The U.S. should bust up its megabanks and impose strict laws curbing
the size and complexity of financial institutions, a top Federal Reserve
official told the Huffington Post.
In a 45-minute interview this week, Federal Reserve Bank
of Kansas City President Thomas M. Hoenig, who's emerged as one of
the few influential voices calling for a fundamental redesign of a
broken U.S. financial system:
- Lambasted the tilted playing field that benefits
Wall Street banks over Main Street banks;
- Called the idea that the U.S. needs megabanks to compete
globally a "fantasy";
- Said Congress should mandate simple, easily understood and
enforceable rules -- rather than guidelines -- so regulators can
restrain financial firms and rein in the financial system;
- Prodded the Senate to get tougher on permanently ending Too
Big To Fail by enacting laws that would take away much of the discretion
currently held by policymakers (who bailed out financial firms when
confronted with these decisions in late 2008);
- And criticized the Federal Reserve's ongoing
policy to keep the main interest rate near zero because it "guarantee[s]
a spread to Wall Street", enabling unearned profits and "encourag[ing]
Hoenig's criticisms echo those made by reformers pushing to remake a
financial system that melted down in 2008 after years of excessive
risk-taking and loose regulation finally took its toll, causing the
worst economic collapse since the Great Depression and costing the
nation more than 8 million jobs.
But Hoenig isn't just any reformer -- he's the
longest-serving Fed policy maker; a voting member of the Fed's main policy-making body,
the Federal Open Market Committee; and his credentials as a deficit-
and inflation hawk are unparalleled.
In February, Simon Johnson, former chief economist of the International
Monetary Fund, professor at the MIT Sloan School of Management and
contributing editor to the Huffington Post, wrote a post on his blog titled "Tom Hoenig for
Treasury," putting him forward as one of just a few viable candidates to
succeed current Treasury Secretary Timothy Geithner should he step
And unlike top officials in the Obama administration, Congress and
his colleagues at the Federal Reserve, Hoenig is calling for perhaps the
most significant changes in the U.S. financial system: breaking up the
big banks and imploring Congress to establish tough rules so that bank
regulators will never again be put in a position to bail out troubled
Breaking Up Megabanks
For example, one of the effects of Too Big To Fail, Hoenig said, "has
been that the concentration of financial resources in this country has
nearly doubled over the last 15 to 20 years. That's what we have to
The banks owned by the four largest financial firms in the U.S. --
Bank of America, JPMorgan Chase, Citigroup and Wells Fargo --
collectively account for about 43 percent of all assets in the U.S.
banking system, according to a HuffPost analysis of Federal Deposit
Insurance Corporation data.
The top 12 banks in the U.S. control half the country's deposits. By
comparison, it took 25 banks to accomplish this feat in 2003 and 42
banks in 1998, according to a Jan. 4 research note by Jason M. Goldberg
of Barclays Capital.
Those four megabanks collectively hold about $7.4 trillion in assets,
according to the most recent regulatory filings with the Federal
Reserve. That's equal to about 52 percent of the nation's estimated
total output last year.
"The fact that they needed to be supported by TARP tells me that
they're too big," Hoenig said. "I think that that's a very clear signal
that they're too big. The fact that they had to be bailed out under
those circumstances suggests they are too big, and that needs to end."
In response, he says policymakers should simply break up the
megabanks and split them off into their component parts.
"I think they should be broken up," Hoenig said. "I think there's no
reason why as we've done in other instances of [sic] finding the right
mechanism to break them into their components.
"Underwriting [securities], hedge fund activities, trading for their
own accounts -- that should be in a separate institution," Hoenig said,
referencing the proposals that have become popularly known as the
Volcker Rules, named after their original proponent, former Fed chairman
Paul Volcker. "And in doing so, I think you'll make the financial
system itself more stable. I think you will make it more competitive,
and I think you will have long-run benefits over our current system,
[which] mixes it and therefore leads to bailouts when crises occur."
By first breaking up the firms, the market will then decide what's an
appropriate maximum size, Hoenig said.
"...We've provided this support and allowed Too Big To Fail and that
subsidy, so that they've become larger than I think they otherwise
would," Hoenig said. "I think by breaking them up, the market itself
would begin to help tell you what the right size was over time."
In a March 24 speech in Washington, Hoenig said that
the TBTF subsidy "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," he said.
That allows them to get even bigger, leaving their smaller
competitors behind who need to worry about raising equity before they
can fund more loans.
"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," he said.
Bringing Back Glass-Steagall
The U.S. should revive parts of Glass-Steagall, the Depression-era law
that long prohibited banks from underwriting securities and engaging in
other Wall Street-like activities, to break up megabanks, Hoenig told
HuffPost. The law was repealed during the Clinton administration. The
Obama administration has shown no desire to bring it back.
"At the moment I would be inclined to break them up along those lines
of activities, and then let the market define what the right size is,
and it will be, I suspect, smaller, much smaller, given our recent
experience," he said.
"When Glass-Steagall was set aside and Gramm-Leach-Bliley [the law
that repealed it] was introduced, I gave a speech which raised the
concern that we would encounter mega-institutions," Hoenig said. "People
would say... 'They're not too big to fail', but when the crisis came
they would be too big to fail, and that's what we've gotten.
'So I am partially in favor of re-establishing elements of
Glass-Steagall that separates the very important commercial banking that
is so critical to our economy and our payment system from what I call
high-risk activities in investment banks and hedge funds.
"I have nothing, nothing at all against high-risk activities in hedge
funds and so forth, but they should not be part of our commercial
banking payment system."
On Whether The U.S. Needs Megabanks
Asked if he believes in a popular notion shared by top policymakers,
legislators, and those on Wall Street -- that the U.S. needs megabanks
to compete globally, Hoenig said:
"That is a fantasy -- I don't know how else to describe it. Our
strengths will be from having a strong industrial economy. We will have
financial institutions that are large enough to give us influence in the
markets but not so large that they're too big to fail.
"The outcome of that is that strong banks [and] strong economies
bring capital to themselves, and they are by themselves competitive.
"The United States became a financial center not because we had large
institutions but because we had a strong industrial economy with a good
working financial system across the United States -- not just
highly-concentrated in one market area," he said in an apparent
reference to Wall Street.
JPMorgan Chase Chairman and Chief Executive Officer Jamie Dimon defended megabanks in his annual letter to
shareholders this week, arguing for the economic benefits of outsized
On The Fed Guaranteeing Wall Street's Profits
Popularly known as the lone dissenter on the Fed's policy-making panel
who twice this year has voted against the Fed's decision to keep the
main interest rate "exceptionally low" for "an extended period,"
Hoenig said part of the problem with near-zero rates is that it
guarantees Wall Street profits.
"When you guarantee a zero rate, you guarantee a spread to Wall
Street or to others, and you encourage speculation, and that's what you
want to avoid," he said. "If we've learned anything from the last
episode, we want to avoid encouraging speculative activity and zero
rates, I'm afraid, have the effect of encouraging it."
On Wall Street, "industry profits could exceed an unprecedented $55
billion in 2009, nearly three times greater than the previous all-time
record," according to a Feb. 23 report by New York State Comptroller Thomas
The national unemployment rate, meanwhile, is nearly 10 percent.
Hoenig calls that "unfair."
Low interest rates enable banks to make a killing because they borrow
at near zero yet lend or invest at much higher rates. They also can
trade in securities. For banks facing debilitating losses on consumer
lending products like credit cards, auto loans and home mortgages --
something that happens in every recession -- low interest rates are an
easy way to make money and protect against losses.
But while Hoenig acknowledges that low rates were necessary in the
immediate aftermath of the crisis, he said they should now be steadily
The federal funds rate -- the rate that banks charge each other on
overnight loans -- was 0.13 percent at the end of February, according to Federal Reserve data. It should be
raised to the 2-2.5 percent range "over the next several quarters"
depending on economic conditions, Hoenig told HuffPost.
"I don't think we have any business guaranteeing Wall Street
spreads," Hoenig said. "We need to recognize that and address it by
removing these guaranteed extremely low rates. I think it's extremely
important that we do that, and not create the conditions for speculative
activity and a new crisis down the road."
"I don't think we have any business guaranteeing Wall Street when
we're unable to guarantee Main Street," he added.
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Dodd's Bill And Too Big To Fail
Senate Banking Committee Chairman Christopher Dodd (D-Conn.) recently pushed through his committee the chamber's
main bill to reform the financial system. Hoenig said it's a "good
start," yet he worries that it perpetuates Too Big To Fail and
solidifies the balance of power currently tilted in favor of Wall Street
versus Main Street.
The bill takes away the Fed's supervisory authority over small banks
and instead gives the central bank authority over all institutions with
more than $50 billion in assets. That shift would just increase the size
of megabanks, Hoenig worries.
"I worry that the Dodd bill, as it's now proposed, will reinforce the
consolidation by removing the Federal Reserve from its supervisory role
for community banks across the country. The effect of that is to make
the central bank of the United States... the central bank of Wall
Street, and that's a very serious error.
"I think it's absolutely critical we have this balance between Wall
Street and Main Street. We're a great nation... because we have checks
and balances and I think it's very critical we have all sorts of banks
and that the Federal Reserve and these regional banks have a role to
play as a counterbalance, if you will, to Wall Street. I feel very
strongly about that."
The biggest firm under the Kansas City Fed's direct supervision is
BOK Financial Corporation. With $23.5 billion in assets, the firm is the
43rd-largest bank holding company in the nation, according to Federal Reserve data.
As for Dodd's treatment of Too Big To Fail, Hoenig said the bill puts
too much power in the hands of regulators.
"What I worry about [is] if you have a large institution, and it got
into very serious trouble and you only have a weekend to take care of
it, the procedures under the Dodd bill would make that very difficult,"
"Let's say you were coming into Monday morning and you didn't have
the ability to get to the judges in time to get this thing approved, and
you had to get to another day. What you would tend to do is lend to
that institution -- if it were not a commercial bank, you would even use
the [Fed's] so-called 13-3 authority... and you would lend to it," he
said in a reference to the legal authority that the Fed claimed gave it
the power to lend taxpayer money to AIG. "So you would still have it as
an operating bank, you would not have taken control of it, not put it in
receivership yet, and yet you would be bailing it out. That's what we
have to avoid.
"There's still this desire to leave discretion in the hands of the
Secretary of the Treasury, and while I understand that desire -- because
you never know what the circumstance is going to be -- the problem is
in those circumstances you always take the path of least resistance
because of the nature of the crisis.
"You don't want to be the person responsible for the meltdown, so you
take the exception and you move it through.
"But if you had a good firm rule of law, and the markets knew...
there were no exceptions... you would be in the long run much better
off. It does affect behavior," he said.
At the end of 2008, the government -- and U.S. taxpayers -- stood
behind about three-fifths of all financial firm liabilities, according to economists at the Federal Reserve Bank of
Richmond. The explicit and implicit federal guarantees protect
lenders from losses due to a borrower's default.
Until that's fixed, megabanks will continue to benefit from the
federal safety net.
"And community banks, of course, because they're not too big to fail,
are much more sensitive to maintaining their capital levels, and that's
the value of the market: Because they know that there's no one [who is]
going to stand behind them. That's how markets work. That's how
capitalism works well, because it allows for success and it allows for
"When you don't allow for failure, you create inefficiencies,
distortions, and bad outcomes."
Clear Rules Needed To Rein In Wall Street
Regarding the amount of leverage in the financial system -- the ratio of
liabilities to equity -- which skyrocketed during the go-go years,
leading to an eventual crisis, Hoenig said Congress "should require that
we come up with simple leverage ratio that can be... understood and
"The simplest is: What is your total assets and what is your
equity capital, and what's that ratio, and what's the maximum we should
allow it to be? Should it be 12 or 14 or in some instances 15? We can
have that debate either through the legislative process or though the
regulatory process with comments and then come to a rule that is binding
and cannot be exempted under any circumstance.
"I think that would do a lot to become counter-cyclical. In other words,
when the boom time comes, people and banks tend to say: 'Let's lend
more against our capital base, and things are good, we always get paid
back.' And it becomes pro-cyclical. [But] when you have a clear rule
that says if you want to lend more once you're at this maximum, you have
to raise proportionally more capital, then it comes counter-cyclical
and much healthier for the economy.
"The max should be -- and this is based on my experience, I haven't
done the studies, so I have to put that caveat in there -- if a bank has
a 12-to-1 leverage ratio, total assets to equity, that's a fairly good
operating level if you look across the country. So I would be inclined
to put 15-to-1 as the max, so that in a growth environment you could get
to 15, but not beyond that. That becomes a constraint, and I think it
would work over time. You would get some blame during the boom that
you're inhibiting growth, but that means you'd have to bring capital to
the table and that would be strong.
"So I would start with 15. Let the debate go on -- if that's not the
right number -- but that's where I would start."
Told that he may upset Wall Street with such a strict ceiling, Hoenig
replied: "That's a good sign it must be a pretty good number."
Prior to the crisis, investment banking firms leveraged up as high as
30 to 1. Using Hoenig's method, Goldman Sachs, the most profitable firm
on Wall Street, currently has a leverage ratio of 12 to 1, according to
its most recent annual filing with the Securities and
Exchange Commission. Citigroup, which was bailed out with $45 billion in
taxpayer money and had its losses guaranteed by the U.S. government on a
$301 billion pool of assets, has a 11.98-to-1 ratio, according to regulatory filings.
Geithner, though, doesn't believe Congress should get involved. In a Jan. 11 letter to Rep. Keith Ellison (D-Minn.),
the Treasury Secretary wrote: "We do not believe that codifying a
specific numerical leverage requirement in statute would be
Hoenig, told that Volcker said that Congress should act because regulators
waffle, said in response: "I would feel more comfortable with Mr.
Volcker's approach because then you have it under the rule of law, which
is my preference in almost all cases." Hoenig also wants strict limits
on totals loans relative to assets and capital levels.
Dodd's bill, though, doesn't call for any such specificity; instead
it passes the responsibility on to regulators. Federal Reserve Chairman
Ben Bernanke said in a January speech that regulators were to blame for
the housing bubble and subsequent financial crisis.
Wall Street needs clear rules. "Guidelines are not as effective
because they are guidelines. They are much more difficult to enforce,"
"The problem with guidelines and having it vary over time is that it
is an opportunity to engage in debate, rather than, 'Here is the rule,
let's have it, you must comply with it.' It becomes much stronger and
much more counter-cyclical," he said.
"You can't ask an examiner to enforce something that is a guideline
because they don't have the ability to do that. They don't have the
authority to do that. All they can do is recommend and criticize, but
when you give them a rule to enforce, then they will."
Instead, "we need to give them clear sets of rules that can be
understood and enforced," he added.
Part of the problem with the current regulatory regime is how banks
account for their assets and capital. Rather than an easily-understood
approach, the U.S. and other industrial countries base their rules on
the Basel Accords,
an international agreement that sets standards for banks.
For example, under Basel banks can lower the amount of capital
they're required to keep to guard against losses by using derivatives
and other exotic financial instruments. But when those financial
instruments blow up, like many did during the crisis, banks become
woefully short of capital. And when losses start to pile up, there's
nothing to protect the banks against failure. That's part of the reason
why taxpayers bailed out banks and other financial firms.
"I'm not in favor of the Basel rules," Hoenig said. "I've never been
in favor of them. They're too complicated, and therefore they can be
circumvented easily, and therefore I think we need simple,
understandable, enforceable rules."
"I think we need to simplify it, not complicate it," he said.
A Canadian Model For The U.S.?
One popular idea in Washington these days is that the U.S. should
emulate the Canadian banking system, where a handful of firms dominate
the financial industry but in return are subject to much stricter
regulation and supervision. Canada escaped the worst of the financial
Hoenig said that's a horrible idea.
"Under no circumstances should [the U.S.] emulate Canada," he said. I
don't think it is as competitive, I don't think it allows for the kind
of innovation we need, and I don't think it serves the local markets as
well as community banks serve the local markets across this country.
"The United States is the strongest, most successful economy
in the world because of its innovation, because of its banking system,
and I think we need to remember that. And as much as I admire Canada, I
don't think they have been as successful as the United States, and I
don't think that's the model.
"I think we have a good model, and what we ought to do is work to
maintain that model. And that means: hold these largest institutions to
firm leverage standards, [a] firm loan-to-value [ratio], make sure
commercial banking is commercial banking.
"Then we can compete, and then we can serve all of our constituents
-- large and small -- and the outcomes are much more beneficial. That I
feel very strongly about."