array(2) { ["nofollow"]=> string(1) "1" ["id"]=> string(1) "6" }

Posts

Sheila Bair was a key player in the response to the last financial crisis. Here’s why she’s worried the coronavirus crisis could turn into another financial calamity.

Sheila Bair was a key player in the response to the last financial crisis. Here’s why she’s worried the coronavirus crisis could turn into another financial calamity.

Sheila Bair — Former chair of the Federal Deposit Insurance Corporation

Sheila Bair is intimately familiar with what a financial crisis looks like and how devastating it can be.

So when she says she’s worried that we may be heading toward one, it’s probably a good idea to pay attention.

Bair, who was a key player in the federal government’s response to the financial crisis a decade ago, sees plenty of danger signs of another such calamity, much of it in the form of corporate debt and the collateralized loan obligations that debt gets sliced and diced and reassembled into. She also worries that the big banks are pushing hard to loosen capital requirements right now — and regulators are accommodating them.

“I think the regulators are focusing on the wrong things,” Bair told Business Insider in an interview Tuesday. “My worst fear,” she continued, “is that what is now a health and economic crisis turns into financial crisis. And that’s what the regulators should be focusing on.”

Bair headed up the Federal Deposit Insurance Corporation from 2006 to 2011. While there, she was part of the small group of policymakers that were trying to respond to the emerging crisis. Her job was to oversee the takeover and resolution of the numerous FDIC-backed banks that failed during that period. She also tried and failed to persuade then Treasury Secretary Tim Geithner to use a similar process to deal with the biggest financial institutions at the time, the ones that were later dubbed “too big to fail.”

It’s perhaps no surprise then that she’s again worried about the health of the banks.

Banks are pushing for looser capital requirements

Part of what concerns her is that the big banks are using the pandemic to persuade lawmakers and regulators to address one of their pet peeves: the amount of capital they have to keep on hand. In the wake of the Great Recession, in an effort to prevent another financial crisis, policymakers required banks of all stripes to increase the amount of capital they had on hand as proportion of their total assets, which include loans, investments, and real-estate holdings. Those institutions have been pressing ever since to lighten those requirements, claiming in part that the rules restrict their ability to make loans.

This spring the Federal Reserve announced new regulations that temporarily allow big banks to ignore certain assets when calculating the amount of capital they need to have on hand. The move essentially allows them to keep less capital in reserve or, with the capital they already have on hand, to make more loans or buy up more assets.

But the big banks are also pushing Congress to rewrite the section of the Dodd-Frank financial industry reform law that sets the capital requirements. The change, which Senate Republicans are reportedly planning to include in their next coronavirus stimulus bill, would allow the Federal Reserve to alter an alternate method of calculating the amount of capital banks need to have on hand than the one it already tweaked. The move would have a similar effect — giving banks a freer hand.

Bair, who saw what happened when the big banks had a similarly free hand before the last financial crisis, thinks such changes are both bad and unnecessary. Research shows that well-capitalized banks not only are better for financial stability, they do a better job of continuing to offer credit through economic downturns such as the one the US is going through now, she said.

“I don’t want to lower anyone’s capital requirements,” Bair said.

Looser rules won’t necessarily lead to more lending

And lowering the amount of capital the big banks have to keep on hand, won’t necessarily spur more lending to consumers and small businesses, she said.

The banks that typically make loans to those kinds of customers are the regional and local institutions, she said. Those banks wouldn’t be affected by the proposed changes.

Meanwhile, the big banks that would be given more freedom could simply use that to do something like invest in US Treasury notes, pocketing the difference between what the government is paying in interest and the paltry amounts they pay their depositors, she said. Indeed, because the new rules the Fed put in place allow banks to exclude Treasury notes when calculating their assets, the regulations essentially encourage them to just park their money there during this and future crises, she said.

“You could do that trade all day long,” she said. “I’m not saying it would go to that extreme,” she continued, “but I think that’s going be the tendency now.”

And regulators have and had a much better way to encourage banks to do more lending, Bair said. Rather than allowing the institutions to weaken their balance sheets, they could have ordered them to stop paying dividends to their holding companies during the coronavirus crisis. FDIC-backed banks paid out $32.7 billion in dividends in the first quarter — nearly twice what they earned in the period — just as the pandemic was starting to get into full swing, the Financial Times reported last month. That money could have supported more than a half a trillion dollars in additional deposits, which in turn could have been used to make new loans.

The danger is that with looser capital requirements, the big banks are going to make risky investments or understate the risks they’re taking. Either way, the moves could blow up in their faces and pull down the financial system along with, just like what happened 10 years ago.

The huge amount of corporate debt is a jumbo-sized danger sign

And there’s already plenty to worry about in terms of existing stresses on the financial system, Bair said. Her biggest concern is the tremendous amount of corporate debt. The total amount of debt held by non-financial companies hit a record $10.5 trillion in the first quarter, according to data from the Federal Reserve Bank of St. Louis. It’s unclear exactly how much of that amount is held by banks, but it’s almost certainly a large chunk.

As part of its response to the coronavirus crisis, the Fed stepped in to backstop the corporate debt markets, buying up bonds from hundreds of companies. That move helped sparked a new wave of corporate debt issuance this spring.

The Fed can’t prop up that market forever, Bair said. If the economy continues to falter, the institution risks impeding structural changes that need to take place and keeping in business companies that are essentially zombies and have no real chance of making a comeback.

Even if the Fed does continue to intervene for the time being in the corporate bond portion of the market, the big banks have other exposure to corporate debt that could hurt them. Many companies, for example, have credit lines with banks or other kinds of lending relationships.

And then there are leveraged loans and the related collateralized loan obligations, or CLOs. Leveraged loans are those made to companies that are already highly indebted or are considered poor credit risks. CLOs are similar to the notorious collateralized debt obligations, or CDOs, that blew up in the financial crisis a decade ago. But instead of being amalgams of mortgages that are then sliced and sold by layers, according to assessed risk, CLOs are collections of leveraged loans, that are similarly sold by layers.

Banks hold a lot of leveraged loans and CLOs

Both kinds of instruments could prove dangerous for the financial system if the economic situation forces companies to start defaulting en masse.

As of 2018, US banks and their holding companies held more than $110 billion in CLOs that were issued just in the Cayman Islands alone, according to a study last year by the Fed. Its quite likely their overall exposure to those derivatives is much greater than that, as Frank Partnoy pointed out in a recent piece in The Atlantic.

US banks also directly held some $760 billion in leveraged loans, mostly in the form of revolving lines of credit, at the end of 2018 and another $65 billion in such loans that they were in the process of turning into CLOs, according to a report at the end of last year by the Financial Stability Board. All told, for the average big bank in the major financial markets, the combination of CLOs and leveraged loans they held amounted to 60% of their capital.

“If [corporations] start getting into trouble, that could cause a lot of problems for the banks,” Bair said.

The fact that regulators are focusing on loosening capital requirements right now instead of taking meaningful steps to shore up bank’s balance sheets to help them weather a potential storm of defaults, indicates the degree to which their mindset has been warped, Bair said. They’re essentially identifying and empathizing with the companies they’re supposed to be keeping in check. Regulators have to recognize that what’s in the banks’ interest is not necessarily in the public interest, she said.

Banks are in the business of increasing their return on equity. Looser capital requirements helps them do that — but could also get them in trouble.

It’s the job of Congress and regulators to protect the broader public from the risk of a financial collapse, Bair said.

“Those [interests] are inherently at odds,” she said.

But she’s particularly frustrated that the big banks are pushing for such looser regulations right now. With the pandemic still raging, millions unemployed, and jobless benefits running out, Congress in particular has a lot more to worry about than addressing the banks’ pet issues.

“I do think a lot of it is cynical,” she said. “I think they’re using the pandemic to get things that have been on their wish list for a long time. And shame on them.”

Got a tip about corporate America? Contact Troy Wolverton via email at [email protected], message him on Twitter @troywolv, or send him a secure message through Signal at 415.515.5594. You can also contact Business Insider securely via SecureDrop.

SEE ALSO: Big Tech’s CEOs wrapped themselves in the flag and warned about China. Here’s why their patriotic appeal was meaningless, misleading, and should be ignored.

Join the conversation about this story »

NOW WATCH: Pathologists debunk 13 coronavirus myths

LEAVE YOUR COMMENT