- Sheila Bair is concerned that the current economic and health crisis will turn into a financial disaster.
- Bair, who played a key role in the government's response to the financial crisis a decade ago as head of the Federal Deposit Insurance Corporation, is concerned that regulators are focusing on the wrong things.
- At the push of big banks, regulators are trying to ease capital requirements for financial institutions while banks should support their balance sheets to protect themselves from a possible wave of corporate defaults, she said.
- Corporate debt is at record levels, and large parts of it are held by US banks.
- You can find more stories on the Business Insider homepage.
Sheila Bair knows exactly what a financial crisis looks like and how devastating it can be.
So if she says that she is worried that we may be approaching you, it is probably a good idea to pay attention.
Bair, who played a key role in the federal government's response to the financial crisis a decade ago, sees numerous danger signs of another such disaster, much of it in the form of corporate debt and the secured loan commitments that result from cutting and dicing debt and reassembled. She also fears that the big banks are currently making great efforts to ease capital requirements – and regulators are picking them up.
"I think regulators are focusing on the wrong things," Bair said in an interview with Business Insider on Tuesday. "My worst fear," she continued, "is that a health and economic crisis turns into a financial crisis."
And that's what regulators should focus on. "
Bair headed the Federal Deposit Insurance Corporation from 2006 to 2011. During her time there, she was part of the small group of policy makers trying to respond to the emerging crisis. It was her job to oversee the takeover and settlement of the numerous banks supported by the FDIC, which had failed during that time. It also tried and failed to convince the then finance minister, Tim Geithner, to use a similar process to deal with the then largest financial institutions, which were later described as "too big to fail".
No wonder that she is worried about the health of the banks again.
Banks are pushing for looser capital requirements
Part of their concern is that the big banks are using the pandemic to convince lawmakers and regulators to tackle one of their favorite issues: the amount of capital they need to have on hand. In the wake of the great recession, policymakers asked banks of all types to increase their capital stock in relation to their total assets, including loans, investments and real estate, to prevent another financial crisis. These institutions have since pushed to simplify these requirements, and in part have claimed that the rules limit their ability to lend.
This spring the Federal Reserve announced new regulations This allows large banks to temporarily ignore certain assets when calculating the amount of capital they need to have at their disposal. The move essentially enables them to keep less capital in the reserve, to borrow more from existing capital, or to buy more assets.
The big banks are also pushing Congress to rewrite the section of the Dodd Frank finance industry reform law that sets out capital requirements. The change, Senate Republicans are reportedly planning to include them in their next Coronavirus Stimulus billwould allow the Federal Reserve to change an alternative method of calculating the amount of capital banks that must be available than that which it has already optimized. The move would have a similar effect – giving the banks a freer hand.
Bair, who saw what happened when the big banks had a similarly free hand before the last financial crisis, considers such changes to be bad and unnecessary. Research shows that well-capitalized banks are not only better for financial stability, but continue to offer credit through the economic downturn that the US is currently going through, she said.
"I don't want to lower anyone's capital requirements," said Bair.
Looser rules do not necessarily lead to more lending
And the reduction in the amount of capital that the big banks must have in stock won't necessarily lead to more loans to consumers and small businesses, she said.
The banks that typically lend to these types of customers are the regional and local institutions, she said. These banks would not be affected by the proposed changes.
In the meantime, the big banks, which would be given more freedom, could simply use it to invest in US Treasury bills, for example, and the difference between what the government pays in interest and the meager amounts they pay to their depositors, in your pocket, she said. In fact, because the new rules that the Fed has introduced allow banks to exclude treasury bills when calculating their wealth, the rules essentially encourage them to only park their money there during this and future crises, she said.
"You could do this trade all day," she said. "I'm not saying it would be that extreme," she continued, "but I think that's going to be the trend now."
And regulators have and had a much better way of encouraging banks to borrow more, Bair said. Instead of allowing institutions to weaken their balance sheets, they could have ordered them to stop paying dividends to their holding companies during the coronavirus crisis. FDIC-backed banks paid $ 32.7 billion in dividends in the first quarter – almost twice as much as during the period – when the pandemic was in full swingThe Financial Times reported Last month. This money could have supported more than half a trillion dollars in additional deposits, which in turn could have been used to grant new loans.
The danger is that large banks may make risky investments or underestimate the risks they take when capital requirements are loose. In any case, the movements could blow up and sweep the financial system, just like 10 years ago.
The enormous corporate debt is a huge danger sign
And there is already a lot to fear about the existing financial system pressures, Bair said. Your biggest concern is the enormous debt of the companies. The total amount of debt held by non-financial corporations hit a record $ 10.5 trillion in the first quarteraccording to the Federal Reserve Bank of St. Louis. It's unclear how much of this amount is held by banks, but it's almost certainly a big part.
As part of its response to the coronavirus crisis, the Fed stepped in to stop corporate debt markets and buy bonds from hundreds of companies. This move sparked a new wave of corporate bond issuance this spring.
The Fed cannot support this market forever, Bair said. If the economy continues to stall, the institution risks hindering structural changes that need to take place and staying in companies that are essentially zombies and have no real chance of a comeback.
Even if the Fed continues to intervene in corporate bond market share for the time being, the big banks are exposed to other corporate bonds that could hurt them. For example, many companies have lines of credit with banks or other types of credit relationships.
And then there are leveraged loans and the associated collateralized loan obligations or CLOs. Leveraged loans are granted to companies that are already heavily indebted or considered to be low credit risk. CLOs are similar to the notorious Collateralized Debt Obligations [CDOs] that exploded in the financial crisis a decade ago. But instead of being amalgamated by mortgages that are then layered and sold by layer, CLOs are rated leveraged loan collections that are also sold by layer.
Banks hold many leveraged loans and CLOs
Both types of instruments could prove dangerous to the financial system if the economic situation forces companies to default on a massive scale.
According to a Fed study last year, U.S. banks and their holding companies held more than $ 110 billion in CLOs in 2018 that were issued in the Cayman Islands alone. It is very likely that their overall exposure to these derivatives is much larger than that of Frank Partnoy pointed out in a recent play in The Atlantic.
The U.S. banks also directly held leveraged loans of approximately $ 760 billion at the end of 2018, primarily in the form of revolving lines of credit, and additional loans of $ 65 billion that they said a Financial Stability Board report at the end of last year. Overall, the combination of CLOs and leveraged loans was 60% of their capital for the average major bank in the most important financial markets.
"If [companies] get into trouble, this could cause many problems for banks," said Bair.
The fact that regulators are currently focusing on easing capital requirements rather than taking sensible steps to support banks' balance sheets and help them weather a possible storm of defaults shows the extent to which their thinking has been distorted said Bair. They essentially identify themselves and empathize with the companies that are supposed to keep them at bay. Regulators need to recognize that what is in the interests of banks is not necessarily in the public interest, she said.
Banks are in the business of increasing their return on equity. Looser capital requirements help them do this – but they could also get them into trouble.
It is up to Congress and regulators to protect the general public from the risk of financial collapse, Bair said.
"These [interests] are inherently divided," she said.
But she is particularly frustrated that the big banks are currently pushing for such loose regulations. With the pandemic still raging, millions of unemployed and unemployment benefits running out, Congress, in particular, has to worry much more than addressing banks' pet problems.
"I think a lot of things are cynical," she said. "I think they're using the pandemic to get things that have been on their wish list for a long time. And shame on them."
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