(This piece was co-authored with John Arensmeyer, chief executive officer of the Small Business Majority.)

A look at the numbers makes it clear that America’s economy relies on small business. After all, they create a majority of new jobs and employ four out of six American workers. And it’s not often political leaders miss an opportunity to tout the importance of this critical constituency.

Like all businesses, small businesses need credit to innovate, expand and prosper. That’s why the two of us — whose organizations often come down on opposite sides when it comes to political issues — both believe Congress must act to free up more small business credit. In particular, we think lawmakers should approve a regulatory relief effort that would allow credit unions to lend more money to small business. Doing so is simply common sense.

First, some background: Small businesses today face a dire credit situation. As a result of the financial crisis, not a single new commercial bank has received a federal charter in the last two years. During the 1990s and early 2000s, more than 100 banks received charters in a typical year. Since small businesses tend to rely heavily on start-up banks, this presents a problem. A survey from Small Business Majority found that more than 60 percent of small business owners find accessing credit to be a major challenge. Furthermore, a Pepperdine University study found less than one out of five business owners seeking a loan of $5 million or less got what they wanted. Even as the economy has recovered, some indexes of small business lending have actually dropped. Congress has made an effort to change this situation, such as creating a “small business lending fund,” but the numbers demonstrate it’s just not enough.

A pragmatic solution to this problem is to change outdated regulations that limit credit unions — democratically governed, nonprofit financial cooperatives — from meeting consumer needs. Right now, federal regulations bar credit unions from lending more than 12.25 percent of their assets to businesses. As a result, businesses that belong to credit unions have $13 billion less in capital available to them. Legislation in Congress would change this and allow credit unions to lend up to 27.5 percent of their assets. This change would have no additional risk for taxpayers and create thousands of new jobs at small businesses.

The proposals to change the regulations have significant bipartisan support. In the House of Representatives, 141 representatives with significant numbers from each party have signed on. In the Senate, 21 members, many more of them Democrats than Republicans, also support the bill. The real opposition to the proposal comes from banks that believe they’ll lose business. While these banks certainly deserve a place at the table, the banks’ own interests should not come ahead of those of small businesses or the economy as a whole.

The bottom line is simple: The slow recovery has not been good for the small business community. Getting more credit to small business owners can get them, and the national economy, on track to a full and sustained recovery. There’s no reason for Congress to delay action. Credit unions must be allowed to make more loans to small businesses.

The following op-ed was co-authored by William M. Isaac, senior managing director and global head of financial institutions at FTI Consulting.

A surprising decision of the Second Circuit Court of Appeals in the case of Midland Funding v. Madden threatens the functioning of the national markets in loans and loan-backed securities. The ruling, if it stands, would overturn the more than 150-year-old guiding principle of “valid when made.”

The effects of the decision could be wide-ranging, affecting loans beyond the type at issue in the case. It is in the banking industry’s interest for the Supreme Court, at the very least, to limit its applicability. And since the Madden case could deal a blow to preemption under the National Bank Act, it is time for the Office of the Comptroller of the Currency to voice an opinion.

Under the valid-when-made principle, if the interest rate on a loan is legal and valid when the loan is originated, it remains so for any party to which the loan is sold or assigned. In other words, the question of who subsequently owns the financial instrument does not change its legal standing. But the appeals court found that a debt buyer does not have the same legal authority as the originating bank to collect the stated interest.

In the words of the amicus brief filed before the U.S. Supreme Court on behalf of several trade associations:

Since the first half of the nineteenth century, this Court has recognized the ‘cardinal rule’ that a loan that is not usurious in its inception cannot be rendered usurious subsequently. ” U.S. credit markets have functioned on the understanding that a loan originated by a national bank under the National Banking Act is subject to the usury law applicable at its origination, regardless of whether and to whom it is subsequently sold or assigned.

This, the argument continues, “is critically important to the functioning of the multitrillion-dollar U.S. credit markets.” So it is. And such markets are undeniably big, with hundreds of billions of dollars in consumer credit asset-backed securities, and more than $8 trillion in residential mortgage-backed securities, plus all whole loan sales.

Marketplace lenders and investors have already raised intense concerns about the decision, but the impact could go further. The validity of numerous types of loan-backed securities packaged and sold on the secondary market could suddenly be called into question. Packages of whole loans, as well as securitizations, include the diversified debt of multiple borrowers from different states with different usury limits, and then sold to investors. But the Madden decision suggests those structures are at risk of violating state usury laws.

A possible interpretation to narrow the impact of the case would be for future court decisions to find that the Madden outcome only applies to the specific situation of this case, namely to defaulted and charged-off loans sold by a national bank to an entity that is not a national bank. Thus, only the buyers of such defaulted debt would be bound by state usury limits in their collection efforts, and the impact will largely be limited to diminishing the value of such loans in the event of default.

The Second Circuit decision might not, based on this hypothesis, apply to performing loans or to the loan markets in general. However, as pointed out in a commentaryby Mayer Brown: “it will take years for the Second Circuit to distinguish Madden in enough decisions that the financial industry can get comfortable that Madden is an anomaly.” The law firm’s commentary presented many potential outcomes, including that the Madden case could be “technically overturned” but without the high court providing explicit support for the “valid-when-made” principle. That “would be a specter haunting the financial industry,” according to the firm’s analysis.

In the meantime, what happens?

It would be much better for the Supreme Court to reaffirm the valid-when-made principle as a “cardinal rule” governing markets in loans, and the Supreme Court is being petitioned to accept the case for review.

But at this point, one would also expect the OCC, the traditional defender of the powers of national banks and the preemption of state constraints on national bank lending, to be weighing in strongly. The comptroller of the currency should protect the ability of national banks to originate and sell loans guided by the valid-when-made principle. But the OCC seems not to be weighing in at all and is strangely absent from this issue.

Everyone agrees that national banks can make loans under federal preemption of state statutes, subject to national bank rules and regulations. Everyone agrees, as far as we know, that the valid-when-made principle is required for loans to move efficiently among lenders and investors in interstate and national markets, whether as whole loans or securities.

In our view, the OCC ought to be taking a clear and forceful public position to support the ability of national banks to originate loans which will be sold into national markets.

To overhaul the Dodd-Frank Act, here is a radical and really good idea from House Financial Services Committee Chairman Jeb Hensarling, R-Texas.

The Financial CHOICE Act, Hensarling’s bill, says to U.S. banks: “Don’t like the endless additional regulation imposed on you by the bloated Dodd-Frank Act? Get your equity capital up high enough and you can purge yourself of a lot of the regulatory burden, deadweight cost and bureaucrats’ power grabs – all of which Dodd-Frank called forth.”

This Choice bill, which stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs, is not an order to increase your capital. Rather, it’s offering a logical choice.

Option 1: Put enough of your equity investors’ own money in between your creditors and the risk that other people will have to bail them out if you make big mistakes. And you may. Then, the government can’t claim you live on the taxpayers’ credit, and therefore, can’t justify its inherent urge to micromanage.

Option 2: Don’t get your equity capital up high enough and live with the luxuriant regulation instead. Think of this scenario as the imposed cost of using the taxpayers’ capital instead of your own to support your risks.

Depending on how large the explicit costs and the opportunity costs of the regulation are, you might think that the second option will yield higher returns on equity than option one or you might not. Some banks would choose one option, while some would choose the other.

Different choices would create diversification in the banking sector. They would also create highly useful learning over time. One group would end up sounder and make greater contributions to economic growth and innovation. One group would, over time, prosper more than the other.

Of course, we have to answer: how high is high enough? The 10 percent tangible leverage capital required to get the deal in the proposed legislation is a lot more than now, but is it even enough?

To consider the matter first in principle: surely, there is some level of equity capital at which this trade-off makes sense, some level at which everyone — even habitual lovers of bureaucracy — would agree that the Dodd-Frank burdens would be superfluous, or at least, cause costs far in excess of their benefits.

What capital ratio is exactly right can be, and is, disputed. Because government guarantees, mandates and interventions are so intertwined with today’s banks, there is simply no market answer available. Numerous proposals, based on more or less no data, have been made. The fact that no one knows the exact answer should not, however, stop us from moving in the right direction.

Among various theories, economist and New York Times columnist Paul Krugman proposed a maximum assets-to-capital ratio of 15:1, which means a minimum leverage capital ratio of 6.7 percent. Anat Admati, a Stanford finance professor, and Martin Hellwig, an economics professor at the University of Bonn, argued for a 20 percent to 30 percent leverage capital requirement with no empirical analysis. Economists David Miles, Jing Yang and Gilberto Marcheggiano estimated that the optimal bank capital is about 20 percent of risk-weighted assets, which in their view means 7 percent to 10 percent leverage capital, in a white paper. A group of 20 academics from finance and banking specializations suggested in a letter to the Financial Times a 15 percent leverage capital requirement. Economists Anil Kashyap, Samuel Hanson and Jeremy Stein proposed 12 percent to 15 percent risk-weighted, which means about 6 percent to 8 percent leverage capital. Professor Charles Calomiris suggested 10 percent leverage capital. Economist William Cline estimated the optimal leverage capital ratio at 6.6 percent to 7.9 percent. Robert Jenkins, a member of the financial policy committee at the Bank of England, gave a speech to the Worshipful Company of Actuaries entitled “Let’s Make a Deal,” where the deal was the “rollback of the rule book” in exchange for raising “equity capital to 20 percent of assets.” In my opinion, the 10 percent tangible leverage capital ratio in Hensarling’s bill is a fair stab at it.

In exchange for 10 percent leverage capital, it is essential to understand that the deal is not to eliminate all regulation. Indeed, there would still be plenty of regulation for banks taking the deal. However, option one is a distinctly better choice than the notorious overreaction and overreach of Dodd-Frank. In exchange for a further move to 20 percent leverage capital, one would rationally eliminate a lot more regulation and bureaucratic power.

It’s also essential to understand that the proposed capital ratio as specified in the Hensarling bill subtracts all intangible assets and deferred-tax assets from the allowable capital and adds the balance sheet equivalents of off-balance sheet items to total assets. Thus, it is conservative in both the numerator and denominator of the ratio.

In my judgment, the choice offered to banks by Chairman Hensarling’s proposal makes perfect sense. It goes in the right direction and ought to be enacted. Even the Washington Post editorial board agrees with this. In an op-ed, the editorial board writes:

More promising, and more creative is Mr. Hensarling’s plan to offer relief from some of Dodd-Frank’s more onerous oversight provisions to banks that hold at least 10 percent capital as a buffer against losses…such a cash cushion can offer as much—or more—protection against financial instability as intrusive regulations do, and do so more simply.

Very true!

Financial events cycle and financial ideas cycle. Here the United Kingdom is again, with real estate generating financial stress. As Patrick Jenkins rightly points out (“Open-ended property funds are accidents waiting to happen,” July 6), this vividly displays “the fundamental mismatch between a highly illiquid asset class and a promise of instant access to your money.”

This same mismatch has led us into trouble many times before. It is why the original U.S. National Banking Act of 1864 prohibited the national banks, as issuers of deposits and currency payable on demand, from making any real estate loans at all. “The property market is already too volatile,” says Mr. Jenkins. Yes, and it always has been.

Mr. Chairman, Ranking Member Waters and members of the committee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I spent 35 years in banking, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago and then 11 years as a fellow of the American Enterprise Institute, before joining R Street earlier this year. I have both experienced and studied many financial cycles, including the political contributions and reactions to them, and my work includes the issues of banking systems, central banking, risk and uncertainty in finance, housing finance and government-sponsored enterprises and the study of financial history.

“Detailed intrusive regulation is doomed to fail.” This is the considered and, in my view, correct conclusion of a prominent expert in bank regulation, Sir Howard Davies, former chairman of the U.K. Financial Services Authority and former director of the London School of Economics. Detailed, intrusive regulation is what we’ve got, and under the Dodd-Frank Act, ever more of it. “Financial markets cannot be directly ‘controlled’ by public authorities except at unsustainable cost,” Davies adds. Surely there is a better way to proceed than promoting unfettered bureaucratic agencies trying through onerous regulation to do something at which they are doomed to fail.

I believe the CHOICE Act offers the opportunity of a better way, precisely by offering banks a fundamental choice.

The lack of sufficient capital in banks is a permanent and irresistible temptation to governments to pursue intrusive microregulation, which becomes micromanagement. This has an underlying logic to it. In a world in which governments explicitly and implicitly guarantee bank creditors, the government in effect is supplying risk capital to the banks which do not have enough of their own. Suppose the real requirement in a true market would be for an equity capital ratio of 8 percent of assets, but the bank has only 4 percent. The government implicitly provides the other 4 percent – or half the required capital. We should not be surprised when the, in effect, 50 percent shareholder demands a significant say about how the bank is run, even if the resulting detailed regulations will not be successful.

However, the greater the equity capital is, the less rationale there is for the detailed regulation. In our example, if the bank’s own capital were 8 percent, the government’s effective equity stake would be down to zero. This suggests a fundamental and sensible trade-off: more capital, reduced intrusive regulation. But want to run with less capital?  You get the intrusive regulation.

In other words, the CHOICE Act says to U.S. banks:  “You don’t like the endless additional regulation imposed on you by the bloated Dodd-Frank Act. Well, get your equity capital up high enough and you can purge yourself of a lot of the regulatory burden, deadweight cost and bureaucrats’ power grabs which were all called forth by Dodd-Frank.”

CHOICE does not set up higher capital as a mandate or an order to increase the bank’s capital. Rather it offers a very logical decision to make between two options. These are:

1. Option One: Put enough of your equity investors’ own money in between your creditors and the risk that other people will have to bail the creditors out if you make mistakes. Mistakes are inevitable when dealing with the future, by bankers, regulators, central bankers and everybody else. The defense is equity capital; have enough so that the government cannot claim you are living on the taxpayers’ credit, and therefore cannot justify its inherent urge to micromanage.
2. Option Two: Don’t get your equity capital up high enough and instead live with the luxuriant regulation of Dodd-Frank. This regulation is the imposed cost of, in effect, using the taxpayers’ capital instead of your own to support your risks.

I believe the choice thus offered in the proposed act is a truly good idea. To my surprise, The Washington Post editorial board agrees. They write:

More promising, and more creative, is Mr. Hensarling’s plan to offer relief from some of Dodd-Frank’s more onerous oversight provisions to banks that hold at least 10 percent capital as a buffer against losses…such a [capital] cushion can offer as much—or more—protection against financial instability as intrusive regulations do, and do so more simply.

Very true and very well-stated.

Making the choice, banks would have to consider their cost of capital versus the explicit costs and opportunity costs of the regulatory burden. Some might conclude that Option Two would yield higher returns on equity than Option One; some will conclude that Option One is the road to success. I imagine some banks would choose one option, while some would choose the other.

Different choices would create a healthy diversification in the banking sector. They would also create, over time, a highly useful learning experience for both bankers and governments. One group would prove to be sounder and to make greater contributions to economic growth and innovation. One group would, in time, prosper more than the other. The other group will end up less sound and less successful. Which would be which?  I think the group with more capital, operating in relatively freer markets with greater market discipline, would prove more successful. But we would find out. Future think-tank fellows could write highly instructive papers on the contrast.

Of course, to establish the proposed choice, we have to answer the question: how much capital makes is high enough? For a bank to make the deal proposed in the CHOICE Act, it would have to have a tangible leverage capital ratio of at least 10 percent. That is a lot more than current requirements, but is it enough?

Consider the matter first in principle: without doubt there is some level of equity capital at which this trade-off makes sense—some level of capital at which everyone, even habitual lovers of bureaucracy, would agree that the Dodd-Frank burdens become superfluous or, at least, cause costs far in excess of their benefits.

What capital ratio is exactly right can be, and is, disputed. Because government guarantees, subsidies, mandates and interventions are so intertwined with today’s banks, there is simply no market answer available. Moreover, we are not looking for a capital level which would remove all regulation—only the notorious overreaction and overreach of Dodd-Frank. For example, the CHOICE Act requires to qualify for Option One that, in addition to 10 percent tangible capital, a bank must have one of the best two CAMELS ratings by the regulator—”CAMELS” being assessments of capital, asset quality, management, earnings, liquidity and sensitivity to market risk.

Numerous proposals for the right capital levels have been made. However, the fact that no one knows the exact answer should not stop us from moving in the right direction.

Among various theories and studies, the International Monetary Fund concluded that “bank [risk-based] capital in the 15-23 percent range would have avoided creditor losses in the vast majority of past banking crises,” and that this range is consistent with “9.5 percent of total leverage exposure.” Obviously, a 10 percent level is somewhat more conservative than that.

Economist William Cline recently concluded that “the optimal ratio for tangible common equity is about 6.6 percent of total assets and a conservative estimate…is about 7.9 percent.”

Paul Krugman proposed a maximum assets-to-capital ratio of 15:1, which is equivalent to a leverage capital ratio of 6.7 percent. Anat Admati and Martin Hellwig came in much higher, arguing for a leverage capital requirement of 20 percent to 30 percent – however, with no empirical analysis. Economists David Miles, Jing Yang and Gilberto Marcheggiano estimated optimal bank capital at about 20 percent of risk-weighted assets, which in their view means a 7 percent to 10 percent leverage capital ratio.

In a letter to the Financial Times, a group of academics asserted a requirement for 15 percent leverage capital, but a study by economists Anil Kashyap, Samuel Hanson and Jeremy Stein proposed risk-based capital of 12 percent to 15 percent, which means a leverage capital ratio of 6 percent to 8 percent. Banking expert Charles Calomiris proposed 10 percent leverage capital.

All in all, it seems to me that the 10 percent tangible leverage capital proposed in the CHOICE Act to qualify for Option One is a fair level. It subtracts all intangible assets and deferred-tax assets from the numerator of the ratio, and adds the balance sheet equivalents of off-balance sheet items to the total assets in the denominator. Thus, it is a conservatively structured measure.

In 2012, Robert Jenkins, then a member of the Bank of England’s Financial Policy Committee, gave a speech to the Worshipful Company of Actuaries entitled “Let’s Make a Deal,” which put forward the same fundamental idea as does the CHOICE Act. The proposed deal was a “rollback of the rule book” in exchange for banks raising “their tangible equity capital to 20 percent of assets.” He explained the logic as follows:

• “We all agree that too many bankers got it wrong.”
• “We acknowledge that too many regulators got it wrong.”
• So, the best solution is to increase the tangible equity and “in return we can pare back the rule book—drastically.”

Under the CHOICE Act, in exchange for 10 percent tangible leverage capital, along with a high CAMELS rating, the deal is, to repeat, not to eliminate all regulation, but to exit from the excesses of Dodd-Frank. We should view Dodd-Frank in its historical context, as an expected political overreaction to the then-recent crisis. Now, for banks taking Option One, there would still be plenty of regulation, but not the notoriously onerous entanglements of Dodd-Frank. In exchange for Jenkins’ suggested move to 20 percent leverage capital, one would rationally eliminate a lot more regulation and bureaucratic power—to pare it back, as he says, “drastically.” The proposed act is more moderate.

The CHOICE Act uses the simple and direct measure of tangible leverage capital. This is, in my judgment, superior to the complex and sometimes opaque measures of risk-adjusted assets and risk-based capital. Although, in theory, risk-based capital might have been attractive, in fact, its manifestations have been inadequate, to say the least. Risk adjustments assume a knowledge in regulatory bureaucracies about what is more or less risky that does not exist—because risk is in the future. They are subject to manipulations and mistakes and, more importantly, to political factors. Thus, for example, Greek sovereign debt was given a zero risk weighting and ended up paying lenders 25 cents on the dollar. The risk weightings of subprime MBS are notorious. Fannie Mae and Freddie Mac debt and preferred stock were given preferential risk weightings, which helped inflate the housing bubble—a heavily political decision and a blunder.

The deepest problem with risk weightings is that they are bureaucratic, while risk is dynamic and changing. Designating an asset as low risk is likely to induce flows of increased credit, which end up making it high risk. What was once a good idea becomes a “crowded trade.” What was once a tail risk becomes instead a highly probable unhappy outcome.

Of course, no single measure tells us all the answers. Of course, managing a bank or supervising a bank entails understanding multiple interacting factors. But for purposes of setting up the choice for banks in the proposed act, I believe the simplicity of tangible leverage capital is the right answer.

In my judgment, the proposed choice between Option One and Option Two makes perfect sense. It takes us in the right direction and ought to be enacted.

Thank you again for the chance to share these views.

R Street Distinguished Senior Fellow Alex J. Pollock testified July 12, 2016 before the House Financial Services Committee about the CHOICE Act, legislation that proposes to loosen regulatory controls on banks that choose to hold sufficient capital to offset their risk to the financial system. Video of Alex’s testimony, as well as Q&A about the Volcker Rules and other reforms to the Dodd-Frank Act, is embedded below.

House prices, commercial real estate prices, stock prices and bond prices are all very high. Remarkable asset-price inflations have been induced by the low, zero or negative interest-rates manipulations of central banks – needless to say, including the Federal Reserve. The U.S. Office of Financial Research recently warned of the systemic financial risks which accompany such low interest rates and elevated asset prices.

A century and a half ago, the great banking theorist Walter Bagehot quoted the saying that “John Bull can stand many things, but he cannot stand 2 percent.” When interest rates went as low as 2 percent, investors began to do foolish things which inevitably ended badly.

If 2 percent is a dire situation, how about 0 percent?

Will there be another financial crisis?  Of course there will. But when?  However much we speculate and however endless the talk about it, nobody knows. For although we can, by science, know with certainty and utter precision when and where the total solar eclipse will appear a year from now, no such science applies to the financial future.

Nonetheless, we can consider the long-term historical average, which is for financial crises to appear about every 10 years. As former Fed Chairman Paul Volcker so wittily said: “About every 10 years we have the biggest crisis in 50 years.” A decade is, it seems, long enough for human beings to forget the supposedly unforgettable lessons of the last crisis.

The last crisis peaked with the panic of 2008. Add 10 years to that, and you get the next crisis in 2018. That seems like a reasonable guess.

Comparing banking in the 1950s to today, we find giant changes that surely would have astonished the bankers of that earlier time. What’s the biggest and most important one?

You might nominate the shrinkage in the total number of U.S. banks from over 13,200 in 1955 to only about 5,300 now — a 60 percent reduction. Or you might say the rise of interstate banking, or digital technology going from zero to ubiquitous, or the growth of financial derivatives into hundreds of trillions of dollars, or even air conditioning making banking facilities a lot more pleasant.

You might point out that the whole banking industry’s total assets were only $209 billion in 1955, less than one-tenth the assets of today’s JPMorgan Chase, compared with $15 trillion now. Or that total banking system equity was $15 billion, less than 1 percent of the $1.7 trillion it is now. Of course, there have been six decades of inflation and economic growth. The nominal gross domestic product of the United States was $426 billion in 1955, compared with $17.9 trillion in 2015. So banking assets were 49 percent of GDP in 1955, compared with 83 percent of GDP now.

But I propose that the biggest banking change during the last 60 years is none of these. It is instead the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.

In 1955, commercial and industrial loans were 40 percent of total banking loans and real estate loans only 25 percent. The great banking transition set in after 1984. The share of C&I loans kept falling, down to about 20 percent of total loans, while real estate loans rose to about 50 percent, with a bubble-induced peak of 60 percent in 2009. In this remarkable long-term shift, the share of real estate loans doubled, while the share of commercial and industrial loans dropped in half. The lines crossed in 1987, three decades ago and never met again, despite the real estate lending busts of the early 1990s and of 2007-9.

The long-term transition to concentration in real estate would have greatly surprised the authors of the original National Banking Act of 1864, which prohibited national banks from making any real estate loans at all. This was loosened slightly 1913 by the Federal Reserve Act and significantly in 1927 by the McFadden Act — in time for the ill-fated real estate boom of the late 1920s.

The real estate concentration is even more pronounced for smaller banks. For the 4,700 banks with assets of less than $1 billion, real estate loans are 75 percent of all loans, about the same as their bubble-era peak of 76 percent.

Moreover, in another dramatic change from the 1950s, the securities portfolio of the banking system has also become heavily concentrated in real estate risk. Real estate securities reached 74 percent of total banking system securities at the height of the housing bubble. They have since moderated, to 60 percent, but that is still high.

In terms of both their lending and securities portfolios, we find that commercial banks have become basically real estate banks.

Needless to say, this matters a lot for understanding the riskiness of the banking system. The assets underlying real estate loans and securities are by definition illiquid. The prices of these assets are volatile and subject to enthusiastic run-ups and panicked, unexpected drops. When highly leveraged on bank balance sheets, real estate over banking’s long history has been the most reliable and recurring source of busts and panics.

A good example is the frequency of commercial bank failures in 2007-12 relative to their increasing ratio of real estate loans to total loans at the outset of the crisis in December 2007. From the first quartile, in which real estate loans are less than 57 percent of loans, to the third quartile, in which they are over 72 percent, the frequency of failure triples, and failures are nine times as great for the highest ratio quartile as for the lowest. In the fourth quartile, real estate loans exceeded 83 percent of loans, and the failure rate is over 13 percent, which represents 60 percent of all the failures in the aftermath of the bubble. The 50 percent of banks with the highest real estate loan ratios accounted for 82 percent of the failures.

Central to the riskiness of leveraged real estate is the risk of real estate prices falling rapidly from high levels — and right now those prices are again very high. The Comptroller of the Currency’s current “Risk Perspective” cites rapid growth in commercial real estate loans, “accompanied by weaker underwriting standards” and “concentration risk.”

The predominance of real estate finance in banking’s aggregate banking balance sheet makes that risk far more important to the stability of the banking system than the bankers of the 1950s could ever have imagined.

Thomas Hobbes (1588-1679), the great philosopher of the authoritarian state, in a famous metaphor portrayed the government as a dominating giant or Leviathan, animated by absolute sovereignty, and passing out rewards and punishments as it saw fit. It alone could control the unruly passions of the people and create stability and safety.

Today’s “administrative state”—or government bureaucracy, acting simultaneously as sovereign legislator, executive, and judge—brings Hobbes’ image of the giant vividly to mind.Nowhere is his metaphor more apt than in the government’s attempts at “systemic financial stability.” Hobbes’ 21st century acolytes include former Senator Chris Dodd (D-Conn.) and former Congressman Barney Frank (D-Mass.), whose Dodd-Frank Act sought to prevent financial crises, as Hobbes sought to prevent civil wars, by enlarging the giant. Now, as then, how to control the unruly passions, lust for power, and misguided enthusiasms of the state itself is left unanswered.

However, Congressman Jeb Hensarling (R-Tex.), who chairs the House Financial Services Committee, is now taking on Leviathan in the financial system with the proposed Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs (CHOICE) Act. If it seems unlikely that he could fell the giant altogether, perhaps he could limit and better control and confine it, at least with respect to banking and the people’s money. If he succeeded, the federal government would place more emphasis on competitive markets and less on the diktats of the central bank and regulatory bureaucrats whom Dodd-Frank made sovereign.

Writing his book Leviathan in 1651, in the wake of the English Civil War and the beheading of King Charles I, Hobbes had this to say: “By art is created that great LEVIATHAN called a COMMONWEALTH or STATE (in Latin, CIVITAS), which is but an artificial man, though of much greater stature and strength.”

He went on:

sovereignty is an artificial soul, as giving life and motion to the whole body; the magistrates and other officers of judicature and execution, artificial joints; reward and punishment (by which fastened to the seat of the sovereignty, every joint and member is moved to perform his duty) are the nerves.

Moreover,

Salus Populi (the people’s safety) its business; counsellors, by whom all things needful to know are suggested unto it, are the memory; equity and laws, an artificial reason and will; concord, health; sedition, sickness; and civil war, death.

Writing four decades before the founding of the Bank of England, Hobbes can be forgiven for not mentioning the central bank, which has since become a key element of sovereignty. We need to extend his metaphor to include it. We could say that the central bank is a kind of artificial heart pumping the circulating blood of credit and money, making sure to lend the government as much as it wants. It often pumps this blood of credit to an excessive extent, causing financial markets to inflate, be overly sanguine, then bust, constrict their flows and suffer the heart attacks of financial panics.

Three centuries or so after Hobbes, Leviathan developed a new capability: that of constructing vast shell games guaranteeing huge quantities of other people’s debt and taking vast financial risks, while pretending that it wasn’t doing this, and keeping this debt off the books. I refer to the  invention of government-sponsored enterprises like Fannie Mae and Freddie Mac, and to related schemes such as government-sponsored insurance companies, like the Federal Savings and Loan Insurance Corporation and the Pension Benefit Guaranty Corporation. All serve as Leviathan’s artificial stomach and gluttonous appetite for risk, causing in time obesity, flatulence, indigestion, and finally the heartburn of publicly admitted insolvency.

Although financial panics temporarily render Leviathan stunned and confused, in short order it resumes its energetic activity and ambitious pursuit of greater power. Writing legislation in 2010, in the wake of the financial crisis of 2007 to 2009, Senator Dodd and Representative Frank ordered Leviathan to make deep expansions into the financial sector. The people’s financial safety and concord became defined as a new supreme demand for “compliance” with the orders of government bureaucrats, who were assumed to know the right answers.

The Dodd-Frank Act was passed in 2010 on party line votes at a time of insuperable Democratic majorities in both houses of Congress. Shortly after voting it in, the Democrats suffered stinging losses in that year’s congressional elections. No subsequent Congress would ever have dreamed of passing anything remotely resembling Dodd-Frank, but financial Leviathan had already been put on steroids and unleashed.

Now comes Chairman Hensarling to try to bring financial Leviathan back under control. The CHOICE Act would reform Leviathan’s activity in a wide swath of financial areas. It would:

• Remove onerous Dodd-Frank burdens on banks that maintain a high tangible capital ratio (defined as 10 percent of total assets), thus creating a simple rule instead of the notoriously complex ones now in force.

• Force the Financial Stability Oversight Council into greater transparency by cutting back the power of this committee of regulators to make opaque decisions in secret.

• Correct the egregiously undemocratic governance of another bureaucratic invention, the Consumer Financial Protection Bureau, by giving it a bipartisan board and subjecting it to the congressional oversight and appropriations process that every federal agency should have.

• Require greater accountability and transparency from Leviathan’s heart, the Federal Reserve.

• Require cost-benefit analysis for new regulations and a subsequent measurement of whether they achieved their goals—imagine that!

• Repeal the “Chevron Doctrine” that leads judges to defer to federal agencies. This is essential, as bureaucrats make ever-bolder excursions beyond their legal authority.

• Take numerous steps to relieve Leviathan’s heavy hand on small businesses and small banks.

The CHOICE Act will likely be taken up by the House Financial Services Committee this fall—and be ready for further consideration if, as is forecast by most people, Republicans retain control of the House of Representatives in the upcoming election. The debates about the bill will be contentious and sharply partisan, with vehement opposition from those who love Leviathan. How far the reform bill can go depends on how other parts of the election turn out.

Will financial Leviathan grow ever fatter, more arrogant, and more intrusive? Or can it be put on a long-term diet by constraining its arrogance, correcting its pretensions, imbuing its artificial soul with behavior befitting a republic, and put in the service of a limited government of checks and balances?

The CHOICE Act is a good start at this daunting and essential project.

Image by Morphart Creation / Shutterstock.com

Today, Oct. 3, is the eighth anniversary of congressional passage of the act that created the famous or notorious $700 billion bank bailout program in the midst of financial panic of late 2008. In case you have forgotten, TARP stood for the Troubled Asset Relief Program, and the authorizing legislation was the Emergency Economic Stabilization Act of 2008. An emergency it was, with one failure following fast on another.

Eight years on, when we know that the panic passed, when house prices are booming again, when the stock market is high and life has gone on, it’s hard to recreate psychologically the uncertainty and fear of that period. Memories naturally lose their vividness and then fade altogether, making the next cyclical bust more likely.

The design of TARP originally was to quell the crisis by having the U.S. Treasury buy depreciated mortgage-backed securities from banks, removing these “troubled assets” from private balance sheets and thus giving them “relief.” When this was proposed, it was already clear that it was not going to work. The crisis had created insolvencies, with deficit equity capital. By buying assets from banks so they realized big losses, you were not going to fix their capital. Neither would lending them more money from the Federal Reserve fix their capital:  if you are broke, no matter how much more you borrow, you are still broke.

By September 2008, the British government already had decided it had to make equity investments in insolvent banks. This replicated the U.S. experience of the 1930s, when the Reconstruction Finance Corp., originally set up to make loans to troubled banks, realized it had to make equity investments instead, in the form of preferred stock. It also replicated the experience of Japan in the 1990s. As TARP was being debated, it seemed to me that the equity investment model was better than the proposed TARP design, and so it proved to be. The RFC overall made a profit on its bank investments, and so, as it turned out, did TARP.

But what Treasury Secretary Henry Paulson had told Congress in getting the legislation passed was that they were approving a program for buying mortgage securities. However, as Paulson revealed in educational crisis memoir “On the Brink,” even as these arguments were being made:

Ben Bernanke had told me that he thought that solving the crisis would demand more than the illiquid asset purchases we had asked for. In his view, we would have to inject equity capital into financial institutions.

Bernanke was right about that, but Paulson thought “we would sabotage our efforts with Congress if we raised our hands midstream and said we might need to inject equity.” Well, you can’t tell the elected representatives of the people what is really going on. When the act did get passed and signed into law Oct. 3, says Paulson: “I made sure to tell…the team: ‘Figure out a way we can put equity in these companies.’” And so they did.

Shortly thereafter, Paulson reflects, “I began seriously to doubt that our asset-buying program could work. This pained me, as I had sincerely promoted the purchases to Congress and the public as the best solution” and “dropping the asset-buying plan would undermine our credibility.” Instead, TARP proceeded by making equity investments in preferred stock.

By now, the TARP investments in banks are almost entirely liquidated at a profit to the Treasury. The program went on to make losing investments in the bailouts of automobile companies (which equally were bailouts of the United Automobile Workers union) and to spend money not authorized by statute on programs for defaulted mortgages. All in all, Oct. 3 launched a most eventful history.

“I had expected [TARP] to be politically unpopular, but the intensity of the backlash astonished me,” wrote Paulson.

Its birthday is a good time to reflect on TARP and try to decide what you would have done in Secretary Paulson’s place, had you been handed that overwhelming responsibility.

Photo by JFunk / Shutterstock.com

Financial technology – or “fintech,” in the modern parlance – may be seen as trendy, but computing technology has strongly influenced banking and finance for decades. Its effects include the creation of general-use credit and debit cards, going back to the 1950s, which we now take for granted worldwide; ATMs available any time and almost anywhere, going back to the 1970s; and the data capabilities that make structured mortgage-backed securities possible, going back to the 1980s.

Visa and MasterCard are considered leading fintech companies, which they are. Former Federal Reserve Chairman Paul Volcker once cynically remarked that ATMs were the only real financial innovation of recent times. Meanwhile, MBS vividly display the double potential of innovation, first for growth and then for disaster.

Investment banker J. Christopher Flowers has expressed the view that the current fintech boom will “leave a trail of failed companies in its wake.” Of course it will, just like the hundreds of automobile companies that sprang up a century ago or the myriad dot-com companies that mushroomed in the 1990s. The automobile and the internet were both society-changing innovations and the hundreds of failures are how we discover which are the truly valuable ideas and which aren’t. To paraphrase Friedrich Hayek’s memorable essay, competition is a discovery procedure.

Over time we will find out which innovations are real and which are mere fads. A key distinction in fintech, as in the financial world in general, is between those changes that make transactions faster, cheaper, more mobile and less bothersome (the “tech”), on the one hand; and those that make it easier to make loans and take credit risk (the “fin”), on the other. The former are likely to yield some truly useful innovations; the latter, which require lending people money that you hope they will pay back on time and with interest, is an old and tricky art. It is much easier to fool yourself about whether you are actually improving lending, as compared to technology.

Consider the idea of “lending money over the internet.” The “internet” part may invent something faster, cheaper and easier—just like the ATMs Volcker touts. The “lending money” part may be simply a new name for making bad loans, just as the dark side of MBS turned out to be.

So on one hand, we may have real innovation and progress, and on the other, merely endless cyclical repetition of costly credit mistakes. For example, the fintech firms LendingClub and OnDeck Capital presently find their stock prices about 80 percent down from their highs of less than two years ago, as they learn painful lessons about the “fin” part of fintech.

Nor is this distinction new. As James Grant, the acerbic and colorful chronicler of the foibles of financial markets, wrote in 1992:

In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history.

So they did, and more than 2,800 U.S. financial institutions, their growing computer power notwithstanding, failed between 1982 and 1992.

Bankers in the 21^st century – avidly using vastly greater technological prowess, supplied with reams of data, running complex computer models to measure and manage (or so they thought) their credit risks – made even more egregious mistakes. As we all know, they created an amazing credit bubble and came close to tanking the entire financial system. Did the technology help them or seduce them?

Mathematicians and physicists – the “rocket scientists,” as they were called – had brought their impressive computer skills to Wall Street to help apply technology to mortgage finance. In the memorable summary of George Mason University’s Tony Sanders, “The rocket scientists built a missile which landed on themselves.” The mistakes were in the “fin” part of this effort, not the “tech” part.

In every financially trendy boom, we hear a lot about “creative” new financial products. A painful example was the homeownership strategy announced with fanfare by the Clinton administration in the 1990s. It called for “creative” mortgages, which turned out to mean mortgages likely to default.

Such products, no matter how much innovative computer technology surrounds and helps deliver them, are not real financial innovations. They are merely new ways to lower credit standards, run up leverage and increase old risks by new names. They are thus illusory financial innovations. As also pointed out by James Grant, science is progressive, but credit is cyclical.

Real innovations turn ideas into institutions which endure over time, various mistakes notwithstanding, as credit cards, ATMs and MBS have. Illusory innovations cyclically blossom and disappear. Both produce uncertainty, and uncertainty means we cannot know the future, period. We will continue to be surprised, positively and negatively, by the effects of financial innovation.

In short, financial markets are always in transition to some new state, but only some of this is progress. The rest is merely cyclical repetition. What is fintech?  Doubtless, it is some of both.

Image by wutzkohphoto / Shutterstock.com

SmarterSafer is pleased to submit this letter of comment on the Office of the Comptroller of the Currency’s joint notice of proposed rulemaking on Loans in Areas Having Special Flood Hazard: Private Flood Insurance. SmarterSafer is a coalition of environmental organizations, taxpayer advocates, insurance representatives, housing organizations and mitigation experts that advocates for environmentally-responsible, fiscally-sound approaches to natural catastrophe policy.

SmarterSafer supports the efforts of the regulators to move forward to ensure implementation of the requirements under Biggert-Waters that private flood insurance policies be accepted by lenders. Federal law requires homeowners in special flood hazard areas (SFHAs) with federally-backed mortgages to purchase flood insurance. Even without the Biggert-Waters clarification, there is nothing in current law that restricts the ability of consumers to purchase private flood insurance. Consumers should be able to purchase coverage from private insurers or through the National Flood Insurance Program (NFIP) based on their needs.

For decades, however, NFIP has basically been the only available flood insurance. This is due in large part to NFIP providing flood coverage at highly subsidized rates to those at risk. As rates begin to move toward actuarial soundness in the NFIP and as the private sector is becoming more innovative on mapping and risk analysis, private insurers are beginning to enter the flood market. Though Biggert-Waters clarified that private flood should be accepted, unfortunately language was not clear, and lenders have voiced concerns about accepting private coverage without guidance from regulators. This means that consumers are limited in their choices and some consumers are being told by lenders that they cannot purchase private coverage. It is critical that banking regulators promulgate a rule that allows consumers to purchase policies through private companies as well as NFIP.

Growth of a private flood market will help consumers as well as NFIP. NFIP is currently over $23 billion in debt, and without significant reform, the program remains at risk. Increased private competition will help take the strain off the NFIP and taxpayers as well as increase consumer choice. In addition, a private flood market will help ensure more property owners purchase coverage. In 2016 only 12 percent of homeowners had a flood insurance policy, down from 14 percent in 2015. A functioning private flood insurance market will increase flood coverage across the board, helping additional homeowners access needed insurance.

By increasing the acceptance of private flood policies by lenders, agencies will ensure that consumers can choose policies that meet their needs instead of a one-size-fits-all NFIP policy. This means consumers can choose policies with different coverage types, limits and premiums. As flood events and recovery costs increase nationwide, consumers must have sufficient and affordable options when purchasing flood insurance.

Definition of “private flood insurance”

The proposed rule requires lenders accept certain private flood insurance while allowing lenders to accept other private flood policies, provided that certain requirements are met. SmarterSafer encourages the agencies to adopt a broad definition of “private flood insurance” that lenders must accept. The rules define private flood insurance as policies from an insurer that is licensed, admitted or approved in the state, including surplus lines carriers. The private flood policy must also be at least as broad as an NFIP policy; and requires 45 days of written notice before cancellation or nonrenewal, a mortgage interest clause similar to a standard flood policy, and a provision limiting the ability of an insured to file suit to no later than one year after a written denial.

The Agencies should consider expanding the definition of “private flood insurance” to increase the number of policies that meet the definition and are accepted by lenders. An overly restrictive definition of “private flood insurance” would restrict the number of private insurance policies accepted by lenders and would stifle consumer choice. A broad definition of “private flood insurance” will increase consumer choice and ensure competition and innovation, while maximizing the number of properties covered by flood insurance.

Criteria for Discretionary Acceptance

Under the proposed rule, lenders are permitted to accept policies that do not fulfill the requirements for mandatory acceptance, provided that certain requirements are met. This discretionary option is critical to the proposed rule and private marketplace, and should be retained and expanded. Lenders should be permitted to accept any private policies as long as the insurance providers are approved by the state insurance commissioners. Insurance is regulated by the state and that is the proper place to regulate private flood insurance.

SmarterSafer encourages broad, expanded criteria for discretionary acceptance of private flood insurance by lenders. The rule as proposed would permit a lender to accept a private flood policy that does not meet the statutory definition of private flood insurance if the plan provides coverage that is at least equal to the lesser of the outstanding principal balance of the designated loan or the maximum limit of coverage available for the particular type of property under the NFIP; is issued by either a licensed insurer in the State in which the property is to be insured or located; protects both the mortgagor and mortgagee; contains a cancellation policy which only permits cancellation for the reasons permitted by FEMA for a standard flood insurance policy (SFIP), and provides for a reasonable notice of cancellation to the borrower; and is either at least as broad as an NFIP policy, or provides coverage that is similar to coverage provided under an SFIP, including deductibles, exclusions, and conditions offered by the insurer. Allowing for various policies besides those that meet the mandatory acceptance criteria is critical to the marketplace and will result in different types of coverages, deductibles, and terms that could be beneficial to consumers. SmarterSafer urges regulators to ensure broad acceptance of private flood insurance by expanding the definition of insurance that can be accepted by regulators.

The proposed rule contemplates not allowing insurance written by surplus lines providers to be accepted under the discretionary acceptance provision. This would harm consumers and stifle development of a private market. As private insurers enter the flood market, the $40.2 billion surplus lines market remains a substantial source of such policies. When an insurance market is first developing, surplus lines insurance is critical, as it allows companies to enter the marketplace with less loss experience and claims data. The exclusion of surplus lines carriers from the proposed definition would be a significant setback for the development of the private flood insurance marketplace and for consumer choice. SmarterSafer strongly supports the inclusion of surplus lines providers in the Agencies’ proposed definition for private flood insurance under both the mandatory and discretionary acceptance.

In addition, the process for discretionary acceptance should be simple and straightforward to encourage lenders to accept private flood policies without unnecessary burdens on the lenders or policyholders. Even when allowing for broad discretionary authority, if the process for acceptance is too burdensome, lenders will not be motivated to accept private flood policies that do not meet the criteria for mandatory acceptance. Instead of a complicated documentation regime as envisioned by the Rule, lenders should be permitted to accept any private policies so long as they determine that the policy protects their interests and the interests of the consumer. The process should be simple and straightforward.

We look forward to working with you on this important matter. For any further information, please contact Jenn Fogel-Bublick at Capitol Counsel at (202) 861-3200, and for additional information on SmarterSafer, including a member list, please go to www.SmarterSafer.org.

Sincerely,

SmarterSafer

57 Years of Banking Changes and Ideas

Remarks at the Dinner in Honor of Professor George Kaufman’s Retirement

Nov. 17, 2016

It is a great pleasure to be able to add these reflections to our proceedings in honor of George Kaufman upon his retirement.

We begin a quick trip through American financial history during George’s career with this quotation:

The past 100 years of American banking have been characterized by periods of remarkably rapid change.

This observation is from 56 years ago, from the 1960 Report of the Federal Deposit Insurance Corp. It was true then, and is true now.

The year before that, in 1959, the young George Kaufman walked into the Federal Reserve Bank of Chicago to begin his career. Needless to say, the “periods of remarkably rapid change” in American banking continued as his career progressed.

In 1960, there were in the United States: 13,126 commercial banks, 5,320 savings and loans, and 516 mutual savings banks. Those institutional differences then seemed much more important than they do now—these groups all had their own trade associations, for example. Together they made in 1960 a total of 18,962 depository institutions. As we all know, this number is now just over 6,000 and continues to fall. But that is still a lot of banks!

Two questions which would occur to the participants in this dinner, although doubtless never to ordinary citizens, are: When did the United States have its maximum number of banks?  And how many banks was that?  (I will not call on Charlie Calomiris here, because he might know.[1])  The answers are the year 1921 and it was 31,076 commercial banks. In addition, there were more than 8,000 savings and loans.

Coming back to 1960, the total assets of the aggregate commercial banking system were $256 billion—about one-tenth of the assets of today’s JPMorgan-Chase. That was 48 percent of the 1960 gross domestic product of $535 billion. The total assets of the prestigious 1959 Citibank—which wasn’t “Citibank” in those days, but the First National City Bank of New York—were $8.7 billion, or about 0.3 percent of the current JPMorgan.

Closer to home, I found the 1958 numbers for the Continental Illinois National Bank and Trust Co. of Chicago. That then-very-conservative balance sheet had total assets of $2.9 billion—today’s size of a large community bank.

A truly striking statistic is that in 1960, non-interest-bearing demand deposits were equal to about 60 percent of banking assets—something unimaginable now.

Also in 1960, there were still outstanding $55 million of national bank notes—currency issued by individual banks. The Federal Reserve had on its balance sheet $279 million of silver certificates. These were the paper money, as you will recall, which the U.S. Treasury promised to redeem for a silver dollar—something quite different from the fiat currency we have come to know so well. Well, perhaps not so different after all, because in the first decade of George’s career, the government decided it would renege on its commitment to pay in silver.

A roomful of economists will not have failed to notice that in all the numbers I have cited, I have used nominal dollars. There are two reasons for this:

1. Rhetorical fun
2. To remind us that George’s long career has involved unceasing, endemic inflation.

Indeed, this has progressed to the point where the Federal Reserve has formally committed itself to perpetual inflation. Such a development in Federal Reserve ideology would have greatly shocked and surprised the chairman of the Federal Reserve for the first decade of George’s career, William McChesney Martin, who called inflation “a thief in the night.”

Speaking of the Fed, George’s first career decade also included the Credit Crunch of 1966 and his second began with the Credit Crunch of 1969. Those were the days of the notorious “Reg Q,” under which the Fed set maximum interest rates on deposits and, in so doing, caused the painful crunches.

Did the Fed know what the right interest rate was in 1966 or 1969?

Nope.

Does the Fed know what the right interest rate is now?

Nope.

We move into the 1970s. They started with a world historical event, at least as far as finance goes: the default by the United States on its Bretton Woods commitment to redeem dollars held by foreign governments for gold. Announcing this decision in August 1971, President Richard Nixon blamed the problem on “international money speculators.” The real proximate cause was French President Charles de Gaulle’s financial good sense of preferring gold to overvalued dollars.

In the wake of the end of Bretton Woods, the 1970s brought us the worldwide system of fiat currencies and floating exchange rates. This system has experienced a remarkable series of debt and currency crises in the ensuing years.

Speaking of debt crises, the default by Puerto Rico was discussed this afternoon. On Page 15 of George’s 38-page curriculum vitae, we find that in 1975, George was involved in the government finances of Puerto Rico and was a consultant to Puerto Rico’s Government Development Bank. This bank is now utterly insolvent, as is the whole government of Puerto Rico. However, I do not think it would be fair to attribute this to George’s 1975 advice!

In 1976, George was working in the U.S. Treasury Department. Here were the 10 largest banks in the United States, in order, in 1976:

1. Bank of America (that is, the one is San Francisco)
2. Citibank
3. Chase Manhattan
4. Manufacturers Hanover
5. Morgan Guaranty
6. Continental Illinois
7. Chemical Bank
8. Bankers Trust
9. First National Bank of Chicago
10. Security Pacific

Of these 10, only two still exist as independent companies. They are Chemical Bank, which became JPMorgan-Chase, and Citibank, which has in the meantime been bailed out three times.

In the next decade, in 1981, George became the John F. Smith Professor of Finance and Economics here at Loyola University of Chicago, the chair he has held ever since, also serving as the director of the Center for Financial and Policy Studies.

Soon after George got his chair, the financial disasters of the 1980s came raining down. I assert, however, that this is correlation, not causation.

On a Friday in August 1982, then-Fed Chairman Paul Volcker called his counterpart at the Bank of Japan and announced that “The American banking system might not last until Monday!” Over the years 1982-1992, the notable total of 2,808 U.S. financial institutions failed. That is an average of 255 failures per year over those 11 years, or five failures a week. As many of us remember, the decade included the crisis of huge defaults on LDC—or “less developed country,” as we then said—debts; the collapse of the savings and loan industry; the bursting of the oil price bubble, which among other things, took down every big bank in Texas; the collapse of a bubble in farmland, which broke the Farm Credit System; and finally, a massive commercial real estate bust.

These 1980s disasters, which George studied and wrote about with much insight, call to mind James Grant’s vivid comment about the time: “Progress is cumulative in science and engineering but cyclical in finance. … In technology, banking has almost never looked back, [but] this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in financial history.”

The 1980s included, of course, the 1984 collapse of Continental Illinois Bank. Defending the ensuing bailout, then-Comptroller of the Currency Todd Conover introduced the memorable term “too big to fail.” The problem of “too big to fail” became an important theme in George’s work.

In the midst of these 1980s financial debacles, in 1986, George led the creation of the Shadow Financial Regulatory Committee. In its operation through 2015, the committee published 362 mostly trenchant and provocative policy statements. No. 362 was still dealing with “too big to fail.”

For the year 1987, George published a summary of this “dramatic year in U.S. banking and finance,” which included these observations: that “rates on long-term Treasury bonds stood at 9 ½%”; that “some 185 commercial banks failed during the year”; that “the drain on the Federal Savings and Loan Insurance Corporation was so great that the corporation ran out of reserves and had to be recapitalized by Congress”; and that “Alan Greenspan replaced Paul Volcker as chairman of the Federal Reserve,” while “M. Danny Wall [became] chairman of the Federal Home Loan Bank Board.”

Remember the Federal Home Loan Bank Board?  Those of us here may, but hardly anybody else does. For Danny Wall, being made head of it in 1987 was like being made captain of the Titanic after it had already hit the iceberg. In contrast, Alan Greenspan rose to worldwide stardom and became “The Maestro”—until he wasn’t.

In the 1990s, George and the Shadow Committee were very influential in shaping FDICIA—the Federal Deposit Insurance Corporation Improvement Act of 1991, which put into statute the theory of prompt corrective action. The decade later brought a series of international financial crises, starting with the frantic bailout of Mexico in 1994.

In the next decade, the fifth of George’s career, came—as we all know too well—the massive housing and housing-finance bubble, bust and shrivel of the 2000s. Reflecting on prompt corrective action in light of those experiences, my conclusion is that it’s a pretty good theory, but financial exuberance makes it hard to practice.

The exuberance of the 2000s was defended as rational by many ex ante, then denounced as irrational ex post. In the aftermath of the 2007-09 crisis, I chaired panel of which George was a member. He gave this wonderful concluding comment:

Everybody knows Santayana’s saying that those who fail to study the past are condemned to repeat it. In finance, those who do study the past are condemned to recognize the patterns they see developing, and then repeat them anyway!

Now here we are, near the end of 2016. I believe we are probably closer to the next crisis than to the last one. It seems to me we need a Shadow Financial Regulatory Committee Roman Numeral II to get to work on it.

Ladies and Gentlemen:

Let us raise our glasses to George Kaufman and 57 years of achievement, acute insights, scholarly contributions, policy guidance and professional leadership, all accompanied by a lively wit.

To George!

[1] The next morning, Charlie told me that he did know

Image by Loyola University Chicago

“Economics and finance are like going to the dog races,” my friend Desmond Lachman of the American Enterprise Institute is fond of saying. “Stand in the same place and the dogs will come around again.” So they will.

U.S. financial markets produced sequential bubbles – first in tech stocks in the 1990s and then in houses in the 2000s.

“What is the collateral for a home mortgage loan?” I like to ask audiences of mortgage lenders.  Of course, they say, “the house,” so I am pleased to tell them that is the wrong answer.  The correct answer is the price of the house.  My next question is, “How much can a price change?”  Ponder that.  The correct answer is that prices, having no independent, objective existence, can change a lot more than you think. They can go up a lot more than you think probable, and they can go down a lot more than you think possible. And they can do first one and then the other.

This is notably displayed by the asset price behavior in both the tech stock and housing bubbles.  As the dogs raced around again, they made a remarkably symmetrical round trip in prices.

Graph 1 shows the symmetrical round trip of the notorious “irrational exuberance” in dot-com equities, followed by unexuberance. It displays the NASDAQ stock index expressed in constant dollars.

Now consider houses.  Graph 2 shows the Case-Shiller U.S. national house price index expressed in constant dollars.  Quite a similar pattern of going up a lot and then going down as much.

The mortgage lending excesses essential to the housing bubble reflected, in part, a mania of politicians to drive up the U.S. homeownership rate. The pols discovered, so they thought, how to do this: make more bad loans—only they called them, “creative loans.” The homeownership rate did rise significantly—and then went back down to exactly where it was before. Another instructive symmetrical round trip, as shown in Graph 3.

The first symmetrical up and down played out in the course of three years, the second in 12 years, the third in two decades. Much longer patterns are possible. Graph 4 shows the amazing six-decade symmetry in U.S. long-term interest rates.

Is there magic or determinism in this symmetry? Well, perhaps the persistence of underlying fundamental trends and the regression to them shows through, as does the reminder of how very much prices can change. In the fourth graph, we also see the dangerous power of fiat currency-issuing central banks to drive prices to extremes.

Unfortunately, graphs of the past do not tell us what is coming next, no matter how many of them economists and analysts may draw. But they do usefully remind us of the frequent vanity of human hopes and political schemes.

Image by Manfred Ruckszio

Excessive real estate credit is the most common cause of banking booms, busts and collapses, throughout history, right up through the most recent financial crisis and around the world.

The U.S. commercial banking system has gotten much bigger relative to the U.S. economy than it used to be, although there are many fewer banks. The principal source of this growth is that banks have vastly increased their real estate exposure relative to the U.S. economy as a whole. This acceleration in real estate risk has fundamentally changed the nature of the banking system and its systemic risk.

Looking back to 1960, there were in the United States: 13,126 commercial banks and 18,962 depository institutions. By the end of 2016, depositories totaled only 5,913, of which 5,113 were commercial banks. That’s a 69 percent reduction in the number of depository institutions, and a 61 percent reduction in commercial banks.

On the other hand, in 1960, the total assets of the commercial banking system were only $256 billion. Though hard to believe, the entire banking system had total assets of only about one-tenth of today’s JPMorgan-Chase, and only 1.6 percent of today’s banking assets of $15.6 trillion. Citibank — which wasn’t Citibank then, but the dignified First National City Bank of New York — had less than $9 billion in assets. To our minds, now muddled by decades of constant inflation — including a central bank that has formally committed itself to creating perpetual inflation — these all seem like very small numbers.

Instead of measuring in nominal dollars, to see through the fog of long years of inflation, we can measure banking assets consistently relative to the size of the economy, as a percent of annual gross domestic product. The $256 billion of commercial banking assets in 1960 was 47 percent of the $541 billion in GDP.

The increase is striking: by 2016, banking assets had gone from 47 percent to 83 percent of GDP. That is more than a 75 percent increase in the banking system’s size relative to the economy, at the same time the number of banks fell by more than 60 percent. At present, this ratio is close to its all-time bubble peak.

What is driving this growth? It’s not commercial and industrial loans. On the trend, their percent of GDP is flat at 8 percent to 10 percent since 1960. On average, the commercial and industrial loans of the banking system have kept up with the growth of the economy, but not more.

The real driving factor is real estate credit. The commercial banking system’s real estate loans rose relentlessly from 5 percent of GDP in 1960, to more than 26 percent at their bubble peak, and are now at 22.5 percent.

Nor is this the whole real estate story. With the popularization of mortgage securitization, the banking system’s securities portfolio, not only its loan portfolio, shifted to real estate risk. Going back to 1992, the sum of banks’ real estate loans and mortgage-backed securities as a percent of GDP has risen to 32 percent — six times the 1960 level.

In short, the vast bulk of the dramatic increase in the size of the banking system relative to the economy comes from the acceleration of real estate exposure — a rising trend for more than six decades. How can the banks keep doing this? Well, it helps to have your liabilities guaranteed by the government, both explicitly through deposit insurance and implicitly through bailouts and central banking.

Should the banking system keep getting bigger relative to the economy, and should this increase continue overwhelmingly to reflect real estate risk? That is a dubious proposition. As Columbia University’s Charles Calomiris has written (in a not-yet-published paper): “The unprecedented pandemic of financial system collapses over the last four decades around the world is largely a story of real estate booms and busts. Real estate is central to systemic risk.”

Very true. But as Calomiris notes, the Financial Stability Oversight Board, set up as part of the Dodd-Frank Act to oversee the U.S. financial system, “seems to be uninterested.”

The Bank Holding Company Act of 1956 defined a bank as an institution that accepts demand deposits and makes commercial loans. Neither part of this old definition still touches on the main point. A bank now is for the most part an institution that makes real estate loans and funds them with government-guaranteed liabilities.

This banking evolution poses a huge systemic question: How do you deal with a banking system whose risks are concentrated in real estate prices and leverage? To this question we are, as yet, without an answer. Do the supposed systemic thinkers at the Financial Stability Oversight Council even understand the magnitude of the historic shift in risk? Maybe a future FSOC with new members will do better.

Image by Yeexin Richelle

Testimony to the Subcommittee on Oversight and Investigations
U.S. House Committee on Financial Services

Madam Chairman, Ranking Member Green and members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I spent 35 years in banking, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago, and then 11 years as a fellow of the American Enterprise Institute, before joining R Street last year. I have both experienced and studied numerous financial crises and financial cycles, including the political contributions to their creation and the political reactions afterward, and my work includes the issues of banking systems, central banking, risk and uncertainty in finance, housing finance and government-sponsored credit, and extensive study of financial history.

To begin, let me compliment the committee staff for their detailed, specific paper on the FSOC’s non-bank designation process. The paper embodies a very good analytical idea: it “compares the FSOC’s evaluation memoranda [of various companies] against one another to measure the consistency of the FSOC’s analysis.” This comparison, as documented in the paper, results in the conclusions that the treatment of different companies is not consistent, that FSOC did not follow its own formal guidance, and in summary, that the evaluations upon which companies either were or were not designated as systemically risky (as “SIFIs”) “have been characterized by multiple inconsistencies and anomalies on key issues.”

The paper says that “These examples cast doubt on the fairness of the FSOC’s designation process.” They do, but in my opinion, the more important point than fairness, is that the observations cast doubt on the objectivity of the FSOC’s work. Were these evaluations impartial analyses looking for disinterested conclusions, or were they rationalizations for conclusions already reached in political fashion?

As we all know, U.S. District Judge Rosemary Collyer, in her decision on the lawsuit MetLife brought against FSOC, found for MetLife and ruled that FSOC’s action was “arbitrary and capricious.” I want to focus on one of the reasons stressed by the judge: the assumptions FSOC made to arrive at its proposed designation.

Considering hypothetical losses resulting from MetLife, Judge Collyer’s Opinion pointedly observes that: “FSOC assumed that any such losses would affect the market in a manner that ‘would be sufficiently severe to inflict significant damage on the broader economy.’ …These kinds of assumptions pervade the analysis; every possible effect of MetLife’s imminent insolvency was summarily deemed grave enough to damage the economy.” [italics mine]

But the judge continued: “FSOC never projected what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result.” [original italics]

Further, “FSOC was content…to stop short of projecting what could actually happen if MetLife were to suffer material financial distress.” FSOC’s work appears pretty pathetic in this light, doesn’t it?  FSOC “hardly adhered to any standard when it came to assessing MetLife’s threat to U.S. financial stability,” the judge found.

This sound and sensible judicial decision was appealed by the previous administration. I believe the current Treasury Department should immediately request the Department of Justice to withdraw the appeal, and that Justice should do so as soon as possible.

Recall that the point of designation of insurance companies as SIFIs is to give significant regulatory jurisdiction over them to the Federal Reserve Board, an institution with little or no experience in insurance regulation and which certainly cannot be considered expert in it. The Independent Member of FSOC Having Insurance Expertise, Roy Woodall, who indubitably is a true expert in the insurance business and its regulation, voted against the SIFI designation of MetLife. Coming again to FSOC’s assumptions, he objected:  “The analysis relies on implausible, contrived scenarios” [my italics], which moreover, include “failures to appreciate fundamental aspects of insurance and annuity products.”

Mr. Woodall continued that “the central foundation for this designation” is the assumption of “a sudden and unforeseen insolvency of unprecedented scale [and] of unexplained causation.” He reasonably added, “I simply cannot agree with such a premise.” Can anybody?

Voting against the earlier designation of Prudential Financial as a SIFI, Mr. Woodall similarly pointed out that “Key aspects of [FSOC’s] analysis are not supported by the record or actual experience,”  that it presumes “an unfathomable and inexplicable simultaneous insolvency and liquidation of all insurance companies” among its “misplaced assumptions.”

Ed DeMarco, a distinguished financial regulator who was at the time the acting director of the Federal Housing Finance Agency and thus the conservator of Fannie Mae and Freddie Mac, joined the dissent on Prudential and also observed the lack of evidence presented in the FSOC’s evaluation. FSOC proceeded “despite the acknowledgment that no institution has as disproportionally large exposure to Prudential”; it “does not fully take account of the stability of Prudential’s liabilities”; it assumes that “withdrawals at Prudential could lead to runs at other insurance companies without providing supporting evidence.” Once again, FSOC was operating on assumptions.

Of course, Messrs. Woodall and DeMarco were in the minority. But did the majority address their serious and substantial objections?  Was there a meaningful, substantive exchange among FSOC members about the conceptual issues and the relevant evidence, as would be appropriate, before voting the proposal in?  I am told that there was not.

Why not?  The whole point of the existence of FSOC is supposed to be the combined substantive deliberation and development of insights by this committee of the heads of financial regulatory agencies. But it doesn’t seem to happen. So the designation process does not work well not only at the staff level, but also at the level of the FSOC as a corporate body.

I directly asked one former senior FSOC insider from the previous administration if the meetings of FSOC members had ever provided a new insight into financial issues. After thinking a moment, he gave me a candid answer: “No.”

Why is this?  The Milken Institute, in a recent paper, proposed idealistically that although FSOC is currently nothing like this, “policy makers should convert the FSOC into a truly cooperative working group of regulators focused on risks.” To anyone familiar with the ways of Washington, this will seem an unlikely outcome.

The underlying problem, it seems to me, is the structure of FSOC itself. The shortcomings of the designation process reflect the underlying problems with the fundamental design. To begin with, FSOC is primarily a group of individuals each representing a regulatory agency, with turf to protect from intrusions by the others, and a regulatory record to defend from criticism, as principal bureaucratic concerns.

It is a big group, with 15 official members, but in addition, they all bring along helpers and allies. At the FSOC meeting of Dec. 18, 2014—which approved the MetLife SIFI designation—there were, according to its minutes, 46 people present. It’s pretty hard, indeed impossible, to imagine a real, open, give-and-take and “truly cooperative” discussion with 46 people.

Moreover, FSOC is chaired by the secretary of the Treasury, a necessarily very political, powerful senior government actor with major partisan and institutional interests always in play. No company can be taken up for systemic risk study by the SIFI staff without the approval of the secretary. Does this suggest a disinterested analytical process?

The Federal Reserve is a special case in the structural design of FSOC, because it stands to expand its power every time FSOC makes a SIFI designation. Does the Federal Reserve like power?  Would it like to acquire a big new jurisdiction?  Of course, and it is a party at interest in every SIFI discussion. I think it is not unreasonable to suggest that, given the Fed’s major conflict of interest, it should recuse itself from any SIFI votes.

With this context, it is easier to see why the FSOC’s SIFI evaluations had to rely on big assumptions and tended to make inconsistent analyses of different companies. It was because the decisions being made were inherently judgmental, with inherently subjective elements, made amid competing interests—that is to say, unavoidably political.

The shortcomings of the FSOC evaluations appear at least consistent with the theory that the evaluations were meant to rationalize decisions already made. Where might the pressure for such decisions have come from?

One publicly debated possibility is that commitments were already made in the setting of the international Financial Stability Board, in which two of the FSOC members, it is sometimes suspected, made deals with foreign central bankers and regulators about which companies were “global systemically important insurers.” There is dispute about whether the FSB discussions were really agreements, and whether they were thought to be binding. But there is no dispute that the international discussions and the naming of “Global SIIs” preceded the Prudential and MetLife designations of the FSOC. Roy Woodall reflected: “While the FSB’s action should have no influence, I have come to be concerned that the international and domestic processes may not be entirely separate.” A related question is whether the Treasury and Federal Reserve FSOC members felt personally committed by their international discussions. If they did, it seems that they should have disclosed that and recused themselves from the FSOC decisions. Did they feel committed to follow the FSB?  Only they know.

During their research for the study of the FSOC designations process, the committee staff asked the FSOC’s executive director, Patrick Pinschmidt, what “significant damage on the broader economy” meant, in their assessments. Mr. Pinschmidt replied: “It’s up to each voting member of the council to decide for him or herself what constitutes a significant threshold.” That sounds like depending on subjective judgments to me.

I agree that it is a naturally good idea for financial regulatory agencies to get together and share information, ideas and experiences (to the extent that they will really share). But what is a committee of heads of regulatory agencies, who are acting as individuals and not even on behalf of the relevant boards or commissions, doing making political decisions?  If Congress wants to have the Federal Reserve Board regulate big insurance companies, it can make it so in statute, using whatever subjective judgments it wants. In my view, FSOC is a distinctly inappropriate body to act as a little legislature.

The staff paper of FSOC’s evaluations of possible SIFIs, those recommended for designation and those not, details the inconsistencies in treatment. But these differences pale beside the huge discrepancy of those companies chosen for evaluation and those companies not evaluated at all, because the previous Treasury Secretary did not approve their being studied. The FSOC staff did not even analyze them, because of some higher, prior, political judgment. I think this could fairly be characterized as desperately wanting to “see no evil” when it comes to the systemic financial risk of some entities.

The most egregious cases are Fannie Mae and Freddie Mac, which are obviously systemically important and without question systemically very risky. To document that is simple, starting with their combined $5 trillion in credit risk, virtually zero capital and ubiquitous interconnectedness throughout the country and world. Two of the biggest causes of systemic risk are leveraged real estate and the moral hazard created by the government—Fannie and Freddie are both of these combined and to the max.

The Dodd-Frank Act gives a key assignment to FSOC:  “To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties that the Government will shield them from losses in the event of failure.” Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses, not only as a hypothetical, but as a vast fact. They operate entirely on the government’s credit. They represent the very essence of the problem that FSOC was supposedly created to address. But FSOC doesn’t even study them—instead, the staff was ordered not to study them.

That is an inconsistency raised to the nth power – in my view, a bankruptcy of FSOC’s intellectual credibility as run by the previous administration.

A recent article claims that “the next financial crisis that rocks America…will be driven by pension funds that cannot pay what they promised.” Whether or not it triggers the next crisis, there is no doubt that this is a looming huge risk.

In the very center of this risk is an insurance company absent from FSOC’s evaluation as a SIFI: the Pension Benefit Guaranty Corp. The PBGC is not only on the hook as guarantor of unpayable pensions nationwide, but is already insolvent itself with, according to its own books, a deficit net worth of $76 billion. Might PBGC represent a systemic risk?  Yes. Do the creditors of the PBGC think “the Government will shield them from losses”?  Yes. Does the FSOC staff evaluate the PBGC?  Nope.

In sum, it appears that the flawed process of FSOC’s SIFI designations is generated by the flawed structure of FSOC itself.

In my opinion, structural reform of FSOC is needed as part of larger the Dodd-Frank reform legislation. But here are a few recommendations for improvements which could be implemented by the new administration in the short run:

• FSOC should have regular meetings of principals only with substantive discussions of major issues and explorations of disagreements. No helpers, no staff.
• The secretary of the Treasury should immediately instruct the FSOC staff to undertake systemic risk evaluations of Fannie Mae and Freddie Mac.
• The secretary of the Treasury should immediately instruct the FSOC staff to undertake a systemic risk evaluation of the Pension Benefit Guarantee Corporation.
• The Treasury Department should immediately request the Department of Justice to withdraw the government’s appeal in the MetLife v. FSOC suit and the Department of Justice should immediately do so.
• FSOC staff should be encouraged to come up with new ideas on evolving risks for discussion among the FSOC principals.
• Any SIFI evaluation should strictly follow the rules and guidance approved by FSOC, with analysis performed in a strictly consistent manner.
• Assumptions about macro reactions and assumptions of implausible and contrived scenarios should be clearly identified as judgments and guesses.
• International discussions and actual decisions of FSOC should be kept strictly separate. Any international agreements, even if informal, made by FSOC members, should be fully disclosed.

Again, my appreciation to the committee staff for their productive study of the inconsistent FSOC designation process and the very important issues it raises.

And thank you very much for the chance to share these views.

The Financial Stability Oversight Council’s process for identifying systemically important nonbank financial institutions is beset by politically influenced assumptions and inconsistent analytical processes, R Street Distinguished Senior Fellow Alex Pollock testified today to the House Financial Services Subcommittee on Oversight and Investigations.

Established as part of the Dodd-Frank Act following the 2008 financial crisis, the 15-member council is unwieldy and, because it is chaired by the secretary of Treasury, inextricably bound to broader political considerations, Pollock said. An examination of its record to date in determining whether insurance companies and other nonbank financial services firms should be subject to oversight by the Federal Reserve Board raises additional questions about the fairness and objectivity of the process, he added.

“The whole point of the existence of FSOC is supposed to be the combined substantive deliberation and development of insights by this committee of the heads of financial regulatory agencies,” Pollock said. “But it doesn’t seem to happen. So the designation process does not work well not only at the staff level, but also at the level of the FSOC as a corporate body.”

In particular, Pollock noted that FSOC members voted to designate insurers MetLife Inc. and Prudential Financial as systemically important financial institutions, despite the objections of Roy Woodall, the lone commission member with insurance expertise. He added that questions have been raised about whether those decisions were unduly influenced by the international Financial Stability Board’s deliberations on which firms it would designate as “global systemically important insurers.”

“If Congress wants to have the Federal Reserve Board regulate big insurance companies, it can make it so in statute, using whatever subjective judgments it wants,” Pollock testified. “In my view, FSOC is a distinctly inappropriate body to act as a little legislature.”

Moreover, he questioned why the council had opted not to consider for designation the government sponsored enterprises Fannie Mae and Freddie Mac, which combine for nearly $5 trillion in credit risk, or the Pension Benefit Guaranty Corp., which has a deficit net worth of $76 billion.

“The shortcomings of the designation process reflect the underlying problems with the fundamental design,” Pollock said. “To begin with, FSOC is primarily a group of individuals each representing a regulatory agency, with turf to protect from intrusions by the others, and a regulatory record to defend from criticism, as principal bureaucratic concerns.”

Pollock’s full written testimony can be found here.

Here’s more from R Street Distinguished Senior Fellow Alex Pollock’s testimony before the House Committee on Financial Services on the arbitrary and inconsistent non-bank SIFI designation process.

Murphy’s law is well-known in the form: “Whatever can go wrong, will go wrong” and similar variations on the theme. But the intellectually interesting substance of Murphy’s law is:  “Whatever can go wrong, will go wrong, given enough time.”

When a financial calamity has a very small probability of occurring—let’s say a 1 percent chance that it will and 99 percent that it won’t in any given year—we tend not, as a practical matter, to worry about it much. In most years, nothing will happen, and when it hasn’t happened for a long time, we may even start to treat the risk as essentially zero. Professors Jack Guttentag and Richard Herring authored a classic paper that gave this tendency the provocative name “disaster myopia.”

Banking and finance are full of events with a very small expected probability, but which are very costly when they do happen – e.g., a financial crisis.

Suppose the chance of a financial crisis is 1 percent annually. Suppose you optimistically start your banking career at the age of 23 and work to age 68, by which time you will be seasoned and cynical. That will be 45 years. Because you have given it enough time, the probability that you will experience at least one crisis during your career grows from that 1 percent in your trainee year to a pretty big number: 36 percent.

We observe in the real world that financial crises occur pretty frequently—every decade or two—and that there are a lot of different countries where a financial crisis can start. We also observe that virtually no one—not central bankers, regulators, bankers, economists, stock brokers or anybody else—is good at predicting the financial future successfully. Do we really believe the risk management and credit screens of banks, regulators and central banks are as efficient enough to screen down to a 1 percent probability?  I don’t.

Suppose instead that the probability of the banking crisis is 2 percent, with 98 percent probability that it won’t happen in a given year. Are banks even that good?  How about 5 percent, with a 95 percent probability of not happening?  That would still feel pretty safe. One more dubious of the risk-management skills of bankers, regulators and the rest might guess the probability, in reality, is more like 10 percent, rather than 1 percent. Even then, in most years, nothing will happen.

How does our banker fare over 45 years with these alternate probabilities?  At 2 percent chance per-year, over 45 years, there is a 60 percent probability he will experience at least one crisis. At 5 percent, the probability becomes 90 percent of at least one crisis, with a 67 percent chance to see two or more. If it’s 10 percent, then over 45 years, the probability of experiencing at least one crisis is 99 percent, and the probability of experiencing at least two is 95 percent. Since we learn from troubles and failures, banking looks like it furnishes the probability of an educational career.

In the last 45 years, there have been financial crises in the 1970s, 1980s, 1990s and 2000s. In the 2010s, we have so far had a big sovereign default in Greece, set the record for a municipal insolvency with the City of Detroit, and then broke that record with the insolvency of Puerto Rico. And the decade is not over. All of these crises by decade have been included in my own career around banking systems, of now close to 48 often-eventful years. The first one—the Penn Central Railroad bankruptcy and the ensuing panic in the commercial paper market—occurred when I was a trainee.

Since 1982, on average, a little less than 1 percent of U.S. financial institutions failed per year, but in the aggregate, there were 3,464 failures. Failures are lumped together in crisis periods, while some periods are calm. There were zero failures in the years 2005-2006, just as the housing bubble was at its peak and the risks were at their maximum, and very few failures in 2003-2004, as the bubble dangerously inflated. Of course, every failure in any period was a crisis from the point of view of the careers of then-active managers and employees.

A further consideration is that the probability of a crisis does not stay the same over long periods—especially if there has not been a crisis for some time. As Guttentag and Herring pointed out, risks may come to be treated as if they were zero, which makes them increase a lot. The behavior induced by the years in which nothing happens makes the chance that something bad will happen go up. In a more complex calculation than ours, the probability of the event would rise over each period it doesn’t occur, thanks to human behavior.

But we don’t need that further complexity to see that, even with quite small and unchanging odds of crises, given enough time across a career, the probability that our banker will have one or more intense learning experiences is very high, just as Mr. Murphy suggests.

Image by Ionut Catalin Parvu

After six years of unfulfilled promises, it’s time the Durbin amendment finally was repealed. A last-minute addition to the Dodd-Frank Act—itself a political overreaction to the financial crisis of 2007-2009—the amendment passed without a hearing or adequate discussion of how it would work in practice. We now know it hasn’t worked at all.

Interchange fees are charged by banks to retailers to allow customers to use that bank’s debit card in that store. The Durbin amendment gave the Federal Reserve power to cap those fees, which at the time averaged $0.44 per transaction, for banks with more than $10 billion in assets.

Proponents of the rule hoped that what would have been banks’ revenues would translate instead into lower retail prices for consumers. Indeed, retailers were projected to save an estimated $8 billion yearly. But nearly six years since the price controls went into effect, consumers have not benefited; a fair number, in fact, were made worse off.

The cost savings have, for the most part, become profits for retailers. The Federal Reserve Bank of Richmond found recently that three-quarters of retailers it surveyed did not change prices since interchange fee caps went into effect, and nearly one-quarter actually increased prices.

The Richmond Fed estimates the goal that retailers would pass savings on to customers in the form of lower prices has had an estimated 1.2 percent success rate. These findings are confirmed elsewhere, providing evidence to conclude that consumers experienced effectively no savings at the register.

For any student of history, it should come as no surprise that governments cannot divine the “fair prices” of things. Rent control laws in New York have created enough abandoned housing units to house all of the city’s homeless. Regulation Q, which allowed for government price fixing in deposits, encouraged complex arrangements that discriminated against smaller and less wealthy savers. One can go back as far as ancient Egypt and Babylon to find examples of people not understanding that prices convey economic realities that remain fixed, even after the government changes the prices.

That the Durbin Amendment would suffer the same fate as these other price controls was not hard to predict. To offset revenue losses and remain competitive, banks needed to find ways to raise their deposit account fees. Some did it through higher monthly service charges, while others cut back on free services like checking. A large number of financial institutions—especially small issuers like community banks and credit unions—essentially were pushed out of the competition due to the administrative costs and red tape of various provisions. And all financial institutions saw reduced incentives to innovate in the payment card industry.

As a result, financial markets suffered fewer free checking accounts, fewer debit-card rewards programs, higher costs of entry into financial services and continued reliance on payment networks more susceptible to fraud. These consequences hurt all bank customers, but especially those with lower incomes. Up to 1 million customers were pushed out of the banking system, presumably into the domain of alternative financial providers such as check-cashers and pawnshops.

From the observable consequences, one would be hard-pressed to find the amendment as accomplishing any legitimate objective, other than unintentionally enshrining benefits to particular kinds of retailers. The rule created market distortions that hurt all financial institutions, especially smaller ones, and hurt all depository customers, especially the poor. The Durbin amendment is a case study in how rushing into legislation—without give-and-take deliberation—tends to produce the opposite of what was intended.

Image by alice-photo

Mr. Chairman, Ranking Member Waters and members of the committee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I have spent more than four decades working in and on banking and housing finance, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago and 11 years focused on financial policy issues at the American Enterprise Institute, before joining R Street last year. I have experienced and studied many financial crises and their political aftermaths, starting when the Federal Reserve caused the Credit Crunch of 1969 when I was a bank trainee.

My discussion will focus on three key areas of the proposed CHOICE Act. All deal with essential issues and, in all three, the CHOICE Act would create major progress for the financial system, for constitutional government and for financing economic growth. These areas are accountability, capital and congressional governance of the administrative state.

The CHOICE Act is long and complex, but there are a very large number of things to fix—like the Volcker Rule, among many others– in the even longer Dodd-Frank Act.

A good summary of the real-world results of Dodd-Frank is supplied by the “Community Bank Agenda for Economic Growth” of the Independent Community Bankers of America. “Community banks,” it states, “need relief from suffocating regulatory mandates. The exponential growth of these mandates affects nearly every aspect of community banking. The very nature of the industry is shifting away from community investment and community building to paperwork, compliance and examination.” I think this observation is fair.

The Community Bankers continue: “The new Congress has a unique opportunity to simplify, streamline and restructure.” So it does, and I am glad this committee is seizing the opportunity.

In November 2016, Alan Greenspan remarked, “Dodd-Frank has been a—I wanted to say ‘catastrophe,’ but I’m looking for a stronger word.” Although the financial crisis and the accompanying recession had been over for a year when Dodd-Frank was enacted, in the wake of the crisis, as always, there was pressure to “do something” and the tendency to overreact was strong. Dodd-Frank’s something-to-do was to expand regulatory bureaucracy in every way its drafters could think of—it should be known as the Faith in Bureaucracy Act. This was in spite of the remarkably poor record of the government agencies, since they were important causes of, let alone having failed to avoid, the housing bubble and the bust. Naïve faith that government bureaucracies have superior knowledge of the financial future is a faith I do not share.

Accountability of the Administrative State

Accountability is a, perhaps the, central concept in every part of the government. To whom are regulatory agencies accountable? Who is or should be their boss? To whom is the Federal Reserve, a special kind of agency, accountable? Who is or should be its boss? To whom should the Consumer Financial Protection Bureau be accountable? Who should be its boss?

The answer to all these questions is of course: the Congress. We should all agree on that. All these agencies of government, populated by unelected employees, must be accountable to the elected representatives of the people, who created them, can dissolve them and have to govern them in the meantime. All have to be part of the separation of powers and the system of checks and balances which is at the heart of our constitutional order. This also applies to the Federal Reserve. In spite of its endlessly repeated slogan that it must be “independent,” the Federal Reserve must equally be accountable.

But accountability does not happen automatically: Congress has to assert itself to carry out its own duty for governance of the many agencies it has created and for its obligation to ensure that checks and balances actually operate.

The CHOICE Act is an excellent example of the Congress asserting itself at last to clarify that regulatory agencies are derivative bodies accountable to the Congress, that they cannot be sovereign fiefdoms—not even the dictatorship of the CFPB, and not even the money-printing activities of the Federal Reserve.

The most classic and still most important power of the legislature is the power of the purse. The CHOICE Act accordingly puts all the regulatory agencies, including the regulatory part of the Federal Reserve, under the democratic discipline of congressional appropriations. This notably would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB—and which was designed precisely to evade the democratic power of the purse. It is sometimes objected that appropriations “inject politics” into these decisions. Well, of course! Democracy is political. Regulatory expansions are political, all pretense of technocracy notwithstanding.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. It provides that actions whose costs exceed their benefits should not be undertaken without special justification. That’s pretty logical and hard to argue with. Naturally, assessing the future costs and benefits of any action is subject to uncertainties—perhaps very large uncertainties. But this is no reason not to do the analysis—indeed, forthrightly to confront the uncertainties is essential.

The CHOICE Act also requires an analysis after five years of how regulations actually turned out in terms of costs and benefits. This would reasonably lead—I hope it will—to scrapping the ones that didn’t work.

To enhance and provide an overview of the regulatory agencies’ cost-benefit analyses, the CHOICE Act requires the formation of a Chief Economists Council, comprising the chief economist of each agency. This appeals to me, because it might help the views of the economists, who tend to care a lot about benefits versus costs, balance those of their lawyer colleagues, who may not.

Further congressional governance of regulatory agencies is provided by the requirement that Congress approve major regulatory rules—those having an economic effect of $100 million or more. Congress would further have the authority to disapprove minor rules if it chooses by joint resolution. This strikes me as a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

Taken together, these provisions are major increases in the accountability of regulatory agencies to the Congress and ultimately to the people. They are very significant steps forward in the governance of the administrative state and bringing it under better constitutional control.

Accountability of the Federal Reserve

A word more on the Federal Reserve in particular, since the CHOICE Act devotes a title to “Fed Oversight Reform and Modernization” (FORM), which includes improving its governance by Congress. In a 1964 report, “The Federal Reserve after Fifty Years,” the Domestic Finance Subcommittee of the ancestor of this committee, then called the House Committee on Banking and Currency, disapprovingly reviewed the idea that the Federal Reserve should be “independent.” This was in a House and committee controlled by the Democratic Party. The report has this to say:

• “An independent central bank is essentially undemocratic.”
• “Americans have been against ideas and institutions which smack of government by philosopher kings.”
• “To the extent that the [Federal Reserve] Board operates autonomously, it would seem to run counter to another principle of our constitutional order—that of the accountability of power.”

In my view, all these points are correct.

The president of the New York Federal Reserve Bank testified to the 1964 committee: “Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to.” That is entirely correct, too.

Under the CHOICE Act, such reviews would happen at least quarterly. I would like to suggest an additional requirement for these reviews. I believe that the Federal Reserve should be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers.

The CHOICE Act requires of new regulatory rules that they provide “an assessment of how the burden imposed…will be distributed among market participants.” This good idea should by analogy be applied to burdens imposed on savers by monetary actions. By my estimate, the Federal Reserve has taken since 2008 more than $2 trillion from savers and given it to borrowers. The Federal Reserve may defend its sacrifice of the savers as a necessary evil—but it ought to openly and clearly quantify the effects and discuss the economic and social implications with the Congress.

Accountability of Banks

Let me turn to accountability in banking, under two themes: providing sufficient equity to capitalize your own risks; and bearing the risk you create—otherwise known as “skin in the game.”

The best-known provision of the CHOICE Act is to allow banks the very sensible choice of having substantial equity capital—to be specific, a 10 percent or more tangible leverage capital ratio—in exchange for reduction in onerous and intrusive regulation. Such regulation becomes less and less justifiable as the capital rises. As I testified last July, this is a rational and fundamental trade-off: More capital, less intrusive regulation. Want to run with less capital and thus push more of your risk onto the government? You get more regulation.

It is impossible to argue against the principle that there is some level of equity capital at which this trade-off makes sense for everybody—some level of capital at which everyone, even habitual lovers of bureaucracy, would agree that the Dodd-Frank burdens are superfluous, with costs higher than their benefits.

But exactly what that level is, can be and is, disputed. Because banking markets are so shot through with government guarantees and distortions, there is no clear market test. All answers are to some degree theoretical, and the estimates vary—some think the number is less than 10 percent leverage capital—for example, economist William Cline finds that optimal bank leverage capital is 7 percent—or 8 percent to be conservative. Some think it is more—15 percent has been suggested more than once. The International Monetary Fund came up with a desired risk-based capital range which they concluded was “consistent with 9.5 percent” leverage capital—that’s pretty close to 10 percent. Distinguished banking scholar Charles Calomiris suggested “roughly 10 percent.” My opinion is that the fact that no one knows the exactly right answer should not stop us from moving in the right direction.

All in all, it seems to me that the 10 percent tangible leverage capital ratio, conservatively calculated, as proposed in the CHOICE Act is a fair and workable level to attain “qualifying banking organization” status, in other words, the more capital-less onerous regulation trade-off. The ratio must be maintained over time, with a one-year remediation period if a bank falls short, and with immediate termination of the qualifying status if its leverage capital ratio ever falls below 6 percent—a ratio sometimes considered very good. All this seems quite reasonable to me.

The CHOICE Act mandates a study of the possible regulatory use of the “non-performing asset coverage ratio,” which is similar to the “Texas ratio” from the 1980s. The point is to compare the level of delinquent and nonaccrual assets to the available loan loss reserves and capital, as a way of estimating how real the book equity is. This study is a good idea.

To be fully accountable for the credit risk of your loans, you can keep them on your own balance sheet. This is 100 percent skin in the game. One of the true (not new, but true) lessons of the housing bubble was that loans made with 0 percent skin in the game are much more likely to cause trouble. So Dodd-Frank made up a bunch of rules to control the origination of mortgages which feed into a zero skin in the game system. These rules are irrelevant to banks that keep their own loans.

The CHOICE Act therefore gives relief to banks holding mortgage loans in portfolio from regulations which arose from problems of subprime securitization, problems alien to the risk structure and incentives of the portfolio lender.

Accountability for Deals with Foreign Regulators

A challenging issue in the governance of the administrative state are deals that the Treasury and the Federal Reserve are alleged to have made with foreign regulators and central bankers, is in the context of their participation in the international Financial Stability Board (FSB). These deals have been made, the suggestion is, outside of the American legal process, and then imported to the United States.

Were there any such deals, or were there merely discussions?

We know that the FSB has publicly stated that it will review countries for “the implementation and effectiveness of regulatory, supervisory or other financial sector standard and policies as agreed by the FSB.” As agreed by the FSB?  Does that mean a country, specifically the United States, is supposed to be bound by deals made in this committee?  Did the American participants in these meetings feel personally committed to implement some agreements?

We also know that there is a letter that would shine light on this question: a September 2014 letter from Mark Carney, the governor of the Bank of England and chairman of the FSB, to then-Treasury Secretary Lew. This letter allegedly reveals the international discussions about American companies, including it is said, whether Berkshire Hathaway should be designated a systemically important insurer (an idea not politically popular with the Obama administration). A Freedom of Information Act request for the letter has previously been denied by the Treasury, which admits, however, that it exists.

I believe that Congress should immediately request a copy of this letter as part of its consideration of the “International Processes” subtitle of the CHOICE Act. While at it, Congress should request any other correspondence regarding possible agreements within the FSB.

The international subtitle rightly requires regulatory agencies and the Treasury to tell the Congress what subjects they are addressing in such meetings and whether any agreements have been made.

Accountability for Emerging Financial System Risks

The CHOICE Act makes a number of positive changes to the structure and functions of the Financial Stability Oversight Council (FSOC). Here I would like to suggest a possible addition.

I believe the responsibility for reporting to Congress on identified emerging financial system risks should be clearly assigned to the secretary of the Treasury. As the Chairman of FSOC, the secretary is in charge of whatever discussions are required with regulatory agencies, the Federal Reserve or foreign governments.

Forecasts of the unknowable financial future are hard to get right, needless to say, but I believe a unified, single assignment of responsibility for communications with Congress of the best available risk assessments would be a good idea.

Thank you again for the chance to share these views.

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WASHINGTON (April 26, 2017) – The Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act, better known as the Financial CHOICE Act, would represent major progress for the financial system, for constitutional government and for financing economic growth, R Street Distinguished Senior Fellow Alex J. Pollock testified today to the House Financial Services Committee.

Sponsored by Financial Services Committee Chairman Jeb Hensarling, R-Texas, the bill is best known for its provision to allow banks with a tangible leverage-capital ratio of 10 percent or more to see reductions in onerous and intrusive regulations imposed by the Dodd-Frank Act. Pollock praised that provision, noting that many aspects of the law—passed in the wake of 2008 financial crisis—represented legislative overreactions that expanded regulatory bureaucracy in harmful ways.

“This was in spite of the remarkably poor record of the government agencies, since they were important causes of, let alone having failed to avoid, the housing bubble and the bust,” Pollock said. “Naïve faith that government bureaucracies have superior knowledge of the financial future is a faith I do not share.”

Pollock also praised aspects of the CHOICE Act designed to improve regulatory transparency and accountability, including subjecting all regulatory agencies to the congressional appropriations process; requiring agencies to conduct cost-benefit analyses of promulgated rules, which would themselves be subject to review by a newly formed Chief Economists Council; and subjecting the Federal Reserve to quarterly reviews by Congress.

“I would like to suggest an additional requirement for these reviews. I believe that the Federal Reserve should be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers,” Pollock said.

Pollock also praised elements of the bill designed to bring greater transparency to the Financial Stability Oversight Council. He proposed the bill should go further by requiring the secretary of the Treasury, who serves as the council’s chair, to deliver regular reports to Congress on emerging risks to the financial system identified by FSOC.

“Forecasts of the unknowable financial future are hard to get right, needless to say, but I believe a unified, single assignment of responsibility for communications with Congress of the best available risk assessments would be a good idea,” Pollock said.

R Street is a nonprofit, nonpartisan public policy research organization whose mission is to promote free markets and limited, effective government. It has headquarters in Washington, D.C. and five regional offices across the country. Its website is www.rstreet.org.

Many of us know what a “seven-year itch” is. Between the famous Marilyn Monroe movie of the 1950s and the legendary Roseanne Cash song of the 1980s, it is a fairly well-understood turn of phrase.

Congress finally got around this past week to scratching one the most economically painful and fairly literal “seven-year itches” by starting the process to roll back the Dodd-Frank Act, which will turn seven this July.

The Financial CHOICE (Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs) Act—currently before the House Financial Services Committee—has many bright ideas and could serve as a great replacement for the burdensome Dodd-Frank bill of the Obama years. However, in the midst of this happy occasion, the American consumer needs to pay close attention, because Congress may in the end do something stupid.

A behind-the-scenes effort is underway let a Dodd-Frank provision commonly referred to as the “Durbin amendment” remain in the law. If you have a checking account, you should not let Congress keep this law on the books. Chairman Jeb Hensarling, R-Texas, took a strong stand in calling for repeal of the Durbin amendment as part of the CHOICE Act, and the committee should follow his lead by keeping that repeal in the final mark-up.

The Durbin amendment affects literally anyone with a checking account and a debit card. It requires the Federal Reserve to impose artificial government price controls to cap what banks charge to retailers for what are referred to as “interchange fees,” which banks use to pay for the security they provide for customers’ accounts. The cap is set far lower than it would be in a free market, creating a host of unintended consequences.

Before the government interference, banks and credit unions would use these fees to cover more than just security. They would use the revenues to offer perks to their customers, like free checking or point rewards system similar to what we see with traditional credit cards. Studies have shown these perks are worth millions in value to customers. But thanks to the Durbin amendment, banks have been forced to scale back their perks dramatically. The end result has hurt consumers, particularly those—like lower-income families or younger customers—who rely heavily on their checking accounts to conduct financial transactions.

While checking-account customers lost out, retailers (especially big-box retailers) made out like bandits. In 2010, the major retailers’ lobby sold Congress on limiting these transaction fees, promising they would pass along the savings to their customers. As of today, there is no evidence that has ever happened. In fact, an analysis of Federal Reserve data shows retailers have made off with more than $42 billion in foregone interchange fees over the last seven years. Shoppers have seen virtually no decrease in prices, even as they watched as many of their banking benefits disappear.

As the Financial Services Committee wraps up its hearings on the CHOICE Act, it’s important for the American people not to sit by idly. The Durbin amendment was sold in 2010 as protection for the American people, but the data prove the only protection it offers is to the major retailers’ profit margins. The House Financial Services Committee should strive to repeal the Durbin amendment, as should the full House when it hits the floor.

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This week, the House Financial Services Committee passed Chairman Jeb Hensarling’s Financial CHOICE Act. Most of the public discussion of this bill is about its changes in banking regulations, but from a constitutional point of view, even more important are the sections that deal with the accountability of regulatory agencies and the governance of the administrative state.

Accountability is a central concept in every part of the government. To whom are regulatory agencies accountable? Who is or should be their boss? To whom is the Federal Reserve, a special kind of agency, accountable? Who is or should be its boss? To whom should the Consumer Financial Protection Bureau (CFPB) be accountable? Who should be its boss?

The correct answer to these questions, and the answer given by the CHOICE Act, is the Congress. Upon reflection, we should all agree on that. All these agencies of government, populated by unelected employees with their own ideologies, agendas, and will to power — as vividly demonstrated by the CFPB — must be accountable to the elected representatives of the people, who created them, can dissolve them, and have to govern them in the meantime. All have to be part of the separation of powers and the system of checks and balances that is at the heart of our constitutional order.

But accountability does not happen automatically: Congress has to assert itself to carry out its own duty for governance of the many agencies it has created and its obligation to ensure that checks and balances actually operate.

The theme of the Dodd-Frank Act was the opposite: to expand and set loose regulatory bureaucracy in every way its drafters could think of. It should be called the Faith in Bureaucracy Act.

In the CHOICE Act, Congress is asserting itself at last to clarify that regulatory agencies are derivative bodies accountable to the Congress, that they cannot be sovereign fiefdoms — not even the Dictatorship of the CFPB, and not even the money-printing activities of the Federal Reserve.

The most classic and still most important power of the legislature is the power of the purse. The CHOICE Act accordingly puts all the regulatory agencies, including the regulatory part of the Federal Reserve, under the democratic discipline of Congressional appropriations.

This notably would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB — which was designed precisely to evade the democratic power of the purse. It is sometimes objected that appropriations “inject politics” into these decisions. Well, of course! Democracy is political. Expansions of regulatory power are political, all pretense of technocracy notwithstanding.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. It provides that actions whose costs exceed their benefits should not be undertaken without special justification. That’s pretty logical and hard to argue with. Naturally, assessing the future costs and benefits of any action is subject to uncertainties — perhaps very large uncertainties. But this is no reason to avoid the analysis — indeed, forthrightly confronting the uncertainties is essential.

The CHOICE Act also requires an analysis after five years of how regulations actually turned out in terms of costs and benefits. This would reasonably lead — we should all hope it will — to scrapping the ones that didn’t work.

Further Congressional governance of regulatory agencies is provided by the requirement that Congress approve major regulatory rules — those having an economic effect of $100 million or more. Congress would further have the authority to disapprove minor rules if it chooses by joint resolution. This is a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

On the Federal Reserve in particular, the CHOICE Act devotes a title to “Fed Oversight Reform and Modernization,” which includes improving its accountability.

“Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to,” once succinctly testified a president of the New York Fed. Under the CHOICE Act, such reviews would happen at least quarterly.

In these reviews, I recommend that the Federal Reserve should in addition be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers.

The CHOICE Act requires of new regulatory rules that they provide “an assessment of how the burden imposed … will be distributed among market participants.” This good idea should by analogy be applied to burdens imposed on savers by monetary actions.

By my estimate, the Federal Reserve has taken since 2008 over $2 trillion from savers and given it to borrowers. The Federal Reserve may want to defend its sacrifice of the savers as a necessary evil — but it ought to openly and clearly quantify the effects and discuss the economic and social implications with the Congress.

In sum, the CHOICE Act represents major improvements in the accountability of government agencies to the Congress and ultimately to the people. These are very significant steps forward in the governance of the administrative state to bring it under better constitutional control.

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The Consumer Financial Protection Bureau—the brainchild of then-Harvard law professor Elizabeth Warren  created in the wake of the 2008 financial crisis as part of the Dodd-Frank Act—may finally gain some basic requirements of accountability and transparency, as Congress moves forward with a significant rewrite of Dodd-Frank rules.

The law tasked the CFPB with supervising depository institutions—banks, thrifts and credit unions—with more than $10 billion in assets. It also has supervisory powers over some other financial services, including mortgage brokers, mortgage originators and servicers, student loan companies and payday lenders. Established as an independent executive agency—with a single director who can only be dismissed for cause and with funding coming automatically from the Federal Reserve, rather than congressional appropriations—the CFPB’s structure has always been constitutionally suspect.

Indeed, the courts may intervene even before Congress has the opportunity. Last fall, a three-judge panel of the D.C. Circuit Court of Appeals struck down the CFPB’s unique arrangement on separation-of-powers grounds in PHH Corp. v. CFPB. More recently, the D.C. Circuit granted the bureau’s request to hear the caseen banc, which will put it before all 10 of the circuit’s judges in a hearing scheduled for later this month.

Regardless how that case turns out, Congress is moving forward on the Financial CHOICE Act, sponsored by House Financial Services Committee Chairman Jeb Hensarling (R-Texas). The CHOICE Act, which cleared Hensarling’s committee last week, would subject CFPB to the congressional appropriations process, reasserting the democratic accountability the agency has lacked since its inception. It also would change the bureau’s mandate to both uphold consumer protection and ensure competitive markets by charging the CFPB with performing cost-benefit analyses for the rules it promulgates.

As my R Street Institute colleague Alex Pollock noted in his recent testimony before the Financial Services Committee, the bill “would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB—and which was designed precisely to evade the democratic power of the purse.”

By focusing its energies on enforcing consumer protection statutes and ensuring competitive markets, the Choice Act would streamline the Bureau’s functions. It also would reverse the original mistake of seizing power from the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and state financial services regulators, who already provided adequate supervision of these areas.

The CHOICE Act would improve accountability by restructuring the bureau as an executive branch agency and making its director removable by the president at will. But as Congress moves forward with the legislation, it should consider slight alterations that would take a longer view. An earlier version of the CHOICE Act Hensarling introduced in 2016 would have converted the CFPB’s leadership structure into a bipartisan commission with staggered commissioner terms, similar to what you see with the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Trade Commission and a host of other independent agencies of the federal government.

This would represent a positive change. Administrations come and go, and the next one easily could return the overall regulatory environment to a heavy-handed approach. A bipartisan commission would give both parties a voice in bureau decisions. A glance at Federal Communications Commission Chairman Ajit Pai’s dissents when he was a commissioner during the Obama administration demonstrates how valuable even minority opinions can be in helping to shape board decisions and highlighting when the majority reaches too far.

Since its inception, CFPB has evaded democratic oversight from either Congress or the president. The CHOICE Act would rectify this by making the bureau consistent with the Constitution’s demands and our democratic norms.

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The following post was co-authored by R Street Outreach Manager Clark Packard.

House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has done the yeoman’s work of putting together a host of fundamantal conservative reforms in the CHOICE Act. Although repeal of the Durbin amendment would have been a positive, pro-market reform, Congress should pass the bill even if this repeal is not included.

The most important provision of the bill allows banks the very sensible choice of maintaining substantial equity capital in exchange for a reduction in onerous and intrusive regulation. This provision puts before banks a reasonable and fundamental trade-off: more capital, less intrusive regulation. This is reason enough to support the CHOICE Act. Its numerous other reforms also include improved constitutional governance of administrative agencies, which are also a key reason to support the bill.

Accountability of banks

The 10 percent tangible leverage capital ratio, conservatively calculated, as proposed in the CHOICE Act, is a fair and workable level.

A key lesson of the housing bubble was that mortgage loans made with 0 percent skin in the game are much more likely to cause trouble. To be fully accountable for the credit risk of its loans, a bank can keep them on its own balance sheet. This is 100 percent skin in the game. The CHOICE Act rightly gives relief to banks holding mortgage loans in portfolio from regulations that try to address problems of a zero skin in the game model – problems irrelevant to the incentives of the portfolio lender.

Accountability of regulatory agencies

The CHOICE Act is Congress asserting itself to clarify that regulatory agencies are derivative bodies accountable to the legislative branch. They cannot be sovereign fiefdoms, not even the dictatorship of the Consumer Financial Protection Bureau. The most classic and still most important power of the legislature is the power of the purse.  The CHOICE Act accordingly puts all the financial regulatory agencies under the democratic discipline of congressional appropriations. This notably would end the anti-constitutional direct grab from public funds that was granted to the CFPB precisely to evade the democratic power of the purse.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. Overall, this represents very significant progress in the governance of the administrative state and brings it under better constitutional control.

Accountability of the Federal Reserve

The CHOICE Act includes the text of The Fed Oversight Reform and Modernization Act, which improves governance of the Federal Reserve by Congress. As a former president of the New York Federal Reserve Bank once testified to the House Committee on Banking and Currency: “Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to.” That is entirely correct. Under the CHOICE Act, such reviews would happen at least quarterly. These reviews should include having the Fed quantify and discuss the effects of its monetary policies on savings and savers.

Reform for community banks

A good summary of the results of the Dodd-Frank Act is supplied by the Independent Community Bankers of America’s “Community Bank Agenda for Economic Growth.” “Community banks,” it states, “need relief from suffocating regulatory mandates. The exponential growth of these mandates affects nearly every aspect of community banking. The very nature of the industry is shifting away from community investment and community building to paperwork, compliance and examination,” and “the new Congress has a unique opportunity to simplify, streamline and restructure.”

So it does. The House of Representatives should pass the CHOICE Act.

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The Banking Act of 1933 was passed in an environment of crisis. In March of that year, all of the nation’s financial institutions were closed in the so-called “bank holiday,” which followed widespread bank runs over the prior months.

Sen. Carter Glass, D-Va., a chief author of the bill and senior member of the Committee on Banking and Currency, was determined not to “let a good crisis go to waste.” Though he did not like the proposals from Chairman Henry Steagall, D-Ala., for federal deposit insurance, he agreed to support it on the condition that the legislation include Glass’ own pet idea that commercial banking be separated from much of the securities business.

It was poor policy from the start, but it took more than six decades to get rid of it. Now some political voices want to revive it. Financial ideas — like financial markets — have a cycle. Reviving Glass-Steagall would be an action with substantial costs, but no benefits. Its primary appeal seems to be as a political slogan.

Not having Glass-Steagall had nothing to do with the housing bubble or the resulting financial crisis of 2007 to 2009, except that being able to sell failing investment banks to big commercial banks was a major advantage for the regulators. And not having the law, in fact, had nothing to do with the crises of Glass’ own time, including the banking panic of 1932 to 1933 and the Great Depression.

Meanwhile, having Glass-Steagall in force did not prevent the huge, multiple financial busts of 1982 to 1992, which caused more than 2,800 U.S. financial institution failures, or the series of international financial crises of the 1990s.

While Glass-Steagall was in place, it required commercial banks to act, under Federal Reserve direction, as “the Fed’s assistant lenders of last resort,” whenever the Fed wanted to support floundering securities firms. This happened in the 1970 collapse of the commercial paper market, which followed the bankruptcy of the giant Penn Central Railroad, and in the “Black Monday” collapse of the stock market in 1987.

The fundamental problem of banking is always, in the memorable phrase of great banking theorist Walter Bagehot, “smallness of capital.” Or, to put the same concept in other words, the problem is “bigness of leverage.” So-called “traditional” commercial banking is, in fact, a very risky business, because making loans on a highly leveraged basis is very risky, especially real estate loans. All of financial history is witness to this.

Moreover, making investments in securities — that is, buying securities, as opposed to being in the securities business — has always been a part of traditional commercial banking. Indeed, it needs to be, for a highly leveraged balance sheet with all loans and no securities would be extremely risky and entirely unacceptable to any prudent banker or regulator.

You can make bad loans and you can buy bad investments, as many subprime mortgage-backed securities turned out to be. As a traditional commercial bank, you could make bad investments in the preferred stock of Fannie Mae and Freddie Mac, which created large losses for numerous banks and sank some of them.

Our neighbors to the north in Canada have a banking system that is generally viewed as one of the most stable, if not the most stable, in the world. The Canadian banking system certainly has a far better historical record than does that of the United States.

There is no Glass-Steagall in Canada: all the large Canadian banks combine commercial banking and investment banking, as well as other financial businesses, and the Canadian banking system has done very well. Canada thus represents a great counterexample for Glass-Steagall enthusiasts to ponder.

In Canada, there is now a serious question of a housing bubble. If this does give the Canadian banks problems, it will be entirely because of their “traditional” banking business of making mortgage loans — the vast majority of mortgages in Canada are kept on banks’ own balance sheets. If the bubble bursts, they will be glad of the diversification provided by their investment banking operations.

To really make banks safer, far more pertinent than reinstating Glass-Steagall, would be to limit real estate lending. Real estate credit flowing into real estate speculation is the biggest cause of most banking disasters and financial crises. Those longing to bring back their grandfather’s Glass-Steagall should contemplate instead the original National Banking Act, which prohibited real estate loans altogether for “traditional” banking.

Among his other ideas, Glass was a strong proponent of the “real bills” doctrine, which held that commercial banks should focus on short-term, self-liquidating loans to finance commercial trade. His views were reflected in the Federal Reserve Act, which, as Allan Meltzer has described it, had “injunctions against the use of credit for speculation” and an “emphasis on discounting real bills.” This approach which does not leave a lot of room for real estate lending.

If today’s lawmakers want to be true to Sen. Glass, they could more strictly limit the risks real estate loans create, especially in a boom, and logically call that “a 21st century Glass-Steagall.”

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Congress originally passed the Military Lending Act in response to scandalous stories of predatory payday lenders who would set up shop around military bases and charge our servicemen and women sky-high interest rates that reached upward of 400 percent.

A decade later, this well-intentioned law, which was signed by former President George W. Bush as part of the 2007 Defense Authorization Act, is having some unintended consequences and in some cases making it harder for service members to obtain secure financial products even from traditional banks and credit unions.

Although the rules initially applied only to high-interest payday loans, vehicle title loans and income tax refund anticipation loans issued to covered borrowers, the Defense Department later expanded its regulations in 2015 to cover a broad range of lenders and credit products, limiting the interest that any lender could charge for extending “consumer credit” to active-duty military borrowers and their families at an annual percentage rate of 36 percent.

Rules that took effect late last year cover essentially all consumer credit products except home and auto loans. As of Oct. 3 of this year, credit cards will fall under the regulation, as well.

While the rules were intended to protect military families, such limitations make it harder for some to obtain short-term, small-dollar loans affordably. A survey completed in May that looked at National Credit Union Administration call data found that 86 percent of military credit unions saw their portfolios of payday alternative loans shrink over the course of 2016, compared to just 47 percent of nonmilitary credit unions. Under rules established by the NCUA, payday alternative loans, or PALs, have a maximum interest rate of 28 percent and a maximum term of six months. The data show that among all credit unions, PALs grew by 9.5 percent in 2016 to $129.5 million, although they are still dwarfed by the $50 billion payday lending industry.

But the effect of the MLA extends beyond just PALs. Essentially, lenders are less likely to write nearly any product for military borrowers with low credit scores or financial difficulties in their past. The credit union survey show that 11 percent of military credit unions have eliminated share-secured loans, while others have discontinued indirect car lending, unsecured lines of credit, overdraft lines of credit or credit cards.

Indeed, while the rules require that lenders check a borrower’s military status against the rolls kept by the Defense Manpower Data Center, there is evidence that some borrowers have gone so far as to deny that they were active duty on loan applications, just to gain quick access to higher-interest loans. Ironically, rules intended to protect military families from abusive lending practices are driving some away from responsible financial institutions and back into the arms of the predatory lenders.

In late June, the major trade associations representing the lending industry — including the Credit Union National Association, the American Bankers Association, the Independent Community Bankers of America, the National Association of Federally-Insured Credit Unions and others — wrote to the Defense Department seeking more clarity on a number of the rule’s provisions, as well as places where it appears to be inconsistent with the department’s interpretive guidance. The lenders also seek a one-year delay before the MLA is applied to credit card products, which could further constrain military families’ access to credit.

That would represent a good start. No one questions that service members enjoy better protections today than in the days when many were vulnerable to deceptive lending practices that could charge APRs in excess of 300 percent. But in a time when nearly 60 percent of U.S. households couldn’t manage an unexpected $500 expense, it’s also important not to kill those products that would best serve military families who find themselves in a jam.

They risked their lives to protect this country. The country owes it to them to protect their financial security, in turn.

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The following op-ed was co-authored by Rafael A. Mangual, who manages legal policy projects at the Manhattan Institute for Policy Research.

The Consumer Financial Protection Bureau earlier this month finalized a rule forbidding financial services firms from including mandatory arbitration clauses in contracts with consumers. The rule is both bad for consumers and illustrative of the need for accountability in Washington, where unelected bureaucrats wield too much power with too little oversight.

Created by 2010’s Dodd-Frank Act, the CFPB is not only an independent agency but is essentially accountable to no one. Former President Barack Obama’s choice for CFPB director — Richard Cordray, the former Ohio attorney general — remains in the post because the law requires that he is removable by the president only “for cause.” It happens that a panel of the D.C. Circuit struck down that arrangement last year as unconstitutional, but the case currently is on appeal to the full circuit.

It isn’t just the White House that faces limits in changing the agency’s direction. The CFPB operates wholly outside the normal congressional appropriations process, and is instead funded by money transferred from the Federal Reserve. This prevents Congress from using its constitutional power of the purse to exercise oversight over the agency, which the D.C. Circuit called “extra icing on an unconstitutional cake already frosted.”

In promulgating the arbitration clause rule, the CFPB is using the tremendous lawmaking powers delegated to it under Dodd-Frank to take the side of the plaintiffs’ bar, who claim that allowing consumer contracts to call for arbitration, rather than litigation, to resolve disputes serves to deny consumers their “day in court.” While mandatory arbitration clauses do indeed curb litigation, the actual process of arbitration is far from the rigged system its motivated critics portray.

A 2009 study by the Searle Civil Justice Institute found consumers actually are more likely to be awarded relief in arbitration than in court. While supporters of the rule contend that arbitration is rigged against consumers, a look at the CFPB’s own study in support of its rule found that 87% of class action lawsuits resulted in zero benefits to the plaintiffs.

Even when consumers are lucky enough to be part of a successful class action, the average individual payment is only about $32. Interestingly, the lawyers in such suits raked in $425 million in fees between 2010 and 2013, according to Forbes‘ Daniel Fisher. Of the arbitrations reviewed by the CFPB in which consumers were victorious, the average individual payment was $5,389.

To be sure, not all customers follow through to arbitration. But no individual customer with a $5,000 claim can get a lawyer to press his case. And arbitration is merely a backstop since sellers of financial products already have a strong incentive to refund wrongfully imposed fees when they receive a customer complaint.

A Mercatus Center study reviewed evidence from one bank that, in 2014, “offered refunds in about 68% of cases in which a consumer complained, resulting in refunds of over $2.275 million.” The evidentiary record in AT&T v. Concepcion, a 2010 Supreme Court ruling which supported enforcement of mandatory arbitration clauses, found that the company in that case responded to consumer complaints by refunding more than $1.3 billion in a single year.

Anti-arbitration activists often respond to this hard evidence by arguing that class-action lawsuits are more likely to result in broad changes to corporate behavior than individual dispute resolution. While this may be true, we traditionally have deferred to the political process, not litigation by profit-seeking plaintiffs’ attorneys, as the proper way to decide how best to regulate corporate conduct.

In this case, companies will doubtless respond to the CFPB rule by changing their practices and eliminating generous arbitration provisions, since they cannot stop expensive class-action lawsuits. But this is hardly a boon for consumers. A 2016 Manhattan Institute study found that the CFPB’s arbitration rule would likely result in higher upfront fees and minimum balance requirements being imposed on the very consumers the agency purports to be helping — a result that already appears to have come to pass.

Despite creating an unaccountable entity in the CFPB and vesting it with lawmaking powers, Congress still has the tools to fix this problem. Under the Congressional Review Act, Congress can repeal any agency action within the last 60 legislative days under an expedited process that avoids the Senate filibuster. This arbitration rule would seem to be an obvious candidate for CRA repeal, but concerns are arising that Congress is so overwhelmed with health care and other legislative priorities that it might not have the floor time to do so.

Unfortunately, the CFPB arbitration episode is not a one-off problem. Over the past century, Congress has delegated more and more of its power to unaccountable agencies, while also failing to exercise proper oversight. Congress has lacked both the capacity and the will to reassert its role as the country’s first branch. Until it does, situations like this could just be the tip of the iceberg.

The notion of “too big to fail”—an idea that would play a starring role in banking debates from then to now—was introduced by then-Comptroller of the Currency Todd Conover in testimony before Congress in 1984. Conover was defending the bailout of Continental Illinois National Bank. Actually, since the stockholders lost all their money, the top management was replaced and most of the board was forced out, it was more precisely a bailout of the bank’s creditors.

Continental was the largest crisis at an individual bank in U.S. history up to that time. It has since been surpassed, of course.

Conover told the House Banking Committee that “the federal government won’t currently allow any of the nation’s 11 largest banks to fail,” as reported by The Wall Street Journal. Continental was No. 7, with total assets of $41 billion. The reason for protecting the creditors from losses, Conover said, was that if Continental had “been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international crisis the dimensions of which were difficult to imagine.” This is the possibility that no one in authority ever wants to risk have happen on their watch; therefore, it triggers bailouts.

Rep. Stewart McKinney, R-Conn., responded during the hearing that Conover had created a new kind of bank, one “too big to fail,” and the phrase thus entered the lexicon of banking politics.

It is still not clear why Conover picked the largest 11, as opposed to some other number, although he presumably because he needed to make Continental appear somewhere toward the middle of the pack. In any case, here were the 11 banks said to be too big to fail in 1984, with their year-end 1983 total assets – which to current banking eyes, look medium-sized:

If you are young enough, you may not remember some of the names of these once prominent banks that were pronounced too big to fail. Only two of the 11 still exist as independent companies: Chemical Bank (which changed its name to Chase in 1996 and then merged with J.P. Morgan & Co. in 2000 to become JPMorgan Chase) and Citibank (now Citigroup), which has since been bailed out, as well. All the others have disappeared into mergers, although the acquiring bank adopted the name of the acquired bank in the cases of Bank of America, Morgan and Wells Fargo.

The Dodd-Frank Act is claimed by some to have ended too big to fail, but the relevant Dodd-Frank provisions are actually about how to bail out creditors, just as was the goal with Continental. Thus in the opposing view, it has simply reinforced too big to fail. I believe this latter view is correct, and the question of who is too big to fail is very much alive, controversial, relevant and unclear.

Just how big is too big to fail?

Would Continental’s $41 billion make the cut today? That size now would make it the 46th biggest bank.

If we correct Continental’s size for more than three decades of constant inflation, and express it in 2016 dollars, it would have $97 billion in inflation-adjusted total assets, ranking it 36^th as of the end of 2016. Is 36^th biggest big enough to be too big to fail, assuming its failure would still, as in 1984, have imposed losses on hundreds of smaller banks and large amounts of uninsured deposits?

If a bank is a “systemically important financial institution” at $50 billion in assets, as Dodd-Frank stipulates, does that mean it is too big to fail?  Is it logically possible to be one and not the other?

Let us shift to Conover’s original cutoff, the 11th biggest bank. In 2016, that was Bank of New York Mellon, with assets of $333 billion. Conover would without question have considered that—could he have imagined it in 1984—too big to fail. But now, is the test still the top 11?  Is it some other number?

Is $100 billion in assets a reasonable round number to serve as a cutoff? That would give us 35 too big to fail banks. At $250 billion, it would be 12. That’s close to 11. At $500 billion, it would be six. We should throw in Fannie Mae and Freddie Mac, which have been demonstrated beyond doubt to be too big to fail, and call it eight.

A venerable theory of central banking is always to maintain ambiguity. A more recent theory is to have clear communication of plans. Which approach is right when it comes to too big to fail?

My guess is that regulators and central bankers would oppose anything that offers as bright a line as “the 11 biggest”; claim to reject too big to fail as a doctrine; strive to continue ambiguity; and all the while be ready to bail out whichever banks turn out to be perceived as too big to fail whenever the next crisis comes.

Image by Steve Heap

Well-functioning credit markets are essential tools for many people in times of personal economic instability or emergency. Unfortunately, some prospective borrowers with subpar credit ratings and credit histories do not qualify for the standard options of credit cards, secured loans or personal loans.

Credit unions frequently are the best available choice for those who have difficulty obtaining credit through traditional banks. But for some, digitally coordinated peer-to-peer lending agreements—inspired by microfinance arrangements for economically fragile communities internationally—also are proving to be an emerging option.

However, before these kinds of lending arrangements can be expected to expand domestically, digital rules will need to be established to give certainty to lenders and borrowers alike.

Subprime borrowers may have practiced poor financial habits or failed to meet their obligations, but this does not change their need for emergency credit when things get tight. Locked out of the prime credit market, these borrowers resort to payday loans, title loans and other products that come with very high interest rates and dubious collection methods. If they default on these loans, the interest and fees skyrocket, leaving them even worse off than before they took the loan. Most lenders must charge these high rates to compensate for the enormous risk they have undertaken to underwrite the loans.

Peer-to-peer digital microlending has the potential to fill a portion of the gap by providing this cohort with small, short-term loans that typically range from $100 to $500. While traditional peer-to-peer lending sites such as Lending Club target prime borrowers, other platforms are helping subprime borrowers.

One of the largest such peer-to-peer digital microlending platforms is the “R/ Borrow” section of reddit.com. This subreddit uses the reputational ecosystem within reddit to identify worthy borrowers, banning users who default or violate the terms of use. The subreddit facilitates the microloans and acts as a central database of transactions, coordinating more than $780,000 in loans in 2015.

If it can be properly scaled, peer-to-peer digital microlending could be a worthy option over payday loans for subprime borrowers. Unlike the latter method, digital borrowers are not necessarily assessed hefty fines or fees for late payments. Instead, they negotiate directly with lenders to find an amicable solution. True enough, some borrowers will default on their commitments and walk away without harm to their credit scores. To compensate, most lenders on microlending platforms (including the “R/Borrow” subreddit) charge high interest rates, ranging from 10 to 25 percent over several weeks or months. This isn’t a problem for most borrowers, as most of their needs are for short-term, small amounts to get them through until their next source of income.

Barriers to the expansion of these platforms come in the form of the myriad usury laws on the books in most states. While banks and other financial institutions are exempt from such laws, individual lenders are not. Digital microlending transactions often happen over state lines, making it very difficult for lenders and potential borrowers to determine their proper jurisdiction and the interest rate restrictions that apply to them. This may be an opportunity for Congress to pre-empt such laws as a matter of interstate commerce. Legislation could provide a consistent standard for digital microlenders to follow, such as through the proposed Uniform Electronic Transactions Act (UETA).

While admittedly there are other challenges to overcome, such as developing a scalable peer-to-peer enforcement mechanism, additional legal certainty would help expand this credit option for borrowers who find themselves locked out of traditional credit markets.

Image by designer491

Most of America’s 4969 are owned by holding companies, so the Bank Holding Company Act of 1956 is a key banking law. But do the prescriptions of six decades ago may not still make sense for the banks of today. The act for most of them creates a costly and arguably unnecessary double layer of regulation. Its original main purpose of stopping interstate banking is now completely irrelevant. One of its biggest effects has been to expand the regulatory power of the Federal Reserve–is that good or bad? Does it simply serve as an anti-competitive shield for existing banks against new competition? Some banks have gotten rid of their holding companies–will that be a trend? This conference generated an informed and lively exchange among a panel of banking experts, including the recent Acting Comptroller of the Currency, Keith Noreika, and was chaired by R Street’s Alex Pollock.

The podcast summarizes how to have realistic, fundamental reform of Fannie Mae and Freddie Mac. This requires having them pay a fair price for the de facto guarantee from the taxpayers on which they are utterly dependent, officially designating them as Systemically Important Financial Institutions (SIFIs) which they obviously are, and having Treasury exercise its warrants for 79.9% of their common stock. Given those three steps, when Fannie and Freddie reach the 10% Moment, which means economically they will have paid the Treasury a full 10% rate of return plus enough cash to retire the Treasury’s Senior Preferred Stock at par, Treasury should consider their Senior Preferred Stock retired. Then Fannie and Freddie could begin to accumulate retained earnings and begin building their capital in a sound and reformed context.

Sir, Your instructive report “Online lenders count cost of push for growth” (Dec. 15) recounts their rising defaults and credit losses. This points out the contrast between the two halves of “fintech” when it comes to innovation. The “tech” part can indeed create something technologically new. Alas, the “fin” part — lending people money in the hope that they will pay it back — is an old art, and one subject to smart people making mistakes. In finance, “innovation” can be just an optimistic name for lowering credit standards and increasing risk, with inevitable defaults and losses following in its train.