Simpler Banks Would Be Safer Banks: Fed's Hoenig

KANSAS CITY, Mo. — Tom Hoenig turned 65 last week, and will retire Sept. 30 as president of the Federal Reserve Bank of Kansas City. He's clocked 38 years with the Fed, the last 20 in his current job.

While Hoenig has always lived up to his plainspoken Midwestern image, over the past couple years he has amped up his opposition to easy monetary policy and sharpened his position on Too Big to Fail.

"We have, for some time, subsidized the largest institutions. That has misallocated resources, encouraged ever-larger institutions without capitalism being able to cleanse those that were not successful," Hoenig said in an interview. "We need to rethink that model."

Hoenig spoke from his office, which overlooks the vast and breathtaking National World War I Museum in Memorial Hill Park, just south of downtown Kansas City. His view also includes a new, but temporary, piece of sculpture that has many in the building buzzing. It's a huge, neat pile of 105 cargo containers that use color to spell out USA on one side and IOU on the other.

His successor has not yet been named, and Hoenig (pronounced HAH-nig; I've been mispronouncing it HOE-nig for years) hasn't decided what he'll do next. But it's a good bet he will continue to speak out about his latest plan to rein in systemically important financial institutions, which are known as SIFIs.

Hoenig insists his goal is not to break up the largest banks. Rather, he wants to make them, as he puts it, "less SI and more FI."

"People call it breaking them up. I call it separating the role of the commercial bank, which is payments system and intermediation. Those roles are protected and therefore subsidized, and should be separated from the high-risk activities like investment banking, trading activities and hedge fund activities," he said. Those activities should be funded by "private capital at risk and not be brought in as part of the safety net."

Hoenig's proposal is quite striking; it would fundamentally change the business. But before you dismiss it as impossible, consider this: our financial system melted down in 2008 because no one — executives, investors or regulators — had even a ballpark idea of how much risk institutions were taking or how closely they were linked to each other.

When the proverbial fan was hit that fall of 2008, one major institution after another — Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, Wachovia — was taken over, bailed out or merged into a stronger rival.

It was a very scary few months. And yet little has been done to ensure it won't happen again. In July 2010 Congress passed the Dodd-Frank Act, which puts the biggest financial firms in a special class and subjects them to "enhanced supervision" and higher capital requirements. The government has new powers to liquidate failed firms and the big guys will be required to map out in a living will how they could be unwound.

But does any of that make these institutions easier to supervise? Does any of it make them less opaque and complex? Is the system any safer?

Hoenig argues an adamant no.

"This is at least the sixth time we have enhanced supervision in my career," he said. "We need to learn from our mistakes. We need to make supervision simpler, easier to understand and enforce."

Hoenig proposes dividing the financial services sector in two: lending, deposit taking, securities underwriting, wealth and asset management would be handled by commercial banks while trading, dealing and brokerage would be offered by investment banks.

Only banks would have deposit insurance and access to the payments systems.

"We would still have large banks," Hoenig said. "But I think the community banks and the regional banks would have a more level playing field and be able to compete more aggressively with the larger institutions."

Hoenig's idea, which he has been working on with Chuck Morris, an economist at the Kansas City Fed, will conjure the Glass-Steagall Act for some readers. That post-Depression law separated commercial from investment banking. But since banks would still be able to underwrite securities, it might be more accurate to think of this as repealing the Gramm-Leach-Bliley Act of 1999, which opened the door for all types of financial companies to combine.

I had two big questions for Hoenig. First, aren't lousy credit decisions behind most bank losses, and if so, why would it be safer to narrow the focus of banks on lending?

Hoenig turned my question on its head.

"Lending is very risky. That's why you need to concentrate on it," he said. If credit quality was all that regulators, and bankers, had to worry about, they'd do a better job at it.

"When you are doing everything, and you have this trading over here where you get your return on equity, and you have your lending over there, you are not paying attention to it, and you get into trouble."

Hoenig also views lending as a long-term relationship business in which the bank's and the borrower's interests are aligned; both win if the loan is paid off. By contrast, trading has a short-term horizon and is often adversarial; only one side earns money.

It is impossible for supervisors to stay on top of fast-moving investment banking operations; policing a traditional bank is much easier. And it would be easier still if the government adopted much simpler regulations, particularly capital rules, which Hoenig thinks should be stripped down to their essence: equity over assets.

To be honest, Hoenig's plan wouldn't require changes at many banks, because most don't do the sort of trading he's trying to nudge outside the safety net.

Still, my second concern is that policymakers can't simply draw a line around permissible banking activities and forget about the rest of the financial services business. Hoenig gets that, and is proposing some fundamental changes to key pillars of the shadow banking system, too.

For one, Hoenig would force money market funds to be revalued daily. No more assuming they are an asset that can never go below par.

"It's not a deposit, it's an investment," Hoenig said of money market funds. "I don't want to have a pretend number, and when you break it, all hell breaks loose."

That's what happened in that terrible fall of 2008 when Reserve Primary Fund "broke the buck." It caused such a panic the Treasury Department was forced to step in and guarantee all the money in these funds for three months. The guarantee was extended and finally lapsed in September 2009.

Under his plan, Hoenig says, "people would know what was going on. Right now they think, 'Here is what I get. It's safe. They are not going to break the buck.' We wouldn't give you that guarantee anymore. You are going to move with the market and you will know that up front."

This would make the shadow system more stable, Hoenig's collaborator Morris said in a separate interview. "It would diminish runs," he said. "There would be no advantage to get ahead of someone else ahead in line in terms of getting the money out."

Hoenig and Morris are also proposing to roll back some bankruptcy rules to 2005 when an act of Congress, the Bankruptcy Abuse Prevention and Consumer Protection Act, made it easier for creditors to make a claim on real estate-related securities used as collateral for certain short-term secured loans. That opened the door for assets like mortgage-backed securities to serve as collateral for repurchase agreements, which in turn are held by money funds.

Given their short maturities, usually overnight, repos have to be backed by high-quality, liquid assets. Back in 2005, most people still considered mortgage assets safe investments, so it isn't all that surprising that Congress decided to include real estate-related securities in the class of assets creditors could seize when a borrower goes into bankruptcy.

But the move fueled the repo market, and Hoenig thinks it's about time to douse that fire.

Under his plan, real estate-related securities would be frozen just like most other assets in a bankruptcy and would no longer be attractive collateral for repos.

Morris said the change would make a direct dent in TBTF. "It would limit the amount of interconnectedness by limiting the amount they could all lend to each other very short term," he said.

If you think Hoenig is missing the benefit diversification can provide, think again.

"Diversity that actually reduces risk is a very rare thing," he said. "Often it just concentrates risk."

To illustrate he points to the vehicles banks created to move assets off their balance sheet, often in an attempt to lower their regulatory capital requirements. These units were often backed by a letter of credit from the bank, lines that were called when the units got into trouble.

"Diversity is actually going into activities where one is procyclical and the other is countercyclical, so that you have something that leaves you whole," he said. "When it's all procyclical and you are just doing more of it, it all collapses in on you, and that's what we just finished doing."

Morris added that even diversity that reduces risk has a downside. "We saw in the crisis how many boards of directors really never understood what their organizations were doing because they were so complex," he said. "So you can diversify, and that's fine, but there are these other factors that come with the diversification and they offset the benefits of diversification, like complexity."

OK, but doesn't the United States need big banks that can go head-to-head with rivals abroad?

"Look at them [foreign banks] today and tell me it's better. Are they more competitive? Are they taking market share away from us, or are they in trouble up to their eyebrows and Europe is suffering?" Hoenig said. "You always can compete best from a position of strength."

Then to put his point into verbal bullets, Hoenig firmly pressed his hand to the table and said: "Size, secondary. Strength, primary."

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.