I joined the Federal Deposit Insurance Corporation (FDIC) Board as Vice Chairman in August 2005 and was confirmed as Chairman in November 2012. I have served the FDIC both when banks were enjoying record profits, and when the US financial system was on the verge of collapse. Since the crisis, important reforms have put the US banking industry on a stronger footing, and banks again are highly profitable. I believe we are now at a point in the cycle when financial regulators need to be especially careful.
The boom years and the crisis
When I joined the FDIC Board, the United States was experiencing a boom in housing prices. Banks were in the midst of a six-year string of annual earnings records that spanned 2001 through 2006. Between mid-2004 and early 2007, not one FDIC-insured bank failed, a record unmatched in the FDIC’s history. The percentage of banks on the FDIC’s problem bank list during 2006 was at record lows.
This prosperity may have encouraged banks and regulators to view the industry through rose-colored glasses. Whatever the reason, a buildup of significant risk in banks and other financial institutions went unaddressed. A number of large institutions operated with excessive financial leverage and inadequate liquidity. The securitization of large volumes of poorly underwritten mortgages, and the growth of an opaque network of credit derivatives backing those securitizations, made risks more interconnected. The result of all this, when the housing bubble burst, was taxpayer bailouts of the financial sector on an unprecedented scale and the failure of some 500 banks.
The bank regulatory framework in the pre-crisis years did not provide adequate safeguards for financial stability, and the US paid a high price. As a result of the crisis and ensuing recession, nearly 9 million people lost their jobs, more than 12 million foreclosures were started, and millions of households owed more on their mortgages than their homes were worth for many years. Most estimates put the loss of US gross domestic product (GDP) from the crisis at between $10 trillion and $15 trillion. All of this occurred despite unprecedented assistance to financial institutions from the Federal Reserve System, Treasury Department and FDIC. Without such assistance, many more large financial institutions would have failed, and the US economy would have faced a catastrophe.
The core post-crisis reforms
The US federal banking agencies implemented a number of reforms to address weaknesses in the pre-crisis regulatory framework. Many of these reforms were directed primarily at large institutions. The core reforms address risk-based and leverage capital, liquidity, proprietary trading, margin for non-cleared swaps, and tools to enable the orderly resolution of systemically important financial institutions (SIFIs) to prevent taxpayer bailouts. I will direct my comments to capital and liquidity.
Capital absorbs losses and reassures counterparties about a bank’s viability. It supports a bank’s ability to lend and grow prudently, and helps address moral hazard problems by ensuring banks have meaningful equity stakes at risk. The banking agencies strengthened the quality of regulatory capital and the level of risk-based capital requirements. The agencies also required large or internationally active banks to meet an enhanced supplementary leverage capital requirement that accounts for certain off-balance-sheet assets.
Strengthening leverage capital requirements for the largest, most systemically important banks in the United States was among the most important post-crisis reforms. In April 2014, the FDIC, Office of the Comptroller of the Currency (OCC) and Federal Reserve jointly finalized a rule that required the eight US global systemically important banking organizations (GSIBs) to satisfy a supplementary leverage ratio capital requirement of 5 percent at the holding company and 6 percent at their insured depository institutions. This simple approach has served well in addressing the excessive leverage that helped deepen the financial crisis.
The strengthened risk-based and enhanced leverage requirements complement each other. Risk-based capital is risk sensitive but also complex, and is premised on the idea that the risks facing banks can be reliably measured; leverage capital is not risk sensitive, but is simple and provides assured loss-absorbing capability.
The crisis was also a reminder of the dangers to banks of operating with insufficient holdings of liquid assets, and of excessive reliance on short-term and potentially volatile funds to finance lending and investment activities. There were no regulatory liquidity requirements in effect for large banking organizations before the crisis. The agencies addressed this by finalizing the Liquidity Coverage Ratio rule to require sufficient liquid-asset holdings to meet short-term periods of liquidity stress. The agencies also have proposed the Net Stable Funding Ratio (NSFR) rule to constrain the extent of longer-term funding imbalances between assets and liabilities.
The post-crisis performance
The core reforms have been strongly in the public interest. Large banking organizations operate with roughly twice the capital and liquidity relative to their size than they did entering the crisis. They are less likely to fail, less likely to trigger destabilizing counterparty runs, and are better able to be a source of credit during a future downturn.
Along with stronger capital and liquidity, US banks are enjoying strong performance. Excluding one-time tax effects in the fourth quarter of 2017, net income at insured banks grew at an annualized rate of 6.2 percent during the three years 2015–2017. Underlying profitability continued to improve, as pre-tax return on assets in 2017 was 1.54 percent, up from 1.51 percent in 2016, 1.49 percent in 2015 and 1.46 percent in 2014. An increase in net-interest margins to 3.25 percent, up from a 2015 low of 3.07 percent, was an important earnings driver. Lower corporate tax rates—and, if it persists, the trend toward higher interest rates—should contribute to stronger bank earnings going forward.
At the same time, the US banking industry is supporting the credit needs of the US economy. Annualized loan growth at US banks during the four-year period 2014–2017 averaged 5.5 percent—significantly outpacing nominal GDP growth in each year. This comparison suggests that US banks are supporting economic growth rather than constraining it.
Large US banking organizations are supporting economic activity through their investment-banking subsidiaries as well. The top investment banks in the world by fee income all have been, for some time, subsidiaries of US globally systemic banking organizations. Supported by the bond-underwriting activities of these and other US investment banks, corporate-bond issuance for both investment- and speculative-grade debt has been at a record-setting pace during much of the post-crisis period, providing further support to economic growth.
In short, US banking organizations are recording strong earnings growth and are supporting US economic activity. The improved cushions of capital and liquidity at large US banking organizations are not a source of competitive weakness relative to banks in other jurisdictions. They are a competitive strength for our banking industry and our economy, and one that is directly attributable to the strong US response to the crisis as reflected in the core reforms.
Risks in the current outlook
The US is currently in the ninth year of an economic expansion, the third-longest US expansion on record. One barometer of economic optimism, the Dow Jones Industrial Average, gained more than 50 percent in value in a little more than two years as of this writing. An abundant supply of investible funds and low interest rates has supported the value of assets—not only stocks, but also bonds and real estate.
No one knows when or how the current expansion will end. Past experience, however, tells us that expansions do end, and that despite the good conditions we currently see, there are always challenges that could quickly change the outlook. Even though the current expansion appears more sustainable than the boom that occurred in the years leading up to the 2008 crisis, there are vulnerabilities in the system that merit our attention.
One vulnerability relates to the uncertainties associated with the transition of monetary policies—both here and abroad—from a highly expansionary to a more normal posture. The effects of a transition to higher interest rates are hard to predict but could be of significant consequence. The prices of stocks, bonds and real estate have been supported by a decade of low interest rates. Stock price-to-earnings ratios are at high levels, traditionally a cautionary sign to investors of a potential market correction. Bond maturities have lengthened, making their values more sensitive to a change in interest rates. As measured by capitalization rates, prices for commercial real estate are at high levels relative to the revenues the properties generate, again suggesting greater vulnerability to a correction. Higher interest rates also could pose problems for industry sectors that have become more indebted during this expansion.
Taken together, these circumstances may represent a significant risk for financial-market participants. While banks are now stronger and more resilient as a result of the post-crisis reforms, they are not invulnerable, and it would be a mistake to assume a severe downturn or crisis cannot happen again.
The road ahead for prudential regulation
Simplifying or streamlining aspects of prudential regulation without sacrificing important safety-and-soundness objectives is a worthy goal. Substantially weakening the core post-crisis reforms, however, would be a mistake. Those core reforms were put in place to address weaknesses in regulation that helped precipitate a financial crisis that no one wishes to repeat.
The rules at issue are both substantive and important—the largest banking organizations are not voluntarily holding the enhanced capital and liquid-asset cushions they now hold. Some have made clear that they would operate with less capital and less liquidity if the rules permitted. If and when some banks go down such a path, others will be pressured by their shareholders to do so as well, to boost return on equity by operating with less capital, or by holding fewer highly liquid but low-yielding assets.
Recent proposed changes to capital regulation for large, systemically important banking organizations include removing central bank exposures, Treasury securities and initial margins from the calculations of the Enhanced Supplementary Leverage Ratio (eSLR), and lowering the ratio itself, as proposed by the Federal Reserve and the OCC. Such proposals would substantially reduce the capital requirements for the largest banking organizations, in particular for their bank subsidiaries for which deposits are federally insured and the failure of which would implicate FDIC resolution mechanisms. They would significantly weaken the resilience of large, systemically important banking organizations and the financial system.
I have been reminded of a speech I gave in May 2006 at a meeting of the Conference of State Bank Supervisors. The subject matter was Basel II, a capital framework that would have substantially reduced capital requirements. The speech included the following statement:
It seems to me the statement in that speech remains relevant today.
The US banking industry has transitioned from a position of extreme vulnerability to a position of strength. Operating with the stronger cushions of capital and liquidity required by the post-crisis reforms, large US banking organizations are experiencing strong earnings growth and are providing support to the US economy through their lending, investment banking and other activities. Moreover, they are better positioned to support economic activity in the next downturn and avoid a financial crisis, such as occurred in 2008.
All of us have a stake in preserving these hard-won improvements in the strength and stability of our banking system.
S&P Dow Jones Indices LLC, Dow Jones Industrial Average [DJIA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DJIA, April 30, 2018.