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FSC 2018 – Keynote Dennis Kelleher

The first keynote at the Financial Stability Conference 2018 delivered Dennis Kelleher, President and CEO of Better Markets, Washington D.C. The prominent critic of Wall Street gave deep insights on what’s going on in the United States as regards financial regulation under the Trump administration.

Financial Stability Conference 2018
31 October 2018
Keynote I  –  Out of the Box

State of Financial Reform: A View from the United States

Dennis Kelleher, President and CEO, Better Markets, Washington D.C.

Dennis Kelleher started out his keynote on the remark that this conference takes place at quite a dangerous time given economic and financial systems that have no positive effect for the majority of citizens. Many people still suffer from gnawing economic anxiety and insecurity caused by the financial crash of 2008 and its aftershocks. Inequality is vast and increasing and there is a real fear that future generations will be worse off when their circumstances are already declining today. Such an environment breeds fear and hostility and fuels social and political turmoil that is roiling the US, Europe and too many other countries. Moreover, it causes people, or rather voters, to do things they would not if their economic conditions and prospects were better and improving. Those economic, social and political facts make the conference‘s subject of financial stability one of the most critical topics facing the world today. That is because financial stability, financial reform and financial rules are but means to achieve the most important social, political and economic goals of supporting the productive economy, producing sustained and durable growth, protecting investors, consumers and workers as well as creating economic security, opportunity and widespread prosperity for all people. Those are the means to the ends for a better, more broadly available quality of life for all citizens, which lie at the core of financial stability and make these issues so important.

In this regard, Dennis Kelleher then went on to specify what exactly is at stake. Just ten years ago the fifth largest investment bank in the US, Lehman Brothers, collapsed into bankruptcy and ignited the worst financial crash since 1929 and caused the worse economic downturn since the Great Depression in the 1930s. That is why the recovery has been so long and painful and is still ongoing. This was not a cyclical downturn of a typical business cycle, but a historic financial, economic and human catastrophe. To capture the scope of that disaster, Better Markets did the very first study on the costs of that crash in 2012 with an update in 2015. That study demonstrated in detail that the costs of the crash just to the US are going to be more than 20 trillion US dollars. Yet, however astronomically high the dollars figures are, they do not tell the real story of the human wreckage, which was far-reaching and tragic. By October 2009, just months after the collapse of Lehman Brothers, the real unemployment rate reached 17 percent, which meant that there were 27 million Americans out of work or forced to work part time because they could not find full time work. Because many of those people were heads of households, this unemployment tsunami directly hit more than 50 million Americans. There were also more than 16 million foreclosure filings and almost 40 percent of homes were effectively underwater, worth less than the amount of the mortgage they were paying.

And, of course, as the economy collapsed, social needs and social spending skyrocketed, which caused massive deficits and debt. While there were lots of bad long-term trends before the crash, regarding wages and much more inequality, they were all made worse, often, much worse due to the crash. Unfortunately, many were also made worse by the policies undertaken in response to the crash. Those costs were not limited to the US, as European and other countries around the world also suffered tremendously.

The causes of the crash can be summarised as the result from the massive de-regulation of the financial sector, particularly the “Too Big To Fail” financial giants that were also too leveraged, interconnected and complex. The result was widespread, dangerous, unregulated and usually opaque risk-taking without even the minimally responsible safeguards or rules. The response in the US was to re-regulate those financial conglomerates in the Dodd-Frank Wall Street Reform and Consumer Protection Act. That law was passed in July 2010. However, like most laws, it was not self-executing, since it required numerous regulatory agencies to consider, propose, finalise, implement, interpret and ultimately enforce hundreds of rules. That took years and the law was only substantially implemented in the last years of the Obama administration. Indeed, many of the rules required by Dodd-Frank have still not even been finalised, for instance executive compensation rules, securities-based swap rules, credit rating agency reform and commodity speculation rules among others. Even many of those that were finalised have not been implemented or interpreted, much less enforced.

Nonetheless, when the Obama administration left office in January 2017, financial reform was being completed and the evidence overwhelmingly demonstrated that its two primary goals were being achieved. First, the most dangerous and unreasonable risks in the financial system had been significantly reduced, making a financial crash much less likely, due to Dodd-Frank rules, which increased capital and liquidity, regulated derivatives, required stress tests, living wills and liquidation authority, reduced short-term funding and counterparty exposure, protected financial consumers and investors, attacked predatory conduct, prohibited proprietary trading, regulated systemically significant banks and non-banks among other reforms. Second, the Dodd-Frank law had another, equally important purpose, but it is almost never mentioned: to ensure that the financial sector served its social purpose, justify its social costs and earn its taxpayer backing.

Thus, the rules were also meant to refocus the largest, most dangerous banks back to traditional banking activities and away from trading, which too often is little more than socially useless gambling designed to enrich a few thousand financiers and executives. Getting banks back into banking was a key objective.

It is important to remember that these financial protection rules are focused primarily on the handful of uniquely dangerous financial institutions in the US and the world. Those are the ones that have carved out an indefensible special exemption from the fundamental rule of capitalism that failure leads to bankruptcy. There are almost 6.000 banks in the US, but only about 40 of them have 50 billion US dollars or more in assets, which constitutes less than one percent of all banks. Fewer than that are so big, complex, interconnected and leveraged as to threaten the financial system and economy. Thus, properly regulating this handful of uniquely dangerous “Too Big To Fail” institutions is manageable if the political will to do so exists.

In contrast, none of that is to say that the law was perfect. No law is, particularly one that intends to re-regulate one of the most complex and sprawling sectors of the economy. However, it was the best law the US political system could produce at the time. And, all things considered, including that the most powerful, wealthy industry in the history of the world opposed it with unmatched ferocity, it constituted quite a good law that was well on its way to being properly implemented. Unsurprisingly with billions of US dollars in bonuses at stake for those too-big-to-fail firms, there continues to be an all-out attack on financial reform in the US. The laughable pretext for these attacks has been baseless claims about the onerous burdens that financial reform rules supposedly impose. There were critics saying over and over again that the law and rules would kill banks’ revenue and profits, which would prevent them from lending which would in turn kill economic growth and jobs. Another allegation claimed that it would put US banks at a competitive disadvantage globally. On the contrary, virtually every quarter, including the most recent third quarter of 2018, the biggest banks report record or near record revenues, profits and bonuses while increasing lending.

The US is now in the second longest economic recovery in history and the biggest banks are enjoying the fruits of that more than anyone else. The biggest US banks have not been hurt in global competition from the rules, as they continue to dominate the globe in almost all banking and finance categories.

Even though these repeated claims have been proved false by objective facts, the Trump administration has installed an army of deregulators and attacked financial reform with a blind ideological zeal disconnected from reality. These dangerous deregulatory developments are likely to result in a handful of enormous financial institutions once again by means externalising their costs and shifting them to taxpayers as well as greatly increasing the likelihood of a crash. Among other areas, the Trump administration has begun to deregulate lowering capital, weakening stress testing and living wills, allowing more proprietary trading, enabling more unregulated derivatives dealing, rolling back consumer and investor protections, reducing prudential regulation of systemically significant banks, neutering the regulation of systemically significant non-banks and the shadow banking system, defunding research and monitoring of the financial industry, stopping enforcing the laws, if not actually siding with the predators. One key example constitutes the de-regulation of systemically significant non-banks and the recreation of the two-tier regulatory system that incentivises and rewards regulatory arbitrage and a bailout culture.

One of the most important reforms of Dodd-Frank was the creation of the Financial Stability Oversight Council known as FSOC. Its mission is to identify and make sure known and emerging risks that threaten the financial stability of the United States are properly regulated. Importantly, the FSOC was not merely focused on preventing the last crash, but it was heavily forward-looking to think about possible future threats and to prevent the next crash. FSOC is also the only organisation in the US with the authority, mandate and duty to regulate the shadow banking system, which was at the core of causing and spreading the 2008 crash. The key mechanism for FSOC to achieve that is by designating systemically significant non-banks, which would then be subjected to heightened regulation.

Nevertheless, the Obama administration was very cautious in using the designation authority and only designated four systemically significant non-banks for increased regulation during its time in office, two of which were and should have been entirely non-controversial. One was AIG, which not only failed spectacularly and engaged in outlandishly irresponsible conduct, but also required an unlimited bailout, which ultimately amounted to 182 billion US dollars. Number two was GE, which, although with fewer headlines and less egregiousness, would have gone bankrupt without being bailed out as well. Three and four were global insurance conglomerates, Prudential and MetLife. Remarkably, the Obama administration de-designated GE, after it de-risked its operations and it was no longer systemically significant.

Thus, when the Obama administration left office, there were only three non-bank financial institutions in the US designated to be systemically significant. However, just months after the new administration was in office, President Trump‘s appointees to the FSOC voted in September 2017 to de-designate and deregulate AIG. Since then, it has de-designated the only other two non-banks identified as systemically significant. Today, according to the Trump administration, there is not one non-bank financial company in the entire US that is systemically significant, which is an obvious illusion. Worse, these actions recreate the two-tiered regulatory system that existed before the last crash, which enabled massive risks to build up in the shadow banking system.

Before the crash, banks were regulated by four separate regulatory agencies while non-bank financial firms engaging in high-risk, bank-like activities were lightly regulated. The impetus for making systemically significant banks and non-banks subject to a similar regulatory regime was intended to end the misaligned incentives and opportunities for regulatory arbitrage as heightened regulation forces those entities to internalise the costs of their high-risk behaviour. The FSOC was the answer to the regulatory arbitrage problem, which is how it became the governmental entity with the power and duty to analyse and designate for regulation systemically significant non-banks. Yet, the Trump administration is using FSOC as a mechanism to deregulate the non-bank financial sector and the FSOC‘s de-regulation of AIG will once again leave it unsupervised.

In fact, AIG will now be less regulated than it was before the 2008 crash and as soon as it was de-designated, it went on an acquisition spree. As Bloomberg News reported, „AIG is no longer too-big-to-fail, so now it wants to get bigger“. That, of course, was the basis Trump’s FSOC used to justify de-designating AIG, which immediately changed course. One well-known commentator captured how this action will incentivise a bailout culture that will lead to a bailout cycle: “Given AIG‘s centrality to the last crisis – and its plans to start growing again – it does seem a little ominous. What if the entire cycle plays out [again]? Regulations were loosened [in the years before 2008], AIG grew big and reckless, it crashed the economy [in 2008], [received massive bailouts,] regulations were tightened [2013], AIG got small and cautious [2016], everyone forgave it, regulations were loosened [2017], and now AIG can grow again. What comes next?” The answer is likely to be irresponsible risk taking, big bonuses, failure and more bailouts. There is little doubt that AIG and other financial firms will repeat their grossly deficient and irresponsible behaviour due to the perverse incentives created by the bailouts, lack of accountability resulting from the behaviour, the irresistible gains generated for executives and the lowering of regulatory requirements again.

Against this backdrop, it is still most important to understand that these events do not require evil actors in or motives by the private sector. It is the nature of markets and financial firms, individually and, ultimately, collectively. That is the unsettling, but undeniable, truth behind former Citigroup Chief Executive Officer Chuck Prince’s infamous and much misunderstood quote in July 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” That is, when a financial institution and its peers are making lots of money doing roughly the same thing, they have to keep doing the same or their revenues, profits, bonuses and stock will go down relative to their peer group. While doing otherwise may be tolerated by a board and stockholders for a short time, it will not last long as revenues, profits and stock drop relative to their peers.

In an oversimplified manner, this is what constitutes the history of Morgan Stanley in the 2000‘s. Morgan Stanley then pursued a business diversification strategy, seeking relatively stable revenues and profits from a broad mix of businesses that avoided the high-risk, high leverage and high return trading gambling that was taking off at its rivals. As revenues, profits, bonuses and stock lagged its rivals, the board ousted Mr. Purcell as CEO and in June 2005, reappointed Mr. Mack, clearly with the mandate to catch its rivals by doing what they were doing. As the Siren song of deregulatory music played, he got Morgan Stanley up and dancing to the tune of big proprietary trading, structured products, and subprime mortgage activities. However, just a little over two years later in the fall of 2007, Morgan Stanley was forced to begin recognising gigantic prop trading losses at the same time it was forced to take substantial subprime-related write downs. Eventually they were cumulatively so crippling that Morgan Stanley was on the verge of failure in the days following Lehman’s bankruptcy and required a bailout by the Fed to survive. To his credit, Mr. Mack recognised what had happened and in 2009 embraced financial reform, regulation and regulators. In fact, he went so far as to say “we cannot control ourselves. You [lawmakers and regulators] have to step in and control the Street. Regulators? We just love them.“

This cautionary tale and the broader history before, during, and after the 2008 crash demonstrate why banking regulators and supervisors as well as oversight, regulation, and enforcement generally are so critically important. They have to step in and slow the tune if not change the song or stop the “music” altogether, regardless of how much “dancing” the private sector is doing or wants to do. Without taking such independent and, at times, unpopular actions, the public interest is subordinated and exposed to the erratic and volatile dynamics of the marketplace, with devastating crashes the inevitable result.

After reiterating his initial statements, Dennis Kelleher concluded on the optimistic note that effectively regulating finance is not impossible, as in fact it has been done and done well before over a long period of time and it can be done again. After the Great Crash of 1929 and in the midst of the Great Depression of the 1930´s, numerous laws and rules were passed and lots of financial regulatory agencies were created in the US. The result was layers of protections between the high risk, dangerous financial activities on Wall Street and the hardworking families on Main Street. Importantly, those layers of protections were of different types: structural, regulatory and supervisory. Those reforms imposed some of the heaviest financial regulation and costs on the finance industry in the history of the world. Yet, the US economy boomed, the financial industry expanded very profitably, and the country built the largest middle class ever, all under extensive, unprecedented and costly financial regulation. That dynamic, broad based growth continued until the financial industry and its allies promoted and sold the myth about markets knew best and that the least regulation was the best regulation. That Wall Street-funded ideology ushered in an era of de-regulation, unbridled risk-taking and illegal activity rising too often to the level of criminality. Nonetheless, it must not be forgotten that for almost 70 years financial stability as well as the economy worked under those layers of protection. And due to those layers of protection, it took the industry and its allies enormous time, money and effort to tear them all down, which did not happen until 2000. For almost 70 years, there was financial stability and no catastrophic crashes, but it took just seven years after industry propaganda fuelled mindless de-regulation for them to cause another historic financial crash.

That history is powerful proof that regulation and financial stability are simply not the enemies of growth and prosperity, but that broad-based de-regulation is. That is why Dodd Frank re-regulated the financial industry and why the Trump administration’s deregulation is so dangerous and unwise. The truth is that strong, robust, effective markets require equally strong, robust, and effective rules that require transparency, oversight and accountability, establish a level playing field, enable competition, enforce a baseline of fair dealing, police market participants, engender investor confidence and ultimately lead to a balanced financial system. Such a system would ideally stimulate the productive economy and raise the standard of living of everyone. Dennis Kelleher ended on the note that this was the conference‘s true subject demonstrating why, in these dangerous times, the work of regulators, supervisors and policy makers is so fundamentally important.

The first question from the audience regarded further deregulation examples taking place in the US, that are specific on what is about to change in terms of the rules. Dennis Kelleher admitted that it is quite difficult to understand what is really going on in the US in terms of de-regulation. There is a somewhat created complexity to make sure people do not understand and to intimidate people from talking about these subjects and looking too closely. However, it is clear that de-regulation occurs in the three primary arenas of legislation, regulation and judiciary and one has to pay close attention to connect the dots. All the pillars that support financial reform are on the hit list of the Trump administration‘s agenda for de-regulation such as lowering capital, loosening up on stress testing and derivatives regulations implying a significant increase in unregulated opaque swap-dealing as well as in view of FSOC‘s powers. There are prospects that the bar on banks that are significantly regulated by the FED will be raised up to the threshold 500 billion US dollars implying to de-regulate banks above that threshold.

Another remark suggested that the US was ahead of Europe regarding the strength of its regulatory framework and that the US has been supervising banks in a much tighter way than Europe did before and arguably even after the crisis. Given this regulatory gap, the US could even de-regulate further and yet US banks would still be held to a higher level being ahead of European supervisory efforts without undercutting European banks on the competitive landscape. Dennis Kelleher was not too sure that regulation was better in the US pre crisis, but globally the race to the regulatory bottom before the crash did not reflect well on any country. At present, the real concern is that the cycle of such a race starts all over again with the example of Brexit and the associated desperation of London not to loose financial businesses, such that it is marketing itself by means of light-touch regulation while others cities do the same.

On top of it there is a political fragmentation within the EU leading to a lower common denominator of where people end up with regulation. In relative terms, it is no question of the US getting down to the European regulation level, but the bigger concern is that nobody is standing up for the gold standard of appropriate regulation in light of the social, political and economic context. In turn, economic discontent stemming from the after shocks of the last crash fuels efforts to de-regulate the financial industry, which, however, should be counteracted especially at times when revenues, profits and bonuses records are established and lending is increasing.

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