Interview: “Nobody is too big to fail”

The Asian Banker (TAB): How do you see the banking sector today compared to the pre-Lehman days in terms of size and overall stability?

Barney Frank (BF): First of all, banks are much better capitalised. The likelihood of incurring debt that they cannot pay off is lesser; in particular, there is much better regulation these days of financial derivatives. That was what went out of control eight years ago. What happened then was that the activity grew without much regulation. Now they’re regulated much better. That I think is a very important feat. In addition, banks cannot conduct this derivative activity for their own purposes—Volcker rule as it’s called. So that’s the regulation of derivatives as part of the restriction on banks. Second, we no longer trust banks to make their own choices about how to control their indebtedness. We believe that what happened in the previous period was that financial institutions and not just banks got indebted far beyond what they could keep track of, or beyond what they could pay off. That’s been the major change.

TAB: You were the chairman of the House Financial Services Committee from 2007 to 2011, and famously known for co-sponsoring the Dodd–Frank Wall Street Reform and Consumer Protection Act. This piece of legislation has had great impact on financial institutions here in Asia as well. Now, eight years later and six years after the Act, as you reflect on the process that financial institutions have gone through, what are some of the lessons you have learned? The aftermath of the Lehman Brothers collapse created the worst financial crisis in modern history. But there are still detractors who say that a big bank needs to be broken up. Has Dodd-Frank cured the issue of “too big to fail”?

BF: The biggest lesson we have learned is a general one: that financial regulation has to keep up with financial activity. The mistake we made in America was not to respond to new forms of financial activity that came up. In particular, you had the liquidity outside the banking system and you had—this is very critical—great advances in information technology. Much of what caused the problem couldn’t have happened 20 years earlier because you did not have the information technology to package all of these loans into various complex derivatives and sell them.

But some people get the question wrong. The lesson we learned was, it is not the size of the financial institution that is the problem. It is the size of the indebtedness incurred. The very large financial institution that has no significant debt obviously is not a problem. What we decided we needed to do was acquire safeguards against them incurring huge debts. The problem after Lehman Brothers was AIG, which turned out to owe $170 billion that it could not pay out in credit default swaps.

Hence, we have done two things in the bill. First, the overall institution has to be much better capitalised. The very large institutions have higher capital-to-asset ratios than the small ones. Second, where derivatives are concerned, individual transactions have to be better financed. There have to be margins on individual trades considering many trades go through exchanges, which of course provide financing. 

Also, we realised that under the new system, when you can securitize a loan, the discipline that the lender would impose weakens because the lender is no longer as responsible for losses. So one of the things we mandated was for regulators to impose various forms of loss protection, of risk retention. So for lenders who made loans and then securitized, there had to be provisions that if those loans were not paid off, then it wasn’t just the investors who got hit, the people who securitized had to pay. 

As to breaking up the big banks, I have said that I am very critical of those who just say that without saying to what level. I wrote an article for the Washington Post a couple of weeks ago where I said, “You say you want to break up the banks, but how small do they get?” Lehman Brothers after all, started off with $600 billion in assets. Do we have to break up every bank so that it’s no bigger than Lehman Brothers was then? So I think this notion that you have to break them up is wrong. What you have to do is substantially restrict the extent to which they can be indebted beyond their ability to pay their debts. 

TAB: While the Act was designed to prevent the failure of big banks or the “too big to fail” banks, it also exacts a regulatory burden on banks of all sizes, especially the regional banks that do not do the kind of business like big banks, such as propriety trading, which is now prohibited. What do you say to critics?

BF: The act is not designed to prevent failure in all occasions. We did want to make failure much less likely by limiting indebtedness, but we acknowledge that no matter how much you try, there may still be failures. What we said, what we ensured, was that if they are too big, they do fail. The problem was that they considered themselves so big that they to be subsidised and kept in business. The bill says that if a large institution gets so indebted that it cannot pay its debts, it fails, it goes out of business. The federal government steps in and takes over and it pays off some of the debts.  It recovers whatever it pays from other financial institutions. So, if AIG, despite our proposals, once again finds it couldn’t pay its debt, it would be out of business and the federal government would put it into receivership and take over it. So nobody is too big to fail. They fail, and we pay some of their debts.

As to the other banks, yes, there are regulations for all other institutions, on consumer protection for example. However, the level of regulation is much tougher on the big banks. Capital requirements and the degree of regulation only apply to the larger banks. Banks under $10 billion in assets are regulated much less.

TAB: The act also introduced elements of extraterritorial impact on financial institutions outside of the US.

BF: Absolutely, especially because the world is one system. One of the things that we did when we were passing the bill was to talk a lot to other bankers and financial institutions in other countries, because if one country has much tougher regulations than other countries in one area then you’ll see institutions go to where there is less regulation—regulatory arbitrage we call it.  The basic principle that we try to say is this: we will monitor activity that has affected America. If the countries that we are dealing with have sufficient regulation, then we will defer to their regulation.

For example, with regard to the derivative activities of American banks conducted in foreign countries, the rule adopted says this, the derivative activities of banks like JP Morgan Chase in London–Whale will be subject to American regulation. But if the American regulators find that the host country has added regulation, we will allow that to be the governing principle, not ours.  So we do regulate the activity that happens in the US, and we regulate the overseas activity of American institutions because we are responsible if they fail. But where the local regulation is sufficient, we defer to that.

TAB: Do you see American banks becoming smaller? Due to regulation, American banks obviously will not grow any bigger, but there are banks in other regions. There was a time when some of the UK banks were among the largest in the world. Today the largest bank is ICBC from China with over $3 trillion in assets.  With all this movement towards breaking up big banks, how do you see the global banking order?

BF: We believe that the principles that we have adopted—and I hope the others agree—is making sure that things are fully capitalised beyond what people can pay. I think that there would be a trend in general in that direction as far as we’re concerned. American banks have been insisting that they follow these rules wherever they are. As long as the American taxpayers and the American economy are affected by a bank wherever it is operating, we will insist on regulating it to a great extent.  For foreign banks in the US, we are going to regulate. We don’t want banks to carry debts that they cannot pay off in the US.

As far as banks in other countries are concerned, there isn’t a lot that we can do or have to do. China, obviously, is a very different model. I would hope the Chinese model would evolve more in a market-oriented direction. I think that Chinese banks have been used to pursuing economic growth and have been lending mainly to promote growth in many ways rather than what we would think would be more prudent. That is up to the Chinese. There is not much that we can do about that nor have an urge to do anything about.

TAB: In terms of the global banking order, for what used to be the global mega banks, are those days gone? Are banks going to be more focused on regional areas rather than global? Is the global universal bank no longer the business model to adopt?

BF: No, I think we will have some banks, a handful of banks that will have the capacity to work internationally. I think it depends on the enterprises they are servicing. There will be companies that will be global banking services. There are smaller companies whose activity do not transcend regions that will be perfectly well served by regional banks. So that very well seems the way to go. We worry about people deciding where to do their banking, whether or not in areas where they are underregulated, but I thought the decision by HSBC to stay headquartered in London rather that in Hong Kong was important because it was a rejection of the notion that they should make that decision based on where they could be less regulated. So I would hope that would be the rule.

I am a board member of a regional bank in America called Signature Bank, and it’s lending overwhelmingly in the New York City metropolitan area with no international operations because there are needs to be met by the region, and that’s what we do.

TAB: How do you see Dodd-Frank evolving in the future, come the next election?

BF: If a Democrat wins, it will become a permanent part of the landscape. Right now many institutions are happy with it and they are recognising that you will have deal with it. If a Democrat is elected, and it will be a she, she will implement it very firmly. So the way it will evolve is that it will become a part of the situation that people will accept, and there are powers in the Act that can be invoked to deal with particular institutions that are most likely to get into trouble. I think you will see regulators ready to claw those powers and perhaps say to the very large institutions, “We are very worried about you.” We don’t break up all banks arbitrarily or impose “one size fits all.” But there are powers to order particular institutions to reduce in size either by becoming less complex or just becoming smaller. I believe that over the next 10 years, those powers will be invoked for one or two institutions.

TAB: But what if the opposite happens?

BF: If the Republicans run the House, Senate and the Presidency they would cut back on it substantially and would go back to the underregulated system. Once elected, Hillary Clinton has said that she would go one step further. The law does give the regulators the power to make banks divest some pieces. She would make it easier to do that. That is basically the law now so that regulators can avoid a crisis. I agree with her, that we increase that power and give regulators the ability well before a crisis situation. But if a Republican takes over, the Act will be substantially dismantled. I do not think that’s likely but it’s possible. I do not think that they would head on with a new law but they could  put the Act away to a point where it would be much less attractive.

TAB: For the Asian Banker Summit in May, what are some of the key messages that you will be bringing to the audience here in Asia?

BF: I will describe what we have done in the United States, on what we recognised, which is to allow financial institutions to play its very important financial intermediary role without endangering the rest. The government does not make business decisions; we let the financial industry make the business decisions. I’ll focus on the indebtedness, and our hope that there will be common applications of these regulatory principles, because we do not want to intrude or dictate on other countries.

Our ways are not terribly prescriptive except for one area—we tell banks that they cannot extend mortgage loans to people who cannot pay them back.  Other than that, we are very much market-oriented in our bill. What we mostly did with derivatives was to try get people to conduct them through exchanges. That is more market-oriented rather than this individual one-on-one situation.