March 28, 2018

Peterson Institute for International Economics Remarks of Thomas Hoenig, Vice Chairman, FDIC “Finding the Right Balance in Banking Supervision”

Key Topics & Takeaways

Capital Standards: Hoenig argued throughout his remarks that simpler prudential standards, especially high capital requirements and leverage limits, if properly enforced, would protect the safety and soundness of the banking industry better than a multiplicity of complex administrative rules. Hoenig dismissed claims that today’s capital requirements are harming the economy and urged U.S. banking regulators to avoid a “race to the bottom” with international jurisdictions in reducing capital requirements.
Regulatory Reform Proposals: Hoenig discussed several specific policy recommendations as well, arguing that:

Giving a capital break to custody banks would erode financial system stability
The Volcker Rule is necessary to prevent moral hazard and protect depositors, though he conceded that the rule’s application could be simplified

Remarks

Hoenig began his remarks by discussing the failure of Continental Illinois in 1984, which he described as the beginning of “too big to fail” (TBTF) in policy history. Hoenig argued that subsequent banking crises have had fundamentally similar elements to the events that brought down Continental Illinois, which were 1) significant changes in monetary policy 2) an increase in leverage 3) management overconfidence and 4) supervisory failures. Hoenig also noted that each banking crisis has led to new banking regulations, all of which face clawback attempts in subsequent years. Hoenig alluded to Senate bill S.2155, the Economic Growth, Regulatory Relief and Consumer Protection Act, as an example of regulatory rollback. Hoenig said his remarks would outline a new approach for providing meaningful regulatory relief without undermining stability, and that this approach would focus on “proven prudential standards” which would need to be enforced rigorously and uniformly. Hoenig argued that simpler prudential standards, especially high capital requirements and leverage limits, properly enforced, could justify the elimination or simplification of many other regulations.

Hoenig described the banking industry in the U.S. as better capitalized than in previous years and compared to its international competitors. Hoenig noted that even though bank profits are at historically high levels, the industry is frustrated with numerous, costly, and complicated regulations. Hoenig argued that despite this, policymakers should not roll back capital requirements, and praised a capital ratio of 10% equity to assets as one that would protect the soundness of the financial system without raising the costs of capital for other firms.

Pivoting to specific policy options being weighed in Congress, Hoenig called exempting the capital held in deposits at the Federal Reserve from the denominator of the supplementary leverage ratio (SLR) a “serious policy mistake.” Hoenig pointed out that custody banks were undercut and needed support in the last financial crisis, and that they play a critical role as “safe havens” for financial assets. Hoenig also criticized proposals to remove initial customer margin from the SLR. For both these policies, Hoenig argued that the reductions in capital would be borne by the FDIC, and ultimately the taxpayer.

Hoenig also discussed “moral hazard” and praised aspects of the Volcker Rule that he argued protect taxpayers by limiting trading activities of depository institutions. Hoenig did concede that the rule’s application could be “greatly simplified” and said that commercial banks should be allowed to enter into swaps for customers, hedge their own exposures, and manage their day-to-day liquidity needs. Hoenig also called for CEO attestation requirements.

Turning to living wills, Hoenig said he believed the current process is cumbersome and misleading. Noting that annual preparation of wills is costly, he pointed out that much of the information in the wills could be (or already is) gathered by bank examiners and that the reporting cycle could be extended without serious issue. Hoenig argued that the largest banks are TBTF, regardless of what is in their living wills. Regarding single-point-of-entry (SPOE) resolution, Hoenig said this approach signals to creditors of operating companies and subsidiaries that they will be able to “get out of their positions” which he called a bailout. Hoenig then returned to his prior point, that having high minimum capital standards for banks will ameliorate some of the risks that the large number of current, complex rules seek to address.

Hoenig said that he believed that community and regional banks are “better positioned” for regulatory relief due to their size and activities, as well as their generally higher capital levels. Hoenig picked out several regulatory burdens these banks could be exempted from, including Basel capital requirements, liquidity rules, the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR), and Home Mortgage Disclosure Act (HMDA) reporting requirements.

Closing, Hoenig reiterated many of his points from earlier in the speech, noting that administrative rules can increase costs but fail to as effectively protect bank stability as high capital standards. Hoenig noted that consolidation in banking has proceeded quickly in the last few decades and described the largest US banks as still TBTF.

Question and Answer

The first question dealt with regulatory discretion in stress tests, and if there should be more specificity in stress test components so individual regulators cannot swing tests in “various directions.” Hoenig argued that with tangible capital around 6%, there is a huge emphasis on the types of models used in the tests. Hoenig said that the stress tests, while helpful, are not a substitute for capital held in the first place, and that stricter standards would make the system better off.

One audience member asked about the Basel December Agreement regarding the output floors of internal models. Hoenig did say he was concerned about output floors getting lowered, and he praised the “gold-plating” of Basel capital standards in the U.S. He argued that higher capital levels will create more confidence in the financial system.

Another question dealt directly with current legislative efforts to change the calculation of the supplementary leverage ratio, specifically by taking items out of the denominator. Hoenig noted that there were many concerns raised about this requirement and said that “when there are losses” the only question will be “who takes them.”

Hoenig fielded a question about the multiplicity of federal financial regulators and asked if the current regulatory landscape created problems. Hoenig said that all the agencies have necessary and important missions, and different views for rules to be products of compromise. He also discussed Brooksley Born, the former chair of the CFTC, and the alarms she raised on derivatives transactions, as evidence that having multiple visible regulators can create more robust debate on financial regulations.

One audience member asked if Hoenig had concerns about the Federal Reserve serving as lead regulatory on the Volcker Rule. Hoenig said that he “could live with that” but called for a consultant role for other agencies, particularly for the FDIC. He argued that the FDIC’s protection of deposits should grant it input into depository institution trading rules.

In response to an audience question, Hoenig discussed in detail his concerns with living wills, with the largest being that they create the “impression” that policy makers have solved TBTF. Hoenig argued that the assumptions under living wills – that there will be no contagion or that institutions will not fail simultaneously – make them unreliable. He also argued that total loss-absorbing capacity (TLAC) will create issues for struggling firms, who will need to service their debt, and noted that groups that hold TLAC debt may lobby to have it saved. Hoenig called the resolution regime today a “prescription for confusion.”

For more information on this event, please click here.