Former Fed Chairwoman Janet Yellen joined current Fed Gov. Lael Brainard and former Fed Gov. Jeremy Stein to discuss the impact of the Dodd-Frank Act on the banking and financial services industry over the past 10 years.
Among the top takeaways from the discussion was Yellen’s desire for Congress to create a new Dodd-Frank Act.
“When we do (recover), I think we should reflect on the lessons from the crisis. I personally think we need a new Dodd-Frank,” Yellen said. “We need to change the structure of FSOC (Financial Stability Oversight Council) and build up its powers to be able to deal more effectively with all of the problems that exist in the shadow banking sector. I think the structure is inherently flawed. I think the agencies need a definite financial stability mandate.”
The panel was part of the Brookings Institute event titled, “A decade of Dodd-Frank,” and was moderated by New York Times editor Deborah Solomon. The current and former Fed governors were joined by Better Markets co-founder Dennis Kelleher.
The hour-long discussion began with a look at the ongoing pandemic and the banking industry’s response so far, with all the panelists in agreement that the work put into Dodd-Frank’s financial reform laid the groundwork for a strong industry able to respond to this crisis.
“As a result of Dodd-Frank and the enhanced prudential standards that were put in place by the board, large banks actually did work hard over the last decade to build strong capital and liquidity buffers and to improve their risk management,” Brainard said. “And I actually think those reforms were vital in positioning banks to respond to COVID.”
She added that the steps recently taken by the Federal Reserve and other banking regulators to roll back rules on the Volcker Rule and swaps, along with other deregulatory steps, were misguided.
“My own view is it is a mistake to weaken core financial reform at a time when they’re clearly putting their value in this financial crisis,” she said.
Yellen recalled that the banking industry leading into the passage of Dodd-Frank was preparing to undergo changes, as regulators looked to increase capital requirements in the wake of the onset of the Great Recession.
“But I think that Dodd-Frank was extremely useful in providing the road map and clear mandate for a host of changes that were put in place to increase the safety and soundness of banks,” she said. “In addition to the capital and liquidity requirements and stress tests, I think living wills, resolution planning, the things that were in Dodd-Frank really have succeeded in making the banking system stronger.
“The Fed always had the notion that there should be tailoring of capital and liquidity requirements to the systemic footprint of particular banking organizations. And some of the changes over the last three years or so that have been put in place are appropriate in tailoring requirements in that way.”
But Yellen said there were other areas, such as new capital standards imposed by the financial reform bill of 2018, that had “gone too far.”
“Places where for example banks over $250 billion had diminished liquidity requirements, capital requirements, changes in the number of cases Lael dissented – and I think if you look through the record and her dissents you can see cases where regulatory relief went beyond what appropriate tailoring would require,” Yellen said. “I do think it makes sense when there’s a crisis for the buffers that firms have built to be run down to be released when the system is under pressure. A lot of what the Fed’s done since the onset of the crisis is exactly that.
“But I definitely agree with Lael, and my guess is the others on this panel, that allowing firms to pay dividends at a time when the system is under stress like this is really inappropriate. It’s not something I would have been supportive of.”
Stein said that although tailoring regulations to the size and scope of institutions makes sense, he was concerned with the direction of regulation today.
“There’s a tremendous amount of regulation put in place 10 years ago, so of course it makes sense to adapt and to tailor. But I really do agree with the proposition – if you pick out any one of these things, many of them seems reasonable or almost reasonable or benign, but the overall direction of travel is worrisome,” he said. “It’s not even just the rules, which are the most visible thing, but if anything we’ve really learned that personnel is policy.”
His biggest concern, though, is the changes which have come to stress tests over the past decade.
“If you’d have asked me what one of the biggest things to come out of Dodd-Frank was, I’d have said the stress test. The great virtue of doing the stress tests every year is that you build the muscle memory and the institutional resolve so that when the next time comes, and we aggressively re-capitalize the banking system, shut off dividends, we’ll have a process that basically allows us to do that,” he said. “I’m sorry to say, my hope for the stress tests as that kind of crisis war-time device has faded considerably. And that’s not in the rules, it’s not in the formal regulation, it’s how it’s implemented, how it’s thought about.
“I think it’s very worrisome the stress test has become something of a compliance exercise. The expectations of what it can do or what it should appropriately do have changed.”
Kelleher extolled the virtual of bank capital, particularly during this crisis, saying the only thing standing between a failing bank and financial chaos and contagion is a taxpayer bailout.
“If you have capital, then you’re more likely to deal with your credit losses, deal with the crisis, deal with the downturn, and not have to stick your hands in the taxpayer pockets. And we saw exactly that happen in ’08,” he said. “So the question is, who in their right mind would allow that to happen now? It’s nonsensical, and history is going to be an incredibly harsh judge here if they don’t have the good luck of the small percentage that they’re not going to require more capital quickly.”
The role, or diminished role, of the FSOC was a prevalent theme through the session. As Yellen discussed some of the areas which were in need of oversight, she came back to the theme that FSOC should have been responsible for seeing some of the troubles in those sectors coming.
“You mentioned hedge funds, well, FSOC formed a working group on hedge funds, and that group found that there were a few hedge funds that had taken on a lot of risk, a lot of leverage. The working group recommended follow up; as far as I can tell that working group was disbanded,” she said. “The pandemic showed that the risks were very real and serious. A group of funds that had taken on extreme leverage, engaging in basis trades in the Treasury and Treasury futures market, when volatility strikes increased in March, they faced margin calls, they sold off massive quantities of Treasuries. Well, it only required $2 trillion worth of Fed purchases of Treasuries to deal with that. Had the Fed not done that we probably would have had another long-term capital management type of episode.”
Other areas in which she noted problems were mutual and money-market funds.
“FSOC had identified dangers relating to open-end mutual funds that offered daily liquidity while investing in less-liquid assets that would include high-yield corporate bond funds, leveraged loan funds. They experienced large outflows in March, again, the Fed stepped in with establishment of the prime and secondary corporate credit facilities to relieve those strains,” she said. “These were things that were well-known.
“Money-market funds, another example. It was almost impossible for FSOC to get at, that was the top of FSOC’s to-do list when it was formed in 2010. It was incredibly difficult for FSOC to persuade the SEC to address systemic risk in these funds.”
Yellen said she recalled a speech by one of the SEC commissioners about money-market funds, with the commissioner saying oversight of those funds wasn’t in the agency’s mandate.
“I do think a big problem here is that FSOC was not given any powers of its own to address things like money market reform, or problems in asset management or hedge funds,” she said. “And the SEC and other regulators also didn’t have any change in their mandates that would force them to address systemic risk. And this commissioner gave his speech, saying, this simply isn’t our job.”
In the end the SEC did act, Yellen said, but the response was something she said most economists were unhappy about.
“They allowed funds, or insisted, that they impose gates and redemption fees once liquidity fell below a minimum. Most economists thought that the erection of the gates by one fund would cause outflows and contagion as people tried to avoid having that happen to them. And I think that’s exactly what happened,” she said.
The last area of concern Yellen pointed to was leveraged lending – a source of concern for financial regulators and members of Congress such as Sen. Elizabeth Warren (D-Mass.) as the amount of leveraged lending rose dramatically in the past five years.
“Leveraged lending skyrocketed in the years before the pandemic, nonfinancial corporate debt rose to levels we haven’t seen, relative to income in the United States. Many regulators, including me, expressed concern about deteriorating underwriting standards and rapid growth,” Yellen said. “There were a lot of different reasons to worry about this development. One of them I think is that firms that have overhangs of debt are usually reluctant to hire and invest. Personally, I think that’s something that would make the current downturn deeper and more longer-lasting.”
The difficulty for the former Fed chair with the problems of areas such as hedge funds, money-market funds or leveraged lending is that she believes they should have been known.
“These were things that were known, they weren’t addressed. But what was the problem? I think it’s, in part, that FSOC doesn’t really have any powers of its own to regulate activities that give rise to systemic risk,” she explained. “The agencies weren’t given explicit financial stability mandates – the Fed was sort of given such a mandate, but only to make the systemic banks safer. If there were developments like leveraged lending that pose, maybe the banks are engaging in, but that pose risk to the economy and the financial system but aren’t major concerns with respect to safety and soundness of the banks, it’s not obvious to me that the Fed has an explicit mandate to do something.
“There really are problems here in the powers created by Dodd-Frank, and we’ve seen it all blow up, except for the Fed intervention that saved us from a financial crisis.”
Brainard seconded Yellen’s thoughts.
“I absolutely think the kinds of risk that Janet talked about in the nonbank financial sector were not only predictable but well-documented and can be subject to an expansion of the regulatory perimeter,” she said.
Saying that oversight of those areas was FSOC’s job, and it didn’t do it, Stein said it would be hard to regulate the nonbanking financial market today because of the pace of innovation in those capital markets.
“I think at some point we also have to think about how do we make policy, and how do we think about a world where we’re just going to be pretty limited. We can surely do better with the banks, we can surely do better with the stress testing, but this is a world with a tremendous amount of innovation. And last time’s problems sort of morphs itself into a different version this time.”
Although that might take time, Brainard said she expected a review of financial oversight in the wake of the pandemic and resulting economic crisis.
“I do think that very quickly, once we have come through this very challenging moment, it will be time to look back and make the necessary changes to those areas where the work of financial reform is incomplete. And to be fair, there will always be new areas,” she said.