reverse the wrong-headed incentives, change behavior and reinforce the structure of our financial system. These changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones. Credit must be allocated efficiently and equitably based on prospective economic value. Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again," he said.

He advocates that regulators "reduce the incentive of our largest financial institutions to take on too much risk by allowing them to fail in an orderly manner."

"This can be accomplished, but to do so, we must have a credible resolution process that forces shareholders, responsible senior management, and creditors to incur loss if the company takes on excessive risk and becomes insolvent. To be credible, the resolution regime must be independent of the political process and based on the rule of law. Only then, will creditors force these firms to operate with lower leverage.

"The current legislation in both houses of Congress begins to address this issue. Unfortunately, both still leave considerable room for exception in the hands of the Treasury. This needs more attention," he said.

Also, TBTF firms need to be cut down in size.

"An often heard statement by many policymakers and financial market experts over the past couple years has been that if a financial firm is too big to fail, then it is too big. I couldn't agree more. Requiring that the largest financial firms be allowed to fail when they are insolvent and that they must meet at least the same equity capital levels as smaller firms will create a natural limit on the size of firms. It will also do the most for returning our financial system to one that is more efficient and equitable," Hoenig said.

Also, bank supervision must be tightened.

"[W]e must strengthen our supervision of financial firms by returning to simple, well-established rules, such as maximum leverage and loan-to-value ratios. In an age of 'markets know best' and 'growth must be accommodated,' such rules were weakened in statutes and regulations. Today, we are paying the price.

"Leverage also tends to rise during economic expansions as investors, lenders, and borrowers forget past mistakes or come to believe that "this time it's different." We saw this in the years leading up to the current crisis. The acceleration of leverage and increase in loan-to-value ratios reflected a massive miscalculation that risks were low and easily manageable."

The regulatory regime also needs to be strengthened.

"[W]e must improve the regulatory framework, which may involve reversing some of the deregulation that occurred in the 1990s. Specifically, adopting a version of the proposed Volcker rule would be healthy for long-term stability. It should (1) focus on banning financial holding companies from proprietary trading and investing in or sponsoring hedge funds, and (2) require trading and private equity investment to be housed in separately capitalized subsidiaries subject to strict leverage and concentration limitations.

"In addition, I strongly support increasing the transparency in financial markets by requiring standardized derivative transactions to be cleared through centralized counterparties, and to the extent feasible, traded on exchanges."

The reason for these reforms is to level the playing field between Main Street and Wall Street. Until that's done, nothing will change, Hoenig cautioned.

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READ his plan to deal with Too Big To Fail:

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