Earlier this week, while on the road, I had a column in DealBook on the use of the Fed's balance sheet to fund the bipartisan highway bill. I'm skeptical:
The bill exemplifies a new trend of legislative hostility toward the agency, which has expressed itself in Republican-sponsored bills calling for audits of the central bank, efforts to limit the Fed’s discretion in setting monetary policy and even calls for its dissolution.
Those bills had never gone far. But now, the tax-averse legislature has chosen to pay for new highway funding through two raids on the Fed’s budget. If this bill becomes law, it will represent a new and troubling interference by Congress in the affairs of the central bank.
The first raid drains the central bank’s “rainy day fund,” money set aside from revenue earned from its trading operations – it trades government debt to set monetary policy — to deal with the possibility of market losses.
The second raid reduces the dividend that the Fed has paid to its member banks. Since 1913, that dividend has been set at 6 percent. Under the highway bill, the new, lower dividend would track the rate of return on the 10-year Treasury note, currently around 2.2 percent, with the difference being used for highway funding.
Reactions and corrections welcome!
For the first time in almost a decade, the Federal Open Markets Committee is likely to raise rates today. Whole careers have been launched without going through one of these things, so there's plenty of attention being paid, though I don't know, maybe instability in the bond market will make them less likely to do it.
That the speculation above is the sort of thing that a lot of people are doing illustrates what an odd creature of administrative law the FOMC is. It essentially is exempt from most rule of law requirements, although its empowering statutes featured a ton of guidance from Congress about what it should think about when it thinks about the monetary supply. But its decision about whether to raise or lower the federal funds rate is a matter left entirely to its discretion, and neither the courts, nor Congress, nor the President will have anything to say about it.
There's lots of good reasons for that - politicized money tends to be very susceptible to inflation. But one of the reasons to have administrative law is to render decisionmaking predictable, and really, nothing's more important than predictability when it comes to the monetary supply, where there's not a good reason, absent terrible economic conditions, to surprise anyone ever. In my view, that's why the FOMC has adopted rather stable customs in lieu of legal constraints, and I wrote about it here. Boring meetings, standardized voting, releases of the data on which the decisionmakers relied ... not of it is required by law, and yet all of it has been adopted by the agency.
Gretchen Morgenson says no, in a long front-page story in the Times, which should raise the hackles of any free-marketer. I though Matt Levine's comments were smart. The political economy of what to do about Fannie and Freddie is partly driven by the hedge funds who have taken big positions on the failed government agencies' stock, which wasn't wiped out when the government took the agencies over (and perhaps you can see how that structure is a weird one). If they don't win their takings claims based on that takeover, they want a "recap and release," that is, they want Fannie and Freddie to go back to being the super profitable guarantors of mortgages that they used to be. It's basically a big bet on Congress agreeing with them, because the current executive branch is dead set against it, and that seems like a very risky bet to me. It is also buccaneering capitalists pushing for government support for residential mortgages, which you don't expect to see every day; it appears that Morgenson thinks the hedge funds are onto something.
Anyway, the takings claim isn't a bad one - Steven Davidoff Solomon and I wrote about it here.
As Mehrsa observes, the largest problem for middle and working-class access to the benefits of banking concerns the perceived cost of catering to such small time financiers. They simply do not borrow or lend enough to make it worthwhile. One question addressed in the second half of her book concerns some alternatives to banks that might be willing to enter a market that the big national banks have largely exited, in her telling.
But of course, fixes that can market efficiently to low dollar depositors might well have some competitive advantages when it comes to high dollar depositors as well. To me, the interesting question is whether the innovation here will be one of financial technology or one that requires a regulatory blessing. Mehrsa considers microfinance, which Christine has discussed (and so I won't), or community minded banking, which looks like a triumph of hope over experience. But she also surveys debit cards, Walmart, mobile banking, and peer-to-peer lending; they all offer the prospect of inexpensive credit, or at least efficient access to the financial system, without necessarily requiring the use of algorithms or robots.
Leaving aside mobile banking and the Wealthfronts and VenMos of the world, it is worth noting that the problems for debit card issuance, by the post office or whoever, banking at Walmart, and P2P are regulatory ones, rather than technological ones. The question has been whether these institutions are enough like banks to be trusted with deposits. Much of the answer to that question is tied up in bad old competition avoidance by the already extant banks, who lobby against potential competitors. But some of it lies in the idea that few can be trusted to hold other people's money. Bank charters, as Omarova and Hockett can tell you, require the institution to act in the public interest. Other holders of funds have fiduciary obligations to the owners. And the regulatory question is whether Walmart or Joey8359 on the internet will feel the same way, or, put another way, whether we should care that they obviously will not.
I will echo the praise of the prior contributors: this is a really well-written book, packed full with insightful and accessible anecdotes, thoughtful analysis, and a strong message. Like Christine, I was particularly interested in the middle chapters, as I worked on bank lending and Community Reinvestment Act issues with the Woodstock Institute prior to law school. My former boss at Woodstock went on to work with South Shore Bank/ShoreBank, and I remember the real enthusiasm and optimism surrounding that bank and its mission. But as the book points out, ShoreBank became insolvent in 2010 after being refused TARP funding. The story of that bank's failure could be one of liberal cronyism and ideology run amok, or simply the collapse of an undiversified regional bank in the midst of an international financial breakdown.
The narrative is important and therefore contested because blame is important in this space. The facts, marshaled clearly and thoroughly by the book, are undeniable: approximately 70 million Americans do not have a bank account or access to traditional financial services. The services provided to the unbanked or underbanked are generally much more expensive and filled with costly penalties and fees. At the other end of the spectrum, banks provide services to the well-off for reasonable prices and in turn are backed by a myriad of federal and quasi-federal protections. The book makes a convincing case that our banking system is not a free market, but rather a highly-regulated market that is supported by the government. And, due to a series of changes in the law over the last century -- ones that accelerated after the 1980s -- average Americans are much more likely to be left out of traditional banking services.
So who is to blame for all this? The book essentially paints a picture of greedy banks shunning the poorer and less profitable consumers in flagrant disregard for their original, public purpose. It is Jeffersonian in its approach: smaller is better, more local is better, community is better. It is not wholeheartedly in this camp -- it acknowledges that large banks are more efficient, less vulnerable to regional conditions, perhaps better (and even cheaper) at providing certain services to certain clients. And it also recognizes that banking services for the poor may not be that profitable (not profitable?) when conducted along the same terms as applied to richer folks. But the central theme of the book, at least on my reading, is that banks have become unmoored from their public trust and are exploiting their special relationship with the government to capture the upsides of capitalism without the downsides.
So it is somewhat surprising that the book lets banks off the hook at the end by promoting a public option for banking, specifically postal banking. The idea has a lot to recommend it, beyond even the problem of underbanking. But it also raises a lot of questions. Can the post office do what community banks couldn't? Do we think post offices will do a better job of moving beyond the credit score to asses the "real" credit risks presented by each loan applicant? Does the public really trust the post office?
But my more theoretical question is this: why should we let the big banks off the hook? If the book had presented the problem of underbanking as a natural and understandable market failure, based on the inability of the poor to make traditional banking profitable for banks, then a public option would make a lot of sense. But if banks are pulling a fast one here by shirking their public responsibilities , shouldn't we make them accountable? The book's discussion of the CRA does a nice job of briefly outlining the history of the act, as well as the views of its supporters and critics. But it left me wondering whether the CRA was doomed to failure, or whether it just hadn't been implemented with the appropriate teeth. And I think this strikes at an ambivalence that underlies a lot of the book. Yes, banks are making beaucoup bucks while safely within the arms of their government protectors. At the same time, however, they are just being what they were designed to be: profit-making businesses operating within a market.
Perhaps, in the end, we'd rather solve the problem of underbanking than exact a just recompense from powerful economic and political actors. Or perhaps we can square the circle by requiring banks to fund the public option with a special bank tax or fee -- something similar to the FDIC. But I think a whole lot more people will be asking these questions thanks to Mehrsa's thoughtful, engaging, and provocative book. Congrats to her on this terrific accomplishment.
Mehrsa's fine book is an appealing combination of history and policy. On the one hand, the book reviews the way that the poor and middle-class have accessed the finance system in the United States over decades, and how that access has been a story of changing institutions. On the other, policy, hand, the book features an appealing recommendation, not for a return to the community banking days of yore, but rather for a supplementation of our current national banking system with a reanimated postal bank. While community banks, for a variety of reasons, handled the banking needs of the poor and middle class (or so she argues; I'm not entirely convinced about that), national banks are unwilling to chase small depositors, for profit lies only in servicing big ones. A postal bank might at the very least be able to provide the unbanked with debit cards, and at best might be able to give them the sorts of financial services that are now being provided by shadow banks such as payday lenders, title loan companies, and the like.
I could see assigning this book to the class of business school or law school students interested in how the banking system has changed and what it does today.
One of the things it does, and has always done, according to Mehrsa, is dependent on the government. On page 16, she posits that "government support is the only reason depositors trust banks, and without trust from depositors, banks don't exist." One of the interesting memes that I have noticed in law and finance scholarship is that, in marked contrast to corporate law scholarship, many of the authors agree with Mehrsa that finance, by some measures the largest component of the economy, is almost entirely a creature of regulation. For other examples of this sort of work see here and here. As someone interested in regulation generally, I see why I've grown particularly interested in financial regulation, though I suspect that an important component of financial intermediation is not purely an example of regulatory beneficence. Indeed, the whole regulatory arbitrage story that plagues financial oversight suggests that regulatory fixes to fundamental finance problems, like banking the unbanked, will always be challenging.
Creating a continent wide deposit insurance program is interesting because of its American antecedent. The FDIC is one of two ways that America's entirely state-regulated banking system became, in essence, entirely federalized (the other one emerged through the Fed's oversight of bank holding companies). Once you have an insurer on the hook for making your depositors whole if you disappear, you have an institution that is going to want to inspect your books and interview your executives. And the EU commissioner who proposed it is British, one of the countries least enamored of the emerging EU agencies who are taking over from local banking regulators. It is quite the rejection of federalism.
One of the amazing things that has happened in the wake of the financial crisis is that international bank regulators have moved from measuring two things - capital adequacy and the leverage ratio of banks - to measuring a lot of different things which must be computationally hard to keep in balance. In addition to the two extant measures, banks have to establish a net stabled funding ratio (NSF) designed to deal with long term assets, a liquidity coverage ratio (LCR) designed to deal with short term assets, and let's not forget the work being done in the US by the stress tests, labelled DFAST and CCAR, or Europe's MiFID.
Into the mix the Financial Stability Board has added a total loss absorbing capacity rule, or TLAC. The best way to think of this rule is as an alternative measure of the capital adequacy of very big banks, with an eye to the moment of failure; it requires banks, in addition to holding common stock and cash, to hold financial instruments like convertible bonds (or maybe plain old unsecured debt) that can be used to bail-in the bank - bail-in means that the bank looks to its creditors to provide it with resources to stabilize it, bailout means it looks to the government to provide those resources. Or, if you like, here's the FSB:
G-SIBs will be required to meet the TLAC requirement alongside the minimum regulatory requirements set out in the Basel III framework. Specifically, they will be required to meet a Minimum TLAC requirement of at least 16% of the resolution group’s risk-weighted assets (TLAC RWA Minimum) as from 1 January 2019 and at least 18% as from 1 January 2022. Minimum TLAC must also be at least 6% of the Basel III leverage ratio denominator (TLAC Leverage Ratio Exposure (LRE) Minimum) as from 1 January 2019, and at least 6.75% as from 1 January 2022.
Without going too far down this road, I think that these varied sorts of capital measurement are basically supposed to discourage regulatory arbitrage, though it also suggests how puissant big banks must be in handling their regulatory requirements. Not a place for a financial startup. TLAC is also a tax on big banks, of course, and a disincentive to become one of the thirty largest institutions in the world. Here's the WSJ with an explainer.
This all has to be adopted by the G20 at its next meeting, proving once again that in finance, the rules that really matter are set by an international, non-treaty based form of administration.
I've expressed some sympathy for the whistleblowing bank examiner Carmen Segarra in the past, and I wrote up my concerns over at DealBook. A taste of the argument:
The bank whistle-blower statute was part of the changes passed after the savings and loan crisis of the 1980s, when hundreds of financial institutions had to be “resolved” – that’s bank terminology for taken through a quick bankruptcy – by the Federal Deposit Insurance Corporation. The statute covers a “person who is performing, directly or indirectly, any function or service on behalf” of the F.D.I.C. The appeals court said that it was “frankly silly” to suggest that Fed employees were working for the F.D.I.C.
But I don’t think it is frankly silly. The purpose of the statute is to protect whistle-blowers who work at, among other places, Federal Reserve banks who bring information to light about mismanagement in a way that performs a service to the F.D.I.C. Moreover, the statute is supposed to be broadly construed.
Goldman Sachs is a bank holding company, but it does not have depositors.
Nonetheless, the F.D.I.C. is a full voting member of the Financial Stability Oversight Council, which has designated Goldman a systemically important financial institution, subject to heightened supervision and its particular attention. Moreover, the F.D.I.C. would play a role in resolving Goldman, if it came to that, under the Dodd-Frank law’s overhaul of the government’s resolution powers.
So I do think that supervising Goldman counts as performing a service to the F.D.I.C.
Do go over there and give it a look.
Here's the Second Circuit decision on the Carmen Segarra case. She alleged that the Fed was too soft on Goldman Sachs, and secretly taped meetings between regulators and the bank in an effort to prove it. And in some ways, she has influenced the policy debate more than you'd think any low level, very briefly employed bank examiner would, so she's already won something.
She lost her whistleblower suit, but that's not even a huge indictment of her. She lost it because she tried to pull herself within the confines of the bank whistleblower statute by alleging that the Fed, and her supervisors (and her), were performing a service for the FDIC when they examined Goldman Sachs. The statute says, in the court's words, "if an individual is subject to liability under this statute, he or she must be '[a] person who is performing, directly or indirectly, [a] function or service on behalf of the [FDIC]." The court said that it was "frankly silly" to suggest that Fed employees were working for the FDIC. Put that way, it sort of sounds silly.
Is it so obvious, though? In a complaint? The purpose of the statute is to protect whistleblowers who work at among other things "Federal reserve bank[s]" who bring information to light about "gross mismanagement" in a way which performs a service to the FDIC, which (I think, the court didn't say) might insure Goldman (but wouldn't, I guess, if it doesn't have depositors; it is a bank holding company), would be involved in any trigger of orderly liquidation authority under Title II of Dodd-Frank, and, as a voting member of the Financial Stability Oversight Council, arguably oversees SIFIs, of which Goldman is one. Segarra alleges that Goldman Sachs didn't have a conflict of interest policy, and her job was to examine the firm for safety and soundness. The statute is supposed to be broadly construed. Although I haven't yet been too convinced by Segarra, her argument is plausible enough. One judge, who maybe agreed, but may be worried about the prospect of every bank examiner reporting, quitting, and suing, once wrongdoing is uncovered uttered a terse "I concur in the result."
Segarra's lawyers don't look classy, and her damages request was nuts, but I'm not quite sure why her claim has been given the back of the hand quite so tersely, in a per curiam opinion that doesn't enjoy the the support of all three members of the court. And do let me know if I've missed something.
Post updated to clarify the FDIC-Goldman relationship
Another update - here's the district court opinion, which is more articulate about the problems with the complaint. Courts don't like to regulate banking supervision, and the district court depends on a conclusion that banking regulation is very informal, which would make a claim that a bank is ignoring a recommendation from supervisors not the same thing as a bank violating the law. It would have been nice if the Second Circuit had evaluated that part of the opinion, given that banking regulation is generally extremely informal. It's not clear to me that Congress didn't want whistleblowers to police this sort of supervision.
The Volcker Rule’s covered fund provisions have not received the attention they deserve. Like the more well-studied proprietary trading rule, the covered funds rule restricts bank investments in the name of limiting their risk-taking and mitigating their contribution to systemic risk. As with proprietary trading, legislators and regulators faced a decision with covered funds on how to define those bank activities that would be off-limits. However, unlike with prop trading, Congress, and federal regulators subsequently, chose to define the scope of the covered funds rule largely by reference to an existing statute.
In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences.
A first cut
Using Investment Company Act exemptions to set the scope of the covered funds rule has advantages. The Investment Company Act exemptions set boundaries that have already been defined by regulators and market expectations. These particular trans-statutory cross references work to circumscribe bank investments in, and sponsorships of, a wide range of entities. Congress appears to have concluded that private equity and hedge fund investments posed inordinate risks for banks and the government safety net. Since those two types of funds typically use those two Investment Company Act exemptions, the trans-statutory cross references seem to accomplish Congress’s intended purposes. A range of other entities also use these two exemptions, but the five federal regulators that promulgated the final rule ultimately carved many of those entities out. Still, many non-real-estate-related securitization vehicles would be covered by the rule.
On the other hand, prohibiting banks from investing in particular exempted funds does not necessarily mean that banks will move their money to safer locales. Many real estate securitizations, for example, are not covered by the rule. Banks could move capital to other exempted funds or even restructure existing investments to fall under other Investment Company Act exemptions not covered by Volcker. More on this in a moment.
When securities law serves banking law purposes
Stepping back from its immediate market consequences: the trans-statutory cross references at the heart of the covered funds rule highlights the ways in which the Investment Company Act, in particular, and securities regulation, more broadly, can and cannot regulate effectively the systemic risk posed by banks and other financial institutions. In other words, the tools of securities relation are in some ways aligned and in some ways mismatched with the purposes of prudential regulation. The trans-statutory cross references exacerbate Volcker’s problems of under- and over-inclusiveness in limiting the risk-taking of banks. The portions of the Investment Company Act most useful for systemic risk are its restrictions on leverage, which are somewhat unique in the pantheon of securities laws and function most similarly to banking rules.
Trans-statutory cross references can delegate power from one agency to another
Volcker’s trans-statutory cross references have not only policy but also political implications. By using a securities law to define the scope of a banking law, the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC). This has potentially profound implications given the differing statutory missions, cultures, and personnel of those agencies. Securities regulators also face different interest groups and have different institutional pressure points compared to their banking counterparts.
How the SEC will wield this power to define the scope of a banking law remains to be seen. Some commentators have doubts as to the SEC’s interest and ability to pursue systemic risk regulation alongside its traditional investor protection role. The covered funds rule will provide one test of the SEC’s resolve. Banking industry interest will likely now focus on other Investment Company Act exemptions. SEC decisions to narrow or expand other Investment Company Act exemptions – particularly Section 3(c)(5) or Rule 3-a-7 – now have cascading consequences by virtue of Volcker’s covered fund provisions. After Volcker, banks and other parties in securitization markets may seek to structure securitizations to rely on one of these other exemptions. Efforts to narrow these exemptions will likely meet strong opposition from banks and the securitization industry. In considering whether to narrow or enlarge these exemptions, the SEC must now consider not only whether investors in collective investment funds are protected. It must also consider the effects on bank risk-taking and systemic risk.
A larger lesson
The political dynamics outlined in my paper point to lessons for policymakers considering using trans-statutory cross references in the future. Trans-statutory references may take power from one regulatory body and give it to another. In the case of the covered fund rules, power over prudential rules was, perhaps unintentionally, delegated to a securities regulator. This works well if the statutory drafters trust the agency from whom power was taken less or trust the agency to whom power was given more. It works if the concern is to check potentially overzealous pursuit of policy objectives by the traditional regulator or to remedy potential shirking by a captured body. However, trans-statutory cross references may fail if the newly empowered regulator works at cross purposes to the statute it now has authority over. Trans-statutory cross references reflect a lesson that is old but one that bears repeating nonetheless: technical drafting decisions can have outsized and unintended political consequences, particularly with respect to the most important question of all – who decides policy going forward.
Cross-posted at Columbia's Blue Sky Blog.
I'm enjoying Philip's guest blogging with us. I think I particularly like this part of his last post:
If it sounds condescending to suggest that the government barely even thought about legitimacy issues during the last crisis, perhaps it is fitting that I end with an obligatory presentation of Wallach’s Law, which is that everything is more amateurish than you think, even after accounting for Wallach’s Law. Everything: financial crisis responding and post-response analysis are no exceptions.
At the end of my review of his book, I said:
one of the reasons I like thinking about the financial crisis, and like reading books like Wallach’s about it, is because it was an enormous almost-disaster that was averted for thousands of different, interlocking reasons. The government’s response to it was both wise, unreflective, tremendously unfair, and highly successful, and a million other things as well.
We may never sort out what exactly happened, and we'll certainly never know whether it was the best possible approach, or three removed from best, or 17, or whatever. Given so many inputs, what can we say about the legal output?
I think we can say a few things. First, that the law mattered, and provided constraints, even when it shouldn't have or was just used as an excuse (ahem, Lehman Bros.). Second, one of the ways it mattered is because it cabined the government's thinking of precisely how it could get creative. We can't save a bank through X, so let's push through a merger to save it that way. We may never want the government too cabined in the middle of a crisis, but there is room to impose constraints afterwards, too. So if you're inclined, for whatever reason, to look at the world through "law only" glasses, I think you can gain some useful perspectives on what happened during that hectic period six years ago.
Though, as we found out today, they're still litigating it all!
My colleague Peter Conti-Brown is interested in Philip Wallach's legal history of the financial crisis, as am I. He's got a post up on it over at the Yale J. on Reg. blog, and go give it a look. They've debated, over there, whether the Fed had the authority to rescue Lehman Brothers; it rather famously claimed that it did not, only to give AIG a massive bailout a couple of days later:
One of the features of Philip’s stint here was a debate we had on the Fed’s claim that it lacked the legal authority to save Lehman Brothers. I say that’s a post-hoc invention; Philip thinks it’s not, or at least,not so obvious. What do we learn from this fascinating exchange?
I still think those inside the Fed—whether at the Board of Governors or the Federal Reserve Bank of New York—had the authority to do whatever they wanted with Lehman. And given the political maelstrom they faced, I’m not sure I would have done a thing differently than they did. My critique of their legal analysis is not a critique of their crisis decision-making. But the legal arguments are distracting from the bigger question, about the appropriate levels of discretion that a central bank should have in using its lender of last resort authority. What the debate with Philip has shown me is that, even if I’m not wrong—and, well, I’m not—the law is something of an omnipresence in the way the government faced the financial crisis. That omnipresence may even have brooded from time to time.
Over at the New Rambler Review (which I'm really enjoying), I've got a review of Philip Wallach's legal history of the financial crisis. The kick-off offers a riff on the crisis:
The government’s response to the financial crisis was an example of messy policymaking that occasioned a happy ending, although not everyone sees it that way. Some are unsure about the ending – they have decried the very modest meting out of punishment that followed the recovery of the economy. Others are unsure that the policymaking was messy – they are likely to think of the government’s response to the financial crisis as an inevitable manifestation of executive preeminence as the doer of last resort, institutionally capable of acting when courts and legislatures cannot.
But I will take a stable economy over a few prison sentences, especially when it is possible that you can’t have both at the same time. And you won’t convince me that the things government officials did during the crisis – last minute deals, concluded late at night and paired with creative reimaginings of underused statutes and regular resorts to Congress for more legislation – was the mark of the smooth progress of an imperial presidency.
Go over there and read the whole thing!
My colleague Peter Conti-Brown has an op-ed in the Times today regarding the Fed's crazy regional bank system. A taste:
Congress should let the Board of Governors appoint and remove the 12 Reserve Bank presidents, as they may do with other employees of the board. The 12 regional Feds would then become branch offices of our central bank, continuing to do research and data analysis, while leaving policy making to Washington.
This plan has several benefits. First, the next time the Fed makes an egregious mistake — like failing to predict the meltdown of the housing market — we would know for certain whom to hold accountable. Second, it would allow the Fed to modernize the distribution of the 12 Reserve Banks. There is strong evidence that the cities for the 12 banks were chosen as much for politics as economics. In 2015, do we really need two regional Feds (Kansas City and St. Louis) in Missouri, but only one (San Francisco) west of Texas?
Everything Peter writes about the Fed is worth reading, and this is no exception. Give it a look here.