Are regulators sowing the seeds of another bank bailout?
Sheila Bair was not only a central figure in the government’s response to the 2008 financial crisis — she also warned about the risky mortgage lending practices that precipitated it.
Now, the former head of the FDIC is warning that today’s crop of financial regulators are forgetting the lessons of that painful saga by weakening banks’ capital buffers, which act as fortifications against unpredictable losses and are intended to ward off potential taxpayer bailouts.
“Regulators have to stand strong, because the banks, it’s in their financial interest to drive those capital levels as low as possible,” Bair told me in a recent, hour-long conversation. “And if they don’t stand firm against it, we’re going to have another crisis.”
Bair, tapped in 2006 by President George W. Bush to lead the agency responsible for safeguarding the deposits of everyday Americans, has never conformed neatly to partisan teams on financial regulation. She’s a Republican with a bit of populist flair, someone eager to rein in “too big to fail” banks with simpler but tougher capital rules.
Today, as ever, the correct calibration of such rules is something of a holy war in financial industry circles, with no simple answer. But Bair says regulators under the Trump administration are going the wrong way.
She pointed to a simple measure of banks’ capital levels — one that considers how much debt they’re taking on without factoring in what kind of risks they’re taking — that suggests megabanks’ capital buffers are now roughly where they were in 2009.
It’s unclear where the next threats to the financial system might come from. Bair is less worried about crypto, for instance, than she is about turmoil in private credit markets, where lenders that aren’t banks make riskier loans to businesses. But the whole point of capital is that it’s intended to guard against the unexpected.
And right now, she’s worried that regulators are letting their guard down.
Regulators under the Trump administration are doing a lot to ease up on the financial system. They’re loosening rules for banks. They’re scrapping oversight of a lot of other financial firms by gutting the CFPB. Does that worry you?
Yeah, it’s hugely troubling. So much of this is just undoing what we did after the 2008 crisis, which, you know, we’re going on 20 years now, so memories fade.
It’s easy to make it partisan and all about Trump and deregulation, but you see these kinds of cycles when you have relatively benign periods in the banking system. Banks are profitable, and they come in and say, “We don’t need all this capital. You’re constraining lending.”
We were hearing that right before the 2008 crisis, so a lot of this is same old, same old. But regulators need to have a long memory, even if the industry doesn’t. Maybe purposely doesn’t.
I think there’s still some people on Wall Street, especially among the big banks and their lobbyists, that still think the crisis was all about government wanting poor people to have mortgages. “It’s all the borrowers’ fault, and what was the big deal? We got through it.” I fear they view bailouts as the new paradigm, and certainly I see how quick the regulators were to bail out those billionaire depositors in Silicon Valley, which was a relatively small regional bank.
The Fed has been willing to step in quite a bit over the years, including with just lowering rates when they see potential stress. So it doesn’t surprise me if the industry just thinks the Fed’s always going to have their back, so they can operate with a lot less capital.
It’s frightening how much more the big banks have levered up. And they did record dividend and buybacks last year — and another, what, $40 billion, in the first quarter? So to say they’re capital-constrained when they’re releasing all this capital for shareholders is hard to reconcile.
With deregulation, with some of the risk-taking that we’re seeing, do you see parallels between today and 2008?
Oh, a lot of parallels. Yeah. The deregulatory trends, we were definitely experiencing leading up to the 2008 crisis, that is true. Risk, to the extent I worry about risk in the system, I worry about private credit. There have been enough warning signs already that I hope that people are more on top of that than we were with the mortgage crisis. But there are similarities — it’s non-bank lending. It’s iffy collateral.
One of the things that made me feel better about private credit is that I didn’t think there was all this financial engineering sitting on top of it the way that we did with the mortgages. We don’t have the [collateralized debt obligations] and the CDO-squared and all the basically gambling going on top of these mortgages. But the financial engineering around private credit financing arrangements is also growing more complex, so it’s hard for me to be completely sanguine.
It’s not as bad as it was prior to 2008, but I think it’s still pretty bad. And I think they’re just getting going. The industry is coming in, they want way more on these capital rules than what the Fed has already proposed, which is pretty generous. So, we’ll see what happens.
They’re going after all these kinds of simpler brakes on excess leverage that are much easier to understand, and for the markets to see, and are transparent. They’re going after all that.
I think that’s another issue. It’s the sheer complexity of these rules. [Regulators] say they want to simplify. With 1,800 pages of proposals this year? I don’t think so. But it becomes an insider’s game. So the people best equipped to have the capability to comment are the banks, the ones who are going to make money off of this, who have their hordes of lawyers and analysts who can come in and dive in and do these weekly large complex comment letters.
This is one of the reasons I founded the Systemic Risk Council.
It’s hard, even for us — and look at our list of former regulators, central bankers, bankers. It’s a struggle to wade through all of this and provide any kind of counterweight to these large banks and their highly complex proposals. And it has become an insider’s game. Journalists, too, have the same challenges to figure out, who’s right? Who’s wrong? Where in the 1,800 pages are you going to look?
Kevin Warsh has got his hands full on monetary policy. I have no idea what he’s going to do on regulatory policy. But if it was just simplifying this stuff, making it more transparent, getting more balanced input in the rulewriting process — without getting into the substance — those would just be really welcome process changes that would produce much, much better rulemakings.
You said by some measures capital is roughly where it was in 2009. That’s even before all of these other capital changes are implemented?
Oh, yeah.
I assume it will get worse once these risk-based reductions come into place.
Banks can optimize these rules, shift their assets around, manipulate their models. We saw it before. They’ll do it again, no matter how hard you try to prevent it. It’s like loopholes in the tax code. You do what you can. It’s a hydra-headed monster. You keep batting it down, but they can manipulate these rules.
The banks are still mad because their market risk capital is going up. Damn straight the market-based capital should be going up, and it is — a tad. Not as much as it should. But they’re fighting that. And it just seems like this Fed wants to be very accommodative.
There are some positive things in those proposals. I don’t want to take that away from them. But, overall, it reduces capital when capital, if anything, should be going up.
How much of this is just a normal pendulum swing toward deregulation you often see under Republican appointees, and how much of this is because independent regulatory agencies are now much more responsive to the White House and Treasury?
That’s a good question. People talk about Fed independence, but they seem to only talk about the context of monetary policy. I think there’s a lot of administration influence at the Fed and the FDIC and the OCC. And some people say that’s fine. Some people say these regulators should be responsive to the political authorities. I don’t think that.
Politics swings more than the regulatory pendulum does, so you’re just going to exacerbate the natural tendency, the poor timing of regulators, to ease when good times are good, and then clamp down when things are bad. So I do think it’s worse because they’re trying to make the Trump administration happy.
And then my guess is the Trump administration wants to throw some sops to the big banks, because on other things like debanking, the anti-immigration stuff and crypto, they’re taking positions that are not consistent with where the big banks would like policy to go. So maybe they’re trying to balance things out.
If there’s another area where risk weights should go up, it’s in private credit or any exposure where you have a situation where it’s a largely unregulated counterparty.
To be giving these highly favorable capital treatments when you’ve got this iffy collateral, an unregulated industry that’s already under distress — those risk weights should be going up, if anything. But it’s just another example of the bias towards weakening where they can, not strengthening.
Regulators’ argument for loosening capital rules is that they want more lending to come from the regulated banking system. Is that the right instinct?
Look, we’ve always had nonbank lending. That’s not new. What’s new is that the banks, and this was going on pre-2008 too, the banks fueled this growth with their own financing arrangements with nonbanks.
You’ll have to use a lot more capital to fund the position if you lend directly to the company versus lending through a private credit intermediary. Plus the intermediary is doing all the underwriting, all the collateral management. They’re doing all the work for you. So it makes it very attractive for banks to fund [nonbank lenders], so yes, [nonbanks], to some extent, on the margin are creditors, but mostly they’re customers.
[Nonbank lending] is going to grow more with these [bank capital] proposals.
There’s a segment of the market where [private credit] can provide a service. But they’re making riskier loans. Some of them are making really irresponsible loans, and for regulated banks to be fueling that irresponsible lending, as they were during 2008 with mortgage lending — no. That’s something regulators should be worried about and clamping down on, not facilitating it with even lower risk weights.
We have pending legislation that would put a framework around crypto and put the CFTC in the driver’s seat on regulation. When there was a crypto blow up a few years ago, there wasn’t really that much of an impact on the broader system because it wasn’t really interconnected with the banks. The bank regulators still haven’t opened the floodgates to crypto, but I’m wondering how you think about the financial stability risks now of crypto.
I always distinguish between the assets and the technology. Crypto assets, they aren’t backed with anything but algorithms or a wing and a prayer or a presidential name, or whatever. I’m not a fan of those, and I think there is a lot of risk in that segment of the “crypto market.” But it’s small. It’s highly speculative. I think it’ll always remain. I don’t see it getting a lot bigger. I really don’t. I think you’re kind of seeing it leveling out already.
The technology, on the other hand: tokenization of real-world assets, which can move on a blockchain. You have a cleaner, more efficient, faster process to transfer a title. You have a cleaner, more efficient, more transparent process to track collateral. Those are really positive things that can help the banking system be safer.
Should banks be buying Bitcoin and other speculative assets? Absolutely not. They’re generally limited in their ability to hold risky assets, and I would put certainly crypto assets in that category. I don’t want bank exposure there, and hopefully that doesn’t happen. But that speculative segment of the market is, I think, still reasonably contained, and I don’t think poses a risk to the system.
Stablecoins too — a lot of people wring their hands. I’ve always been a supporter of stablecoins. I think it’s a very promising technology. I hate that it’s the payment of choice for a lot of scams and speculation with other crypto assets, but I still believe in it as a technology for legitimate, broader-scale use. And I know the banks, especially smaller banks, are worried about disruption. I think it can be compatible with them.
Being able to use stablecoins, custody stablecoins, facilitate stablecoin redemptions — those are all things that banks can and should be doing, and that would, frankly, make the stablecoin environment more stable. And a lot of that was not permitted in the Biden administration, which is unfortunate, because I do think, if given the appropriate latitude, the smaller banks can actually leverage the stablecoin technology in a mutually beneficial way. But they need the flexibility to do that.
The CFPB had oversight of all of these other financial firms that aren’t banks. Are we just not doing that right now? What are the risks there?
You’re seeing a resurgence of state consumer activity, and that’s making the banks unhappy, because they don’t want these piecemeal consumer rules, state by state. One of the ways that I argued this in supporting the CFPB is, if you have a national standard setter, you reduce the incentives of the individual states to come in with their own rules. So I think to some extent this is backfiring on the banks.
I knew a young woman who was being scammed by her landlord. The scam is, you leave your apartment, and you’re current on your rent, and you clean the apartment. Everything’s lovely. And then a couple months later, you get a notice from a debt collector that you didn’t pay your last month’s rent, and they’re going to notify the credit bureaus. They’re going to ding your credit score if you don’t pay up.
She had sent this sleazy debt collector all the receipts showing that she had paid her rent. And I helped her. We wrote two letters, one to the CFPB and the other to the state consumer regulator. And within a week, she got a response from the state consumer regulator, who called the sleazy outfit. They immediately backed off. Two months later, she gets this bureaucratic letter from the CFPB that she hadn’t followed the correct format in filing her complaint, so they were sending it back and really couldn’t help her. And it wasn’t like, “This is how you do it.” It was just a complete blow off. And I thought to myself, boy, if the Trump administration thinks they’re making friends with the consumers by doing that kind of stuff, then I don’t know what they’re thinking. So it’s just an example. It’s anecdotal. But on the ground, I think this matters.
And you’re right, the non-banks are pretty much scot-free at this point, which was another reason why some of the banking industry did support the CFPB, because it was going to bring in nonbanks into consumer protections.
At least you have some oversight with banks. Ironically, because the CFPB can only supervise banks above $10 billion, the community banks still have their continuous consumer exams. So that was kind of ironic, that the big banks were benefiting more than the smaller banks from the CFPB being effectively closed. But I think they’re running into a bigger hodgepodge of state consumer rules. The nonbanks are even more competition now, because they don’t have to worry about consumer rules, and that’s letting the bad players in.
I don’t know why industry thinks any of that is in their interest.
Now you’re seeing this executive order where it seems to be a big jump ball in reviewing everything, which I think is very dangerous.
It seems like this is once again going to be an all-out, potential dismantling of all the very sensible ability-to-repay rules that were put in place by the CFPB after the crisis, and that not only threatens financial stability, it threatens consumers. It threatens homeowners. You’re not doing any homeowner any favor by putting them in a mortgage they can’t afford, as we learned painfully in 2008.
You mentioned bailouts earlier. Where do you think we’re at on them, politically? Everybody really hates them conceptually, but if we had another part of the financial industry failing, do you think a bailout would be likely?
I think the new Fed chair is much less likely to intervene than the previous leadership. But when push comes to shove, because these guys are too big, they can blackmail the government, right? And if you don’t, then you worry that the little guy’s getting hurt if you don’t step in.
I do think that the best way to prevent failures is to begin with higher capital levels. Runs are almost always symptomatic of market concerns that the bank is no longer solvent or will soon become insolvent. A very well-capitalized, strongly capitalized bank will not have runs.
Instead, they’re lowering the capital requirements.
These big banks that are going to be so challenging to resolve? Make them have truly fortress balance sheets. Not little advertisements that they have fortress balance sheets or bogus numbers from the stress test or the risk-based rules. True fortress balance sheets, and that takes care of a lot of your problem.
That should be the first strategy. But they also need to have the political will. The market needs to believe that they have the political will to actually put these folks into some kind of a [temporary government-run company to run the bank’s operations until it’s sold or liquidated], wipe out the shareholders, impose losses on unsecured creditors, as you would in a bankruptcy proceeding, and if you just did that once, you would probably end bailouts.
I hope and pray that we don’t have another big bank get into trouble. But the trajectory of these capital rules, make no mistake, is weakening the resilience of the banking system and significantly lowering capital for the larger banks who have already, on a non-risk-weighted basis, been taking on a lot more leverage since the pandemic.
On Wednesday we get the stress test results. Doesn’t sound like you really trust them that much.
Oh, I don’t pay attention to them anymore. I just think they’re a dog-and-pony show. I do. I’m just so frustrated. I mean, they don’t stress what they should. They don’t stress the stagflation environment. The severe distress scenario always assumes interest rates basically go down to zero, so I think they’re misleading. I think they are an enormous time sink for bank staff and supervisors, and the rules keep changing, usually in response to industry requests to weaken them, not to strengthen them.
So, no, I don’t pay attention to them anymore, and I tell investors not to pay attention to them anymore. You can pay attention to them only to the extent that this is the Fed publicly saying this is [the banks’] capability to withstand stress. So, to the extent that locks the Fed into some kind of bailout, if they get into trouble, it might be relevant from that perspective. But as a test of the financial strength of the bank, no, I don’t trust them anymore. I really don’t.
I’d just scrap them. I really would.
I don’t think I’ve ever said that publicly.
If you were in charge right now — you’ve talked about raising capital requirements, scrapping the stress tests. What else would you be focused on right now? How worried are you about AI?
I want to say something good about the big banks: They have consistently been industry leaders on cybersecurity, and that’s not just me saying that. A lot of people say that.
I mean, it’s essential to their business model, having good cyber information security infrastructure and governance. But also for people they do business with, requiring that of them too, I think, has done a lot to improve security. I want to give a nod to that. And so that is an area where I have much more confidence that the banks are self-motivated to deal with these problems.
So far, the regulators have been hands off, saying, “This is evolving technology. We’re not going to put out guidance right now.” At this point, maybe that’s the right decision.
And there may be a big hack tomorrow, and I’ll be totally proven wrong. But I do think banks have their own strong motivation to deal with it, unlike capital, where the more leverage they can take on, the bigger their shareholder returns. They clearly have self-interest in lowering capital rules. I think their self-interest is to have really tight information security, because they know they’re cooked if there’s a significant hack.
But it really does all come back to capital. Because as I said earlier, if you have strong capital levels, so many of these other problems just go away. You don’t have liquidity runs. You don’t have failures. But regulators have to stand strong, because the banks, it’s in their financial interest to drive those capital levels as low as possible. And if they don’t stand firm against it, we’re going to have another crisis.
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