– Sheila Bair (former FDIC Chairwoman)

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In November 2009, I published the following op-ed in the South Florida Sun-Sentinel:

What do you like about Citigroup?

It’s been almost two years since I had to answer that question, and I still can’t believe I got it wrong.

It was February 2008, and at the University of Pennsylvania, that meant interviews. Penn’s Wharton School of Business has the top undergraduate program in the world, which makes it the number one destination for Wall Street firms looking for eager young summer interns.

At that point, the banks had already announced massive losses, but Bear Stearns and Lehman Brothers still existed, “moral hazard” seemed like it belonged in Catechism instead of Congress, and TARP was what they used to cover Turner Field when it rained. So when the interviewers wanted to know what I liked about Citigroup, I said it was big and global and interconnected. It had more resources than anybody else and therefore more opportunities. It would give me the chance to travel and work with clients that shaped industries.

They nodded their heads. Yes, but did I know that they considered themselves entrepreneurial? Did I realize that they were looking for risk-takers?

I remember thinking their attitude was unusual. Now I think it was dangerous.

Citigroup bankers should not be entrepreneurial risk-takers, at least not without someone watching over their shoulder. They are privileged to be so big and global and interconnected, and they should use those resources wisely. Unfortunately, over the past decade their size and interconnectedness seems to have caused much of their carefree attitude, when it should have given them pause.

In 1999, Congress gave its blessing to the merger that created the modern behemoth of Citigroup. Since 1933, the Glass-Steagall Act had kept commercial banking (a la George Bailey) and investment banking (a la Gordon Gecko) separate. After its repeal, investment banks like Bear and Lehman had to compete against the superior war chests of Citigroup. The only way to keep up was to dive further into dangerous bets for quick profits.

Meanwhile, reports from inside Citigroup indicate it had become too large for its internal risk managers to police its own trades. My interlocutors were understating matters. Citigroup wasn’t just entrepreneurial. It was out of control.

This leaves Congress with two challenges: how to prevent banks from getting too big and what to do if those banks fail.

Treasury Secretary Timothy Geithner argues that the Federal Reserve should perform both duties. FDIC Chairwoman Sheila Bair is fighting for her agency to retain the latter authority. Senate Banking Committee Chairman Chris Dodd supports Bair but wants to create a new agency to regulate “systemic risk” in advance.

No one wants to admit that the government had the authority to raise capital requirements and unwind failing banks but, except for the successful case of Washington Mutual under the oversight of Bair’s FDIC, it failed to do so. Meanwhile, they all ignore the law that served us so well for over six decades. Reinstating the Glass-Steagall Act is the only solution that can return banks to a less dangerous size and keep them that way.

(The part about the government having the authority to unwind failing banks is more complicated than I had room to explain. For more details, see this speech by Thomas Hoenig. This complication doesn’t contradict the larger point about Glass-Steagall.)

How well do the new regulations address this issue? Take it away, Mark Thoma:

This bill is not going to end the problem of too big to fail. If the banking system is threatened, then one way or the other it will be bailed out. The consequences to the economy would be too large to do otherwise. Thus, banks that are big enough to pose a systemic risk enjoy an advantage over other banks. Banks that pose a systemic risk will be assumed to be safer than other banks due to the implicit government guarantee. This gives large banks an advantage over smaller banks that do not, on their own, threaten the financial system if they fail.

In addition, the implicit guarantee gives large banks the incentive to take on too much risk, and this is a reason to regulate the amount of risk they can take (and I don’t think the proposed legislation does enough in this regard).

In January 2010, I followed up with this op-ed in the Sun-Sentinel:

“Too big to fail” will go down in the history books as the Siren song of the Great Financial Crisis.

According to Greek mythology, the Sirens were three seductive women whose singing would drive sailors mad, causing them to crash their ships. Homer’s Odysseus famously ordered his crew to bind him to the mast so he could hear the beautiful song as they passed the Sirens’ island. His sailors plugged their ears with beeswax in order to steer without falling under the musical spell.

If only Sheila Bair had read the Odyssey.

When I wrote about the failure of big banks in December, I referred to the FDIC Chairwoman’s actions in September 2008 as “the successful case of Washington Mutual.” In light of recent evidence, I retract that adjective.

At that point, the seizure of WaMu and sale of its assets to JPMorgan Chase had a mixed reputation. Several readers reminded me that the FDIC faced a lawsuit for wiping out all the shareholders’ investments and intensifying the panic in the interbank market. I agreed—with the caveat that only a handful of insiders knew whether the bank had enough cash to survive successive runs. Without that information, I said, we have to trust that the regulators pulled the plug just in the nick of time.

What a difference a day makes. Twenty-four hours after my column hit this page, the Puget Sound Business Journal released the conclusion of its behind-the-scenes investigation: The FDIC blew it.

Since we’re using the mythology analogy today, it helps to think of the FDIC as the Anubis of the banking world. When a person died, the ancient Egyptians believed that this god weighed the deceased heart. If it weighed too much, Anubis fed the heart to a monster. Otherwise, welcome to the afterlife.

When the FDIC judges banks on the brink of death, the “heart” is net liquidity, a measure of how much cash they have readily available. Too low, and you will probably be devoured by a monster—in this case, JPMorgan Chase. The danger threshold is 5% of assets. WaMu had 9.4%.

Another important indicator is the tier-one leverage ratio, which gives a better idea of whether the bank owns more than it owes. The danger level: 2%. The all-clear sign: 5.75%. WaMu: 7.66%.

Meanwhile, banks that probably were insolvent lived to fight another day, courtesy of the Wall Street Welfare Office on Pennsylvania Avenue. Somehow, our government managed to punish the innocent and save the guilty in one bizarre week. I thought politics was backwards before the crisis, but with “too big to fail,” they outdid themselves.

In all the talk of regulating the bankers, we’re neglecting the lesson of WaMu: We also need to regulate the regulators.

Congress needs to take a cue from Homer and fill the regulators’ ears with beeswax. They need to set strict liquidity thresholds for the FDIC to follow, lest they succumb to the urge to pronounce the time of death before a bank has breathed its last.

(This issue is part of a larger problem that Paul Krugman explains with another classical analogy.)

How well do the new regulations address this issue? Let’s turn our attention to the former comptroller of the currency:

The simple truth is that we have nothing but a sketch of the regulatory new normal.

The bill creates the outlines for America’s financial system of the 21st century, but it leaves the regulatory agencies with the job of filling in the blanks.

It is in the trenches of these agencies where the real skirmishes will begin as more than 150 rules are proposed and subject to public comment and sparring. Here is where it will be determined just how far-reaching or not the legislation will be, and here will be determined the winners and losers.

There you have it. The major regulatory gaps remain relatively untouched. That’s not to say the new law makes no improvements on the old system. It only means that we shouldn’t succumb to the temptation to end the debate here. The long, hard work of making our economy safe, just, and sustainable must go on.

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Back in 2001, the Fed caught hell for allowing the dot-com bubble to escalate so steeply. For the following two years, it found itself between inflation hawks who worried about historic low interest rates and deflation hawks who thought high unemployment was a harbinger of Japan-style depression.

After giving the Fed a breather for a few years, observers jumped on them in 2007 for ignoring warnings about predatory lending, in March 2008 for fostering moral hazard with the Bear Stearns deal, in September 2008 for crashing the economy by letting Lehman Brothers fail, and in the rest of 2008 for lowering interest rates too slowly before and during the crisis. In 2009, they were sandwiched between economists who wanted more aggressive, “unconventional” monetary policy and those who cautioned against loading up the Fed’s balance sheet with dangerous assets.  

Now they are in the middle of inflation hawks like Washington Post columnist David Ignatius and U.S. Senator Charles Grassley, weak-recovery worrywarts like Fed Chair Ben Bernanke and Nobel Prize-winning economist Paul Krugman, and bubble predictors like LSE economist Willem Buiter and NYU economist Nouriel “Dr. Doom” Roubini.

It makes the 1990s seem quaint, no?

This latest bind, like most of the Fed’s troubles, was predictable and preventable…but not by them.

Severe inflation is a laughable prediction to anyone with the faintest understanding of financial crises (pick up a copy of This Time Is Different by Kenneth Rogoff and Carmen Reinhart for a superb summary), but another bubble is not out of the question. It was, after all, in the wake of the dot-com crash that the housing bubble formed.

The most prominent such warning came from Roubini in the pages of the Financial Times a few weeks ago. He, like Buiter, worries that low interest rates will fuel asset speculation. Roubini sees it manifesting in the foreign exchange market, Buiter in developing nations like China.

Their fears are not misplaced. If consumers are willing to spend and workers can demand higher wages, low interest rates can fuel inflation. But when the economy is depressed, low interest rates may encourage investment by those with the means to borrow.

The paradox is, while Buiter and Roubini are right to worry about speculation, Bernanke and Krugman are also right to worry about high unemployment and slow growth. Low interest rates are a necessary evil until the economy becomes much stronger.

What most observers have failed to recognize is that economists predicted precisely this Catch-22 in early 2009 when they recommended that the government nationalize failing banks. Because they failed to fix the financial sector, toxic assets continue to weigh down the recovery to this day. From the beginning, the Fed has been forced to help banks in the only way it can—through monetary policy—when the best solution would have been for the FDIC and Treasury to nationalize them and strip them of their toxic assets like Buiter, Krugman, and Roubini all suggested.

In my column in today’s South Florida Sun-Sentinel, I address how to prevent this misstep in the future.

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