An eyewitness to the financial panic and its aftermath, Kevin Warsh offers his unique insights on “too big to fail,” causes of the crisis, reg reform, and more in an exclusive interview.
On TBTF, risk models, and more
By Bill Streeter, editor-in-chief,
We need to deal with the too-big-to-fail problem. The test of whether the proposed reform legislation is real, comprehensive, and fundamental, says Fed Governor Kevin Warsh, is if it effectively solves TBTF
Even among bankers, the governors of the Federal Reserve Board are not all that well known. Everyone knows the chairman, Ben Bernanke, of course, and former banker Betsy Duke, now a Fed Governor, is familiar to many bankers, but Daniel Tarullo, Donald Kohn, and Kevin Warsh?
To those who know of him at all, Warsh, who has been a Fed governor since February 2006, is likely thought of as the “Wall Street” governor. He did, in fact, spend seven and a half years doing M&A work for Morgan Stanley, and he is a Harvard lawyer and a Stanford-trained student of economics and public policy. Based on that minimal set of facts, some may think: “Smart, no doubt. But is he in touch with the real world?”
“Thumbnail sketches,” however, can sometimes mislead.
One fact seldom mentioned about Warsh, who turns 40 this month, is that he grew up in a small town in upstate New York near Albany, the state capital. So, despite his elite credentials, he has seen first-hand the role of small businesses and community and regional banks—“real businesses and real banks,” as he puts it. But he also knows the ways of Wall Street and of Washington, which is an important reason that Ben Bernanke wanted Warsh to come along with him from the White House when Bernanke was named Fed Chairman in early 2006. The two had worked together closely during the last year of Warsh’s four-year stint at the White House when Bernanke was chairman of the Council of Economic Advisers.
Warsh joined the Fed just as the unprecedented run of economic growth that began in the early 1980s began to waver, followed by the headlong run-up to the full-blown financial panic of 2008-9.
Causes of the panic
Although books have already been written on the panic, the views of someone so centrally placed as to what made this bust so much tougher than others are noteworthy. Warsh has stated in speeches that the panic resulted from a “multitude of flawed private and public practices.”
The common narrative, he says, is that the panic was largely caused by subprime mortgages and the failings of big financial firms. Both were important components, says Warsh, “but I wouldn’t stop the story there. The failure of Fannie Mae and Freddie Mac doesn’t get the emphasis it deserves. It was a huge shock to the system.”
“The world learned during the weekend of intervention with Fannie and Freddie that risk-free assets might not be worth what investors were led to believe. And if you don’t know the value of a risk-free asset, it’s almost impossible to know the value of a risky asset. Once that foundation was called into question to the tune of more than $5 trillion, the world was brought to a more fragile place, from which Lehman Brothers, AIG, and others pushed it over the edge.”
The distinction is important, says Warsh, because if you only pay heed to the common narrative you miss the full story and the need for broader reforms. “It’s not simply about what do you do on Sunday night with the next Lehman Brothers,” he observes.
A big part of why the bust was so severe, Warsh continues, was the complacency of market participants that asset prices broadly could only go up, and that governments around the world had so refined their macroeconomic tools that very bad things wouldn’t happen. And so risk premiums were remarkably low.
Complacency also was behind the widespread use and acceptance of credit default swaps, and other products of financial engineering.
“Financial institutions have long been in the business of product creation and innovation, sometimes to the good, sometimes to the bad,” says Warsh. “Some of the bad products got traction because of the underlying complacency.” Investors were willing to accept complex and highly structured products, he explains, because they came to believe that “tail scenarios”—the bad results on one side of the center of the bell-shaped curve—weren’t going to happen.
Regulators’ missteps—silos and models
Warsh does not exempt his own institution, or himself, from responsibility for some of what led up to the panic. The central bank, he says, is “changing fundamentally how we supervise—how we go about trying to manage risks at large institutions.”
In speeches he has used the line that “regulation is too important to be left to regulators alone.” What he means is that Fed supervisors need to be aided by the economists and financial market professionals at the Fed who up until now have largely concentrated on preparing research and statistics for Federal Open Market Committee meetings. The Fed has broken down some of its silos to bring that expertise to bear in supervision, Warsh notes.
Bankers have asked, why didn’t the Fed clamp down on the enormous counterparty risks some of the big banks were taking with firms such as AIG and Lehman?
Warsh acknowledges that the Fed, the regulatory community worldwide, and market participants alike relied too much on the models used by these financial institutions. The predominant view, he says, was that financial institutions had all the right incentives to be good policemen of their counterparties. But in the panic, says Warsh, the Fed found that the banks’ risk models and their assessments of risks were not sufficient. The most common of these risk models—VAR, or “value at risk”—“systematically underestimated the risks these banks were taking,” says Warsh. Unfortunately these models were very similar across institutions, he adds, and the regulators relied on them to an extent, as well.
“No one should have had so much confidence in these models because they weren’t tested in periods of stress. I think that’s a failing that regulators everywhere in the world need to recognize coming out of the crisis.”
TBTF—the elephant in the room
The overreliance on models is being addressed at the Fed, in Basel, and elsewhere. But Warsh believes there is an even bigger challenge than that.
“At core, I think we in the U.S., we at the Fed, need to deal fundamentally with the too-big-to-fail problem. And I think that the measure of proposed reform legislation—of whether it’s real, comprehensive, fundamental—is whether it effectively deals with too big to fail.
“We need a competitive banking system now more than ever,” he continues. “We are far better off with a system where community and regional banks aspire to be great and strong competitors for the institutions that are now at the top of the list,” instead of having the latter be so large and so interconnected that they must be around forever.
Warsh says it’s up to policymakers, including the Fed, to make sure they don’t countenance or sanction a special class of institutions that forever has funding advantages and lower capital costs over the small. He has several suggestions for how to accomplish that.
First, in order to solve too big to fail you need market discipline along with regulatory discipline. However, markets—institutional investors in particular—“can only be good policemen if they understand the enterprise.” Warsh maintains that, unlike the financial statements of community and regional banks, if you look at the public information coming out of large financial institutions, it’s very difficult to understand how they make their money, and what their capital and liquidity cushions are.
“The reason why markets opened up when the stress test results were put out,” says Warsh, was because markets “finally got some clarity.”
He believes the information that comes from stress tests should be part of quarterly financial disclosures.
Second, large financial institutions should have the burden to persuade both markets and regulators that in the event of a major shock, they have a plan in place to “unwind themselves in a way that doesn’t put taxpayer dollars at risk,” says Warsh.
Third, the government needs the ability to resolve complex financial institutions. Warsh notes that this point, while useful, isn’t sufficient in and of itself. “Market participants have seen what happened in this last cycle,” he says, “and have concluded, rightly or wrongly, that when you get to a tough weekend, the government is going to blink. What we really need is market discipline to work so that markets are helping us police on all the Sunday nights that precede the tough weekend.”
Thoughts on capital, exams, forbearance
One of the hotter buttons you can push with bankers right now is regulatory overcorrection. Warsh observes that there is a supply explanation for the downturn in bank lending and a demand explanation. The supply part gets most of the attention in Washington, right now, where the common refrain is that banks don’t want to lend. Warsh feels that is a bit unfair. “Banks have all the right incentives to put good loans out to the real economy,” he says. “The way to get lending going is mostly on the demand side. If the people that were showing up on the doors of these banks were in stronger condition then we would find that bank lending increased dramatically.”
He is also aware that the rules of the game for bank capital are in flux, which is making it more difficult to lend. “It is a fair criticism from banks that they don’t know what level of regulatory capital Washington is going to demand,” says Warsh. “The sooner we can provide that clarity, the sooner they can get back to the business of banking.”
For some banks the markets may demand higher capital than the regulators, he adds, or they may reward some banks by making it cheaper to raise capital. To Warsh, both are good results.
Although he does not oversee supervision, Warsh is familiar with bankers’ complaint that examiners have become overly aggressive, to the detriment of lending.
“We don’t want examiners to try to compensate for the past, given where we are in the cycle.” The best way to address that, he says, is for the governors to go out to the field, which they have been doing more often, now that the crisis has subsided.
“It’s one thing for them to see a directive from the board,” says Warsh. “It’s another thing for them to hear from us live and in person that if they are engaging in best practices, the board will support them.”
But as for the calls of some in the industry to allow banks to write off bad loans over a longer period of time, if that would enable the bank to survive, Warsh doesn’t agree. Confidence in the banking system has been slowly returning over the past 12 months, he says, and “I think we’d be undermining that if we endorsed a policy of forbearance.” •