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The Atlantic Council of the United States

The Future of Banking: Regulation and Reform in the United States

Welcome and Moderator:
Frederick Kempe,
President and CEO,
The Atlantic Council

Sheila Bair,
Former Chair,
Federal Deposit Insurance Corporation

Wednesday, September 14, 2011
4:30 – 6:00 P.M.
Washington, D.C.

Transcript by
Federal News Service
Washington, D.C.

FREDERICK KEMPE: I’m Fred Kempe, president and CEO of the Atlantic Council. I want to thank you all for joining us for what I think will not only be an informative discussion, but I would say an extremely timely one. I want to thank the former FDIC chairman, Sheila Bair, for joining us this afternoon.

SHEILA BAIR: My pleasure.

MR. KEMPE: This session will be held on Chatham House rules. So you will be enlightened by everything you learn. If you want to repeat everywhere, you can, that you’ve learned all this information at the Atlantic Council. You can do that as well. But you can’t attribute this to the former FDIC chairman, Chairman Bair, and the information is nonquotable. I hope that means that you’re going to be particularly provocative.

MS. BAIR: (Chuckles.) OK.

MR. KEMPE: I see we have several Atlantic Council board members here in attendance, including our vice chair, Brian Henderson, Robert Abernethy, Patrick Durkin, Ambassador Boyden Gray, Roger Kirk, John Macomber, Wendy Makins and Martin van Heuven. So it’s a good sign that many board members are here. They are all invested in the markets, wondering where things are going to go.

Chairman Bair, I know you’ve got a very busy schedule now so we particularly appreciate you taking the time. You’re working on your book which we look forward to and many other projects including as an advisor to the Pew Charitable Trust.

MS. BAIR: Right.

MR. KEMPE: I am very eager to hear what now you are not being in that position but knowing what you see and what you’re affected by, seeing what’s happening in the U.S. economy, seeing what’s happening in the Eurozone, how you’re viewing the world that you’ll be worried about at the moment. The event is part of our “mapping the economic and financial future” series.

Our global business and economics program has curated this thanks to Alexei Monsarrat and Garrett Workman. Alexei has really done a terrific job directing this program and leading us in the direction of putting the transatlantic world as the largest economic space on Earth.

MS. BAIR: Yes, that’s true.

MR. KEMPE: And has in the past been the place where the rules are written, where the rules are constructed. And so we really are concerned about how we exercise transatlantic leadership at times like this. Our discussion with you today adds to a growing list of extraordinary speakers. We talked with Senator Dodd shortly after Dodd-Frank was approved, Christine Lagarde when she was finance minister – we’re honoring her next week with our Global Citizen Award in New York – and Bob Zoellick. So it’s a good crowd. And we’ve been doing conference calls linking together particularly through this Eurozone crisis – conference calls linking together our global membership around these issues.

This has been traditionally – the Atlantic Council has a 50-year history – a place that thinks about the security issues but the security issues and the prosperity issues are so interlinked that we’ve really been building our prosperity pillar.

You’ll see outside copies of the mapping of the economic and financial future report with many of the conversations we’ve hosted. Or you can get a copy on our website if you missed it.

So we’ll get started. Chairman Bair will speak for a few minutes on her time chairing the FDIC, her instrumental role in formulating Dodd-Frank Wall Street reform act and her views on the current progress of implementing this law, putting it in its current context as well as areas of concern she sees that could hinder the global economic recovery.

She did say she was going to start with brief comments and then lots of Q&A. But what I just said you were going to talk about would probably take a day-and-a-half.

MS. BAIR: (Chuckles.) Right.

MR. KEMPE: Let me turn the floor to you. We’ll do this informally sitting here and then get to questions as quickly as we can.

MS. BAIR: Right. Well, thank you. It was a very nice introduction and I’m very happy to be here. I want you to know this is my first public speaking engagement since I left the FDIC. I’m very glad we could do it as the Atlantic Council that was the first forum. We tried to get this scheduled before I left the FDIC and it didn’t work out, so I’m delighted to be here now as my first speaking engagement.

I was on Diane Rehm last week and that was interesting. She had me on for an hour. And you take calls from the public and that can always be an interesting situation. But about halfway through the interview, lightning actually struck the tower and disrupted the broadcast.

And I wasn’t sure how I should interpret that, if somebody liked what I was saying or didn’t like what I was saying. They did resume the broadcast later. You know, you just can’t shut me up. What can I say? And then they rebroadcast it at 9 o’clock. But that was fun and interesting but anyway, I’m very pleased to be here today.

I think I would just like to respond to a lot of these issues in the Q&A segment of the program. I do look with what’s going on in Europe right now with a lot of sadness. I have somewhat of a personal history with some of these problems.

When I became chairman of the FDIC in 2006, the FDIC even at that point was really fighting what we’ll call the Basel II advanced approaches on capital standards for banks.

And the reason we were fighting it was because all of these studies – the quantitative impact studies of that new framework showed that capital levels would fall precipitously for banks – large banks that would implement it. So we fought it here successfully.

We delayed. U.S. banks never went to the Basel II advanced approaches and their capital levels stayed relatively high. It was implemented in Europe and we saw consistently declining capital levels as the result of the implementation of that protocol.

But anyway, in an effort to try to head this off in 2006, at my first Basel committee meeting in Mérida, Mexico, I got brave and suggested that we talk about an international leverage ratio. Now, a leverage ratio – I don’t know, some of you may or may be familiar with that.

There are generally two types of capital standards that regulators apply to banks in the U.S. at least. One is called a risk-weighted, a risk-based capital ratio. So you let the banks weight the riskiness of their assets and there are a couple of different ways to do that. The regulators can tell them what the risk weight is or they can decide for themselves what the risk weight was and that’s really what Basel II is about.

And which is why letting banks decide how risky their assets were led to these low capital levels. But we also have the leverage ratio which is just a simple ratio applied to balance sheet assets. So in the U.S. you’ve got to have 5 percent capital against your total assets, your total on-balance sheet assets.

It doesn’t matter if those assets are U.S. Treasury securities, if cash, Greek debt, whatever it is, got to hold 5 percent. They never had that in Europe. So they had this risk-weighted standard under Basel II that kept going down and down and down and they never had a constraint with the leverage ratio.

So I brought this up hoping to get somewhere. And I was just pillared by the Germans and the French. You know, they really didn’t like this idea and thought I was quite the upstart even bringing it up. And they were probably right there.

Actually it was the Germans leaked a story to The Economist magazine that was a scathing article about I was derailing this international agreement and I was a Luddite and it as just kind of amazing – my first foray into international bank regulatory policy.

I just kept hammering away and we actually did. Last year the Basel committee did approve an international leverage ratio – a little late, a very long transition period unfortunately. But we have significantly strengthened the capital rules in the wake of the crisis. This obviously is too late.

I think a big driver of the problem is in the conundrum that the Europeans face right now is the fact that, you know, there’s a lot of sovereign debt on a lot of bank balance sheets that probably is not going to get paid back at par and perhaps they don’t have the capital to absorb what the real losses are.

So they’ve got a banking system problem that feeds their inability to come to grips with restructuring the debt where clearly there are going to be some losses. So I think it’s a lesson and at least proactively looking forward why capital levels need to go up. Leverage was a key driver of this crisis.

It was a global problem and I hope at least when we emerge from this most recent European sovereign debt crisis, that that lesson will be learned across the Atlantic as well as in the U.S.

So that was a thought I wanted to share with you, given what’s going on and my early experience at the FDIC with European capital levels. And I’d be happy now to just get into the questions and talk a bit more about it or any other subject.

MR. KEMPE: Well, lots to talk about. Let me drill down just a little bit on what you just said about Europe and the banks there. The general view is that French banks are the most exposed.

MS. BAIR: Right.

MR. KEMPE: You see the statements that have been made by SocGen and BNP, some complaints that they’re losing their access to dollar lines.

MS. BAIR: Right.

MR. KEMPE: What is your analysis of what’s going on and could SocGen or just generically a French bank be a European Lehman? Others point to the Italian bond market as a soft spot.

MS. BAIR: Right.

MR. KEMPE: What would you be concerned about when you’re looking at Europe? And more to the point, how exposed is the U.S. to a European problem of this sort and what sort of knock-on impact could it have here?

MS. BAIR: Well, I think it’s very unlikely that the French would let any of their large banks fail. I think too big to fail is very alive and well in Europe, though the relative size of the banking industry – the French-domiciled banking industry – to the size of the French economy is much greater than it is here. So at some point the French as a sovereign have limitations on their ability to stabilize these very large institutions.

But in the near term I would be very surprised if it got to that point. Unfortunately, the Europeans have not yet done what we’ve done under Dodd-Frank. We’ve instituted a new resolution regime. We’ve given regulators tools to wind down failing institutions if necessary. None of that infrastructure is in place.

They also have very weak deposit insurance systems in Europe. And so you see more volatility with the retail deposit base in European banks which could also be a problem that could at least precipitate additional liquidity distress for those very large French banks.

But I would be surprised if in the near term there would be any significant risk of one of those banks failing. I just don’t think the French government would let that happen and at this point I think they probably have the capacity to prevent it from happening should they get into trouble. But you know, this thing isn’t getting better with time.

MR. KEMPE: Yeah.

MS. BAIR: And it’s been going on for a while now. And I think, again, at the root of the problem is the inability to come to grips with the fact that many of the sovereigns backing these debt instruments do not have the apparent capability to make good on their obligations and, you know, if that was any other type of asset, a regulator you would think would require that the banks write down those assets, take the losses, get on with it.

But that’s not going on in Europe. They didn’t even stress the risk of the sovereign debt default in their stress test.

So you know, their inability to acknowledge that the losses are there, they need to be dealt with, they need to be recognized, they need to be reflected on banks’ balance sheets, additional capital – if that would impact the solvency of any of those large banks, then perhaps they need to infuse capital on a temporary basis until it can recapitalize.

Perhaps that’s what they should do. But they just don’t want to seem to come to grips with the core problem. And I think the political will isn’t there. We saw the same kind of dynamic in a different context with the debate on our need to increase the debt limit here in the U.S. and fortunately it did. It got there. It wasn’t pretty and it took too long.

But you know, waiting for a major crisis to actually act as a catalyst for action is really a bad idea. And the problem is always so much more worse the longer you wait. I think probably the U.S. and maybe China too need to get a little more perhaps in a coordinated way need to get a little more proactive in talking with the European government about this.

MR. KEMPE: Well, and it seems that’s what is in store in Poland this week with Tim Geithner going out to meet with his European – or it seems to be wanting to meet with his financial counterparts. Let’s talk about that political will briefly and then go back to Dodd-Frank. You were talking about the size of the French banks as compared to the French government. If you take Europe and the French banks –

MS. BAIR: Right, that’s different.

MR. KEMPE: – that’s a better match.

MS. BAIR: Right.

MR. KEMPE: But I think the question in the markets is are the Germans willing to accept unlimited liability for the French or anybody else in Europe.

MS. BAIR: Yeah.

MR. KEMPE: And I think is that what the markets are questioning?

MS. BAIR: Well, I think it’s clearly the strongest economy and longer term moving towards more fiscal integration would probably make sense for the Eurozone.

I think short-term that would help stabilize and longer term, if they want to keep it together, it would make it a stronger, more viable economic unit. I mean, there may just be an inherent structural flaw with this association of fiscal and monetary policy.

So perhaps greater fiscal integration in both the short-term and the long-term would help a lot. But that would mean Germany would clearly be the driver and with that they would be having to assume a lot of responsibilities for a lot of weak countries.

And it doesn’t appear to me that the political support exists for that even though long-term I think that would probably be a good move for them and they might actually even, you know, at some point become against our interests actually because the euro might actually be at some point be more competitive with the dollar if they went towards fiscal integration. But I just don’t see the political will to do that.

MR. KEMPE: For the domestic political support for tighter fiscal, yeah?

MS. BAIR: Yeah, I don’t.

MR. KEMPE: I wonder if you could talk a little bit about Dodd-Frank and just give us a feeling of are we in a safer world now if you were to assess what Dodd-Frank has changed in the world.

MS BAIR: Right.

MR. KEMPE: Would you look and say, yeah, we did it. We’re safer. We’re better off.

MS. BAIR: Right.

MR. KEMPE: Or do you have a different view of that?

MS. BAIR: Well, I think Dodd-Frank in combination with a lot of regulatory measures that were taken post-crisis have made certainly the financial system more stable and a safer.

I think there’s more to do but I think regulators should be given credit for getting capital levels increased here among United States banks, stabilizing liquidity, requiring them to issue more long-term debt and rely less on short-term debt which was not done in Europe.

And again, this is a source of instability on their liquidity because they rely on a lot of short-term financing which can flee very quickly, as you see with money market mutual funds. They’re looking for very safe bets and so at the first sign of problems you’re going to lose that funding very quickly.

So regulators should take credit for that. I think Dodd-Frank gave regulators a number of new very important tools that we didn’t have during the crisis. But it’s really up to the regulators to use those tools. Dodd-Frank by itself didn’t make many changes.

It gave a lot of directives to regulators to do particular rulemakings and gave general guidance about the direction the Congress wanted them to go. But there’s an enormous amount of discretional attitude for the regulatory community. You know, I’m very proud of my agency.

I think all of our rulemakings, the ones that we can drive by ourselves were done on time actually head of schedule. They approved the living will rule yesterday and that actually wasn’t even supposed to be done until January of next year.

But I think that was clearly needed to be a priority and make sure the infrastructure was in place to resolve a very large and unlike financial institutions, if one got in trouble, I don’t see that happening in the near term.

But it’s good to have the process in place. And I think that has made it safer for taxpayers. There is a mechanism now. I know there are skeptics out there. But I am confident it can and will work. And if you need to resolve one of these large entities, the losses will go where they need to go onto shareholders and their secured creditors, as you have with the bankruptcy process.

If there are any losses beyond that, there’s an assessment against the industry, not against taxpayers. And it’s exactly the same approach that we’ve used for insured banks since the establishment of the FDIC in 1933 and it’s worked very well. It’s a closed system and insulates taxpayers and hope to use it very rarely but it is there.

MR. KEMPE: Have we truly put an end to too big to fail?

MS. BAIR: Well, we put an end to too big to fail when the market is convinced that these institutions will no longer be bailed out. And I still think the market is not convinced of that. The rating agencies have not been very helpful. If there are any of you in the audience, shame on you.

They continue to give large financial institutions a bump up in their rating based on implied government support. I know we’ve had a robust discussion with S&P on that. I actually filed a comment letter on the Wall Street editorial board saying somebody’s got to be crazy when a bank regulator is telling them to downgrade a bank.

But you know, I believe strongly that we are safer if these large institutions, some do and perhaps some don’t, need to understand they stand on their own. And investors need to look at them as standing on their own. And is this a safe place to invest? Do I want to buy their shares? Do I want to buy their unsecured debt? How well are they managed? What kind of crisis are they taking?

We want investors out there asking those questions. We don’t want them just happily buying bank debt because they think we’ll never take a loss on this, right, the government is going to come in.

So market is extremely important and I think when we convince the market that their money is at risk, and you should because you demand a higher risk premium on your debt if you invest in banks with that being the understanding.

So you’re underpricing yourself to some extent by assuming that there’s an implied government backstop. Because read the law, it isn’t there anymore. S&P thinks that Congress is going to authorize another bail out. And I would be really surprised at that. I’ve got to tell you, I think that that would be amazing if that happened given all the folks who lost their reelections or came very close because they voted for TARP.

I don’t really see that happening and I wouldn’t want to see that happen. So I think this is a new paradigm and I hope as the market understands that, accepts it and works with the FDIC and the Fed and the banks also.

You know, it’s in the banks’ interest to convince the public that there will be no more bail-outs because if there is another bail-out, if it should happen, I think that’s going to be the end of big banks. I think there’s going to be such political outrage there will be a tremendous push to break them all up now – healthy or weak, break them up. And so I don’t think the banking sector wants to see that happen either.

MR. KEMPE: And that’s why you thought the government should have let a firm like Bear Stearns actually go under?

MS. BAIR: Well, I think yes. I was detached from that process as an investment bank. We weren’t involved in it. They had a couple of very small depository institutions that had nothing to do with anything really.

So yes, looking at it as an observer, I do think it set up a market expectation that the government was going to keep coming in. and I think that was bad because then the market instead of looking to its own self-help mechanisms, I think it was assuming the government was going to take care of all of this. And the government just didn’t have the tools or capacity to take care of all of it.

So you know, in retrospect, hindsight’s always 20/20. But I do think Bear Stearns – and it was a smaller institution too. It’s hard for me to believe it was systemic but unfortunately we didn’t have the data or the analysis. That’s another thing that’s very important with Dodd-Frank. It requires these large institutions to have living wills to show regulators how they could be broken up and resolve in a financial crisis. It requires them to map their business lines with their legal entities. So if we want to sell of mortgage servicing someplace and the investment bank someplace, the retail banker, you know where the legal entities are housed and the infrastructure support.

So you have a roadmap for doing that and that’s very important. And we didn’t have any of that kind of data going into the crisis. But most importantly, we didn’t have data on who the counterparties were. So if Bear Stearns failed, just went into bankruptcy, who’s going to get hurt?

We didn’t know that. So I think just the fear of the unknown, not knowing who else might take losses, regulators and others erred on the side of doing bail-outs. Dodd-Frank now requires that these large institutions file something called credit exposure reports with the FDIC and the Fed.

This unfortunately was not part of the rule they approved this week. But it will be hopefully done before the end of the year – that requires these large institutions to tell regulators, OK, if you fail, who else is going to take a material loss and more importantly, if somebody – what other institutions out there, if they fail, is going to impose a material loss on you.

And identifying those interrelationships and those concentrations is really key to dealing with and preventing the domino effect that everyone fears if a large institution goes down. So I think that information we didn’t have. So it’s easy for me to sit here and say, whoa, why did you bail out Bear Stearns.

But at the end of the day I don’t think anybody had any information to know with certainty what the market impact to – who else was going to be taking losses that could be – materially impact their insolvency if Bear Stearns had gone into bankruptcy.

MR. KEMPE: One last question from me and then I’ll turn to the audience. You’ve talked about decisions that were made this week. The writers of Dodd-Frank gave regulators some significant leeway.

MS. BAIR: Yes, they did.

MR. KEMPE: And I wonder if you could assess what you’ve seen happen since then and just tell us whether you see any divergence between the original intent of the law and what’s actually happened in the way it’s been implemented by various regulatory agencies.

MS. BAIR: Well, that’s a really good question. I think it does seem like things are getting bogged down a bit and I think maybe the FSOC – the Financial Services Oversight Council – can play more of a role in prioritizing these rules because Dodd-Frank threw a lot of things at the regulators all at once and perhaps some prioritization of sequencing would be important.

But things do seem to be slowing down. Volcker are slowing down, moving customized derivatives to clearing seems to be slowing down.

So I am a little concerned about that and I do think back to the concentration with interconnectedness, that’s very much related to trying to move more of this business onto centralized clearing because with centralized clearing you also have very concentrated decisions which you’ve got in a clearing mechanism.

And clearing houses have a very good track record. There’s a lot of discipline, you know, very rigorous margining and collateral and financial integrity requirements for the clearing members. If one of the clearing members defaults, you’ve got the rest of the industry, the rest of the members to back it as opposed to just a bilateral counterparty where you’re relying on the creditworthiness of a single institution.

So I think getting more of that business into clearing can help reduce these concentrated decisions among really four or five large banks have so much, for instance, of the CDS market. It’s a little frightening.

But that is slowing down. And so I think that should have a very high priority at least with the credit default swap market because that is a very concentrated market and as we saw during the crisis, did not function well at all and contributed to the problems.

MR. KEMPE: Thank you very much, Chairman Bair. Let me turn to the audience. Harlan, and even though I identified you, identify yourself again if you could when you ask your question please.

Q: I’m Harlan Ullman.


Q: Thank you very much for your comments. My question has to do with ticking time bombs and which do you think are the loudest. When you take a look at the political and financial landscape, it can really scare the daylights out of you, both long- and short-term.

China potential real estate bubble that goes poof, lack of demand and what does that do, let alone the fact that they hold a couple of trillion dollars. Here in the United States, also it’s of instabilities, euro questions, Greece and the other countries that are very weak, whether we have overregulated or too underregulated. Jamie Dimon says Basel III is the kiss of death. So what do you think from your perspective now as a private citizen? What really worries you most short-term and long-term?

MS. BAIR: Yeah, well short-term is definitely the Eurozone crisis. I think that is definitely front and center. I think that could have a very bad impact on the U.S. economy.

You know, we had a miniplay of this in mid-2010 when the recovery was going at a pretty good clip here and the problems with sovereign debt in Europe raised their ugly head. The Fed’s policy is the U.S. dollar had been devalued somewhat, which was positive frankly. It was helping out exports.

And when the Eurozone debt crisis occurred, the euro went down and that stymied recovery here. And so that was just a bit of a glimpse of, you know, full-scale crisis over there, what could happen. So I think that is very much keeping me up at nights or certainly would be if I was still in government.

As a private citizen it’s keeping me up at night. I think the housing market here is still a real problem. I think there are a lot of losses which haven’t been realized yet and I don’t think the market’s going to clear until those losses are taken and nobody wants to take losses. Nobody wants to sell property and take the market price and, you know, charge it off.

And I know that’s hard to do. It’s hard for the banks to do. It’s hard for the GSEs to do. But the market’s going to recover until that happens. And so there’s, again, nobody wants to recognize losses. It’s kind of a recurring theme here but until that happens, housing isn’t going to start recovering and our broader economic picture is going to still be the recovery sluggish at best.

You know, China I worry less about and maybe I’m just happy in my ignorance because I probably know less about that. But I do know the Chinese regulators pretty well. And they’re pretty traditionalist and the banks – they have a lot of capital and they assure me, you know, you never know.

I don’t go in there and look at the longs on their banks’ balance sheets but they assure me that they have very, very high down payment requirements, low undervalue ratios and so that even with a correction there’s still plenty of equity there to protect their banks and their credit exposure. So I’ll take that at face value.

But certainly that’s also something to watch but probably lower on my worry list. But it’s a very uncertain time. And we’re in such a weakened position and we’ve spent so many bullets already getting ourselves out of the 2008 crisis, I think it’s really problematic.

MR. KEMPE: Speaking to a major global investor myself recently, the way he put it was it’s the first time in my life of investing around the world where I’m having trouble seeing that this big of a conglomeration of danger spots.

MS. BAIR: Right, right.

MR. KEMPE: And this small a conglomeration of places where I see emerging growth and great possibilities. Would you say that as well or?

MS. BAIR: Yeah, no, I think that’s right. And of course those few pockets where you think some investment opportunities, then you start feeding bubbles there because so much capital goes in and that was one of the unintended consequences of QE2.

So I think it’s very difficult if you’re an investor right now to make decisions and that’s why Treasury yields have stayed so low even notwithstanding our fiscal problems and people, you know – banks wanting to turn insured deposits away because they know it’s guaranteed by the government and they’re just desperate for a safe place. Nobody’s really looking for return right now. They’re just going for a safe place where they know they won’t lose money.

MR. KEMPE: Yeah, please?

Q: Paul Gallagher, EIR News Service. If I could ask two very brief and closely related questions.

MS. BAIR: Sure.

Q: First, do you think that the United States, the Federal Reserve may soon find itself in the middle of a big new bail-out of euro bank debt –

And secondly, legislation to restore Glass-Steagall has picked up – 45 sponsors in the House – fairly quickly this summer and is about to be introduced in the Senate. What do you think about that as the means of really protecting the commercial banking and screening out the rest?

MS. BAIR: Right, right. Well, I think that the Fed may have to reopen some facilities. I think that they’re having problems with their dollar funding and, you know, I’m not inside the Fed. I don’t know. But my sense is that that may be there and if they have to do it, they have to do it.

And you know, I think that’s unfortunate because there’s been such a public hostility towards the Fed which really troubles me a lot and it troubles me that this is kind of becoming a theme in the Republican presidential primary.

And I don’t think there’s anybody that’s a more dedicated public servant than Ben Bernanke and he has – whether I’ve agreed with him or not on everything, I will tell you he has done exactly what he thinks is right for the country and our economy and for American people.

And there’s not, a bone in his body that’s trying to play favorites with banks or whatever. So if they have to do it, they have to do it and I hope the political process will support and respect that.

On Glass-Steagall, my sense on Glass-Steagall I think I would like to see and I don’t know if the regulators will get there but as part of the resolution planning process, I would like to see greater within the larger financial organization I would like to see greater autonomy between the investment bank and the commercial bank.

But requiring that they could be completely severed, you know, taking that – trying to put that genie back in the bottle – I think probably that would be challenging to get done. And I’m not sure it would help.

At the end of the day, some diversification is helpful and when the investment banks were all going down because they market-to-market and they were having tremendous liquidity pressures, the commercial banks were more stable and could come in and help stabilize them through acquisitions or through capital injections.

Though now you see the reverse of BoA where actually their investment banking unit is helping their earnings picture as they struggle with all these legacy loans that they acquired from Countrywide.

So I think some level of diversification is OK so long as we know that we can resolve them in a crisis and break them off easily and so long as they do not use insured deposits in any way, shape or form to support their proprietary investment functions or any type of speculative activities that are appropriate for an investment bank but have no place in commercial banks.

And that’s a lot of that Volcker is about. And the Canadian banking system, I’m actually going to Canada tomorrow to speak to a banking group there.

MR. KEMPE: Where things have gone pretty well.

MS. BAIR: And they’ve never had Glass-Steagall and they’ve had an integrated financial system and things have worked just fine. So I think a lot of it is just good regulation, good management and you do need to take extra care to wall off those insured deposits from any kind of speculative activity that might be going on in the investment banking unit.

But other than that, I think I don’t see a repeal of Glass-Steagall is a big driver during this crisis. I’m not really sure what it would accomplish.

MR. KEMPE: Yeah, and thank you for your subliminal message to Governor Perry and Governor Romney. (Laughter) Please?

Q: Robert Abernethy. Could you give us a brief teaser on your upcoming book?

MS. BAIR: Well, it’ll be my memoirs and I’m up into 2008 and I’ve got 30,000 words already. So clearly I’m going to have to write this book and then cut it back by half. I want to write it for a mainstream population.

I think it’s important. I want people to understand through my eyes, if you will, what happened, what we did right, what we did wrong, what we need to fix going forward. I do think that, you know, there’s tremendous backlash already against trying to implement some of these regulatory reforms.

And with all due respect to Jamie Dimon, I wish the banking system was leveraged far too excessively going into this, even in the U.S. with our stronger capital levels.

And I know it creates regulatory disparities because the Europeans are so weak on capital. But I wish he’d spend his time lobbying the Europeans to, you know, up their capital levels and institute a leverage ratio than putting pressure here to weaken decisions that have already been mad. So I think that’s very important.

And you know, I just hope we hold the course. Ironically I think people were so angry at government and regulators when the crisis hit and when the bail-outs occurred that it created a cynicism about the ability of government and regulators to do anything right.

And so ironically I think that is weakening the political will to support the regulators now as they try to implement reforms that will make the system more stable. So I’m hoping my book can help correct that and engage them on positive reforms like higher capital.

MR. KEMPE: Speaking of books, I didn’t go into the details of your bio because I was trying to save some time.

But just for the record, as you know, she was nominated to the FDIC by President George W. Bush in 2006, term ended in July, assistant secretary of financial institutions in George W. Bush’s Treasury Department, senior vice president New York Stock Exchange, commissioner Commodity Futures Trading Commission.

So that’s the reason you have all rich context and also several years as a long-time aide to Senator Bob Dole. But here’s the real point, you have penned two children’s novels.

MS. BAIR: There you go.

MR. KEMPE: Which demonstrates savings skills and good money management.

MS. BAIR: Right.

MR. KEMPE: So I’m wondering whether you’re going to change your children’s novels for a book that should be written for government and legislative bodies on saving skills and good money management.

MS. BAIR: Well you know, maybe so. I think that could be helpful. Maybe I should. It’s a good suggestion.

MR. KEMPE: Well, I look forward to reading the children’s books. More questions please?

Q: Thank you. Raul Burbacker, University of Oxford and U.S. Treasury. Related to the previous question, do you have any views specifically on the Vickers Commission report just released?

MS. BAIR: The what?

Q: The Vickers report

MS. BAIR: The Vickers Commission

Q: And the British banking sector.

MS. BAIR: Well, I thought there were some helpful things in it. I think one thing that concerned me is the implication kind of trying to ring-fence the retail banking and have that really heavily regulated and then everything else kind of maybe not so much. That really makes me nervous. I think first of, let’s just go back to capital again.

You know, if you’re going to have higher capital in terms of the types of assets that banks hold on their balance sheets, loans are probably not the big danger zone. I mean, certainly the mortgages blew up.

But it’s really the mortgage-backed securities that precipitated the crisis in their market-to-market loans, they’re held at amortized cost, you can work them out over time. It’s a slow burn. It’s not a sudden hit the way it is with investment banks that have – that market everything to market.

And so they can face crisis and liquidity runs pretty quickly. So I think to the extent Vickers could imply that it’s OK to have lighter touch regulation on that sector, I think that makes me a little nervous.

If I could wave my magic wand and say OK, we’ll have insured banks that’ll take deposits and make loans and we’ll take care of them and they’ll be in the safety net and nobody else will be, that would be nice.

But I don’t think that’s realistic. And so you’re going to have lighter touch regulation with the investment banks, the big ones will get in trouble and then you’re stuck. So I think you need equally robust regulation, higher capital if anything for them.

I know they don’t like to hear me say that but I think that again was another lesson of the crisis. This is all integrated now and to try to make these nice little categories and say, OK, we just need to worry about insured banks and retail banking and make sure that’s safe in the safety net, I just don’t think that works anymore unfortunately.

MR. KEMPE: Yeah, clearly. Doug?

Q: Mike Elliott from the Brookings Institution. I wanted to go back to a good question of Fred’s, which is if the Eurozone does have more serious problems, what do you see the level of effect on U.S. banks and how prepared are they to handle it?

MS. BAIR: Well, I think there’s been a lot of focus already on it and I think certainly, you know, any default on the PIGS debt would not be an issue. There’s not a lot of direct exposure there.

There is obviously a lot of direct exposure to the European banking system so if the big European banks started to get into trouble, I think that could have a pretty profound impact on U.S. banks here as well as banks all over the world.

I mean, I think they’re integral to the global economy and a stress among those major institutions would end up hurting everybody. But I think the Fed’s been on top of this. The Treasury’s been on top of this. I think bank management probably the good news with this happening so soon after the crisis, nobody’s complacent about this. I will tell you that.

So I think what preparations can be taken are being taken. But you know, at some point if it spins out of control there’s nothing the bank or regulators are going to be able to do to insulate us from the repercussions.

MR. KEMPE: And if you would compare this to subprime obviously had global ripples.

MS. BAIR: Right.

MR. KEMPE: The magnitude of the global ripples of a European banking crisis would be greater than this.

MS. BAIR: If it became very serious, yeah, I think absolutely, absolutely.

MR. KEMPE: Doug has been involved in some important work we’ve done with Thompson-Reuters, taking a look at financial regulatory gaps between Europe and the U.S., what sort of problems there are. We’re doing some follow-on work on that. We’re actually doing some work as well on the Canadian situation, what we can learn from Canada with Thompson-Reuters.

I wonder if you could tell us, if you’re looking to the international impact of financial reform, how closely did you work with your European counterparts? Are we doing a good job now coordinating across the Atlantic?

You were talking about how perhaps maybe the Chinese and the Americans ought to be sending some clear messages right now. Are you seeing more of a convergence of compatible practices – Washington, Brussels, New York, London – or are we not on the right path.

MS. BAIR: Unfortunately not. I mean, I think the Basel III Accord is not perfect. But it was a tremendous seismic shift for the Europeans in terms of raising those capital levels and agreeing to implementation of an international leverage ratio.

But I see political will waning on implementation. We did provide for very long time period for transition to give the banks time to raise capital to meet those new higher standards.

And maybe in retrospect we shouldn’t have because I think it’s just being chipped away. And so, I think this time it’s different. Governor Reinhard’s book, I think one of their recommendations at the conclusion was to have some type of international body that could enforce on a consistent basis international capital standards for banks.

And maybe that’s what we need. And nobody’s going to want to give up their individual authorities sand jurisdictions and certainly that should be setting a floor, not a ceiling.

But I fear, and I think this is probably what’s driving Jamie Dimon, as he knows that we do have stronger will here to improve the quality of capital, to get those ratios up and he thinks it won’t happen in Europe.

And I can understand why from a competitive standpoint that would worry him. But I worry that all the hard work that went into the Basel III Accord, I’m afraid it is going to become undone at least in Europe through weakening implementation.

Again, the political pressure is to weaken that and not to strengthen that. And I don’t for the life of me understand that and that’s way I want to write this book because the general population should be angry about this. One of the reasons that the European nations are facing the conundrum that they are right now is because their banks don’t have enough capital.

They don’t want to bail out – the Germans don’t want to bail out Greece. Make sure the German banks have enough capital to withstand the loss if the Greek debt defaults.

I mean, at the end of the day, that’s what it comes down to and that’s what I’d like the general population to understand better ,because I’d like to see the political pressure support good commonsense regulation, not, you know – some of them – the moneyed interest creating all the pressure to dilute it.

MR. KEMPE: But more concerned about increase capital requirements on European shores rather than on our own shores?

MS. BAIR: I think the Fed has really – you know, Dan Tarullo is very strong on capital. It’s been a real breath of fresh air working with him since he joined the Fed. And I think there is a lot of resolve and even very conservative free marketiers like Alan Greenspan acknowledge that bank capital levels need to go up and go up significantly.

So I think in the U.S. again you’ve got that long transition period, and you know, there will be continued pressure to water it down. But I think the resolve is pretty strong here but I do worry about Europe.

MR. KEMPE: Give me one second and I’ll get right to you. One last question on this. We’re the Atlantic Council. Why isn’t this happening? What’s the problem? Why can’t U.S. and Europe get their act together? What should we do? What should policymakers do to fix that?

MS. BAIR: Well, you know, I think when I first started going to Basel, and this dynamic changed somewhat. I’ll just tell some secrets out of school. You know, it was really more about everybody kind of representing the unique profile of their banks.

I think through strong leadership of Nat Welnick (ph) who I don’t think gets enough credit for this, he changed the dynamic of the debate into what will stabilize the system, what will protect people as opposed to whether, you know – how we count mortgage servicing rights, which is capital, and that’s what the U.S. banks do and other European banks do so let’s go after mortgage servicing rights or something called minatory interest which European banks count as capital.

Let’s leave those alone. Those are the kinds of parochial debates that you would get into. And I think really the perspective needs to change to what is in the common good for the stability of the global financial system.

And I think progress has been made there but I think at the end of the day there’s still a lot of pressure to protect our home banks and I think regulators has to get beyond that. Central bank heads have to get beyond that and maybe that’s another thing I would like to talk about in my book about, you know, how you change the regulator mindset to get away from turf and more broadly protecting the public who uses the financial system and not so much the individual institutions that comprise it.

MR. KEMPE: It’ll be interesting if you could crack that.

MS. BAIR: Yeah.

MR. KEMPE: Please, sir?

Q: Thank you. Richard Dagy (ph), professor of economics, Johns Hopkins SAIS. My question regards the Fed. We have recently an increment of additional candor from the FOMC with regard to their monthly reporting. Is this consequential and who should be reassured by this for anything?

MS. BAIR: Yeah. Well you know, I think Ben in general has really made the Fed a much more open institution and that’s true with the FOMC as well as on the regulatory side of what they do in their 13-3 facilities and if you compare what the Fed discloses now with that they used to disclose. Chairman Greenspan is a friend and I admire him a lot.

But it was more the traditional Fed philosophy, very closed. And that worked for him and it was very benign economic times. And so it could work. So I think that kind of gets back to my concern about kind of the punitive attitude towards the Fed right now because I think Ben has done some wonderful things at the Fed.

I think they’ve strengthened their supervisory arm. They’re much more focus on supervision as a compliment to monetary policy. So they have provided more information, perhaps not enough, but they’re – there’s an increment.

And instead of being rewarded for this, it seems like the more you try to engage the public an open the information, there’s pushback as opposed to, you know, positive reinforcement.

So I would hope that if you’re still considering you want more information, I’m glad you acknowledge at least that it’s improving because I think he’s a very good person and very public oriented and I think wants to do the right thing and constructive engagement is absolutely the right way to engage with that.

MR. KEMPE: Mr. Bernanke and Mr. Trichet can commiserate with each other.

MS. BAIR: That’s for sure. That’s for sure.

MR. KEMPE: Please?

Q: Clay Lowery, good to see you, Sheila, and thanks for your service.

MR. KEMPE: Sorry, we couldn’t hear the name/

Q: Oh, Clay Lowery. So in terms of your point about too big to fail, if Secretary Geithner in the reports that he’s going to go to Europe and one of the things that he is going to talk about is that doing almost like a TARP over there, doesn’t that kind of suggest that maybe the too big to fail is not really over –

MS. BAIR: Not here.

Q: — if that is the policy response which is basically kind of suggest also a backdoor recapitalization of the European banks.

MS. BAIR: Right, right. Well, I tell you, I think it worked in 2008. There were limited tools that were available to stabilize the system. Europe has not done what we’ve done here which is institute a new resolution authority and as well as increase their bank capital, so to reduce the risk of failure.

So I think their choices are limited. I would hope, though, if they inject government capital, that they force the banks to recognize losses regarding the sovereign debt that they’re carrying on their balance sheet, that’s clearly troubled. I hope they put restrictions on bonuses. I think that was – you know, again, hindsight is 20/20.

But boy, looking back on that now and, you know, at the public backlash against TARP and within a year these fabulous bonuses being paid. It is taxpayer money and I know banks need to pay good talent and all of that. But you know what, you’ve got to balance that against your public reputation and how people feel about their government and about their financial sector.

So I would hope there would be some very tough conditions imposed if they feel like they need to go that route. But first and foremost they need to make the banks get that debt restructured, make the banks take the loss and then if they have to inject capital, fine. But that should be the first step, not just bailing them out now without them having to do anything.

MR. KEMPE: Thank you. Please?

Q: Hi. My name is Julie Chon. I joined the Atlantic Council a couple of months ago from Chairman Dodd’s banking committee staff and one of the very early projects that we worked with your staff on when he first became chairman in January 2007 was the effort to promote broad-based loan modifications.

MS. BAIR: Right.

Q: And you were obviously one of the few public champions of that type of initiative. Some people were expecting a bigger housing rescue plan to come out of the Obama jobs announcement a couple of nights ago. And you mention that there is a pretty negative outlook for future improvements in the housing sector.

What tools do you think exist within the regulatory agencies, tools that would not require new authorization from the Congress that can help at least make things better? And secondly, do you foresee any significant reforms to the FHFA system and the GSEs?

MS. BAIR: All right. Well, I think, again, it gets back to loss recognition. I think getting a bit more aggressive on recognizing losses on second liens could help but not necessary to be an impediment to getting the first lien restructured. And I think the GSEs probably could do more in terms of we’ve never advocated principal write-downs for current loans.

But the good news on housing is that the delinquencies and defaults are actually slowing. So the people have mortgages now that are still performing loans are continuing to perform. But you’ve got this tremendous backup of the foreclosure process. So not so much is going into the pipeline, but the pipeline has really backed up.

So we had suggested what we call the super mod which is to say, you know, any loan that was more than 60 days delinquency as of August 1st – pick a day – that there would be a one-time write-down to, say, 97 percent of appraised value. So you can do a refi in FHA with 3 percent equity if the borrower qualified, or take a short sale, or let the borrower try to see if the borrower could perform on the reduced principal amount.

But in exchange for that, if the borrower redefaulted, that they would be willing to turn the keys in, vacate the house and let it be dealt with because this foreclosure process is becoming completely dysfunctional.

I think you need a jolt to the market to get it cleared. And you know, facilitating principal write-downs, at least for the delinquent space, currently delinquent ones, could have that kind of an impact.

I think short sales, again, people resist that. Once you take the short sale, you’re going to take it to a discount and once it’s sold, you know, it’s gone. You’ve got to charge off that portion of the unpaid principal balance and people are reluctant to do that. And they still had kind of this sense of kicking the can down the road.

And I think with the GSEs, that’s a particular problem. This idea that maybe if they just hold out for a couple of years or more that the housing market’s going to recover. And it’s just not going to happen. So there is through coordinated action with the regulators you could get hat. We suggested putting that in as part of the global settlement. I don’t know if the global settlement is happening now.

I think the banks would be very motivated. They’re worried about litigation, which they should be and I think they’re very motivated to do some things if an exchange – some very significant things if an exchange they could get some relief at least from the litigation exposure on the borrower side. The investor lawsuits are something else.

But you know, the regulatory save for some massive government spending program which Congress isn’t going to approve to just do what they did during the depression and just buy all this and have the government take it over, I don’t think that’s going to happen. So I think you’re going to be stuck with incremental measures.

But I think trying to do some one-time principal write-down for delinquent loans could help clear the market and getting rid of these second liens that are really creating a lot of problems with getting the first tier written down. And we also had said that if you do the principal write-down, you can take a soft second.

So if there was subsequent home price appreciation, the current owner of the mortgage could either share in that or take that. And again, to try to soften the blow to the mortgage investors or for portfolio loans to the banks.

But there’s just real resistance to do anything. Again, nobody wants to take the losses and so just kind of bumbled along like this and hoping it recovers by itself seems to be the mindset. I don’t think that’s going to get us out of our problems.

MR. KEMPE: Can Fannie Mae and Freddie Mac end government conservatorship?

MS. BAIR: Well, it’s just gone on forever. I’m a capitalist and I thought we had a free market economy not in the housing market anymore. I think they’re 90 percent of new originations are probably between FHA, Fannie and Freddie. They’re probably about 60 percent of the mortgage market right now. What is that? I don’t get that.

So I would like to see an exit strategy for Fannie and Freddie. I think we need to bring the private securitization market back. We need reforms like risk retention and better just loan level disclosure of what’s in the securitization before investors need to commit on whether they’re going to invest or not.

And I support the covered bond market. I don’t think the corporate bondholder should have a super priority over the FDIC. I think that’s just another government guarantee. But a covered bond market without any kind of special privilege debt as recovered bond investors I think makes a lot of sense.

So but that private sector, who’s going to fund that if you can buy GSE securities that are government backed? So who’s going to do that? So you’ve got to start getting them out.

I don’t know why they just don’t ratchet up the guarantee fees, just keep making that more and more expensive to guarantee these loans. And at some point they’re going to hit the break point and transition back into the private sector. But that doesn’t seem to be the case now.

And unfortunately back to your question about where investors put their money, I think there’s a lot of investor demand for these GSE securities. That’s got to factor in to Treasury’s thinking as well. There’s a lot of foreign investment that wants to keep buying it.

So I think it’s a real problem and I would like to see an exit strategy and I would like to see the private securitization market come back. But that doesn’t seem to be part of the policy agenda right now.

MR. KEMPE: Thank you. We’re down to the last couple of minutes. So I think we’ll take one more question. Brian Henderson, by the way, let’s take two more questions. Let’s take them in a bunch. Why don’t we give you yours first and then I’m going to let Brian ask the last question.

Brian, aside from what he’ll tell you his jobs are, also sits on my endowment committee. So now if you could give him any advice about whether or not – (laughter).

Q: Back to the issue of trans-Atlantic bail-out we were earlier talking about, what about the fact that Greece just announced that their GDP, their economy seems to be shrinking at 8 percent annual rate in the first half of the year?

The bail-out of last May obviously didn’t work. So and now they can’t pay for that reason. So why are Secretary Geithner and President Obama seem to be pushing that Chancellor Merkel make a bigger EFSF bigger and bigger. How can it work?

MR. KEMPE: Let me take the last question so you can take them as a bunch. On the Greek one, I’m also hearing people talk about the potential creation of a parallel currency.

MS. BAIR: Oh I heard of – yes, I saw that.

MR. KEMPE: As an option, which I thought was quite interesting.

MS. BAIR: Yeah.

MR. KEMPE: They’re comparing it to the Argentine situation where they couldn’t pay bills any longer so they handed out IOUs and the IOUs became a parallel currency. I didn’t know whether you could comment on hat.

MS. BAIR: Yeah, I don’t know how that works either. But I did see it.

Q: I first would like to thank you very much for your service.

MS. BAIR: Sure.

Q: And also thank you for coming to the Atlantic Council.

MS. BAIR: Sure.

Q: I also hope by the way that you will stay engaged with your former colleagues and fellow regulators on an ongoing basis because clearly your experience and the perspective you bring is very much needed. I also, and forgive me, it’s not so much a question, more of a compliment to your agency because as a director of an FDIC-regulated institution, and it’s in Florida and it’s a perfectly fine little bank.

But we’ve had a very good engagement with the FDIC staff and it’s been very clear and despite the increase in fees of course, which we always object to, we think it’s well worth it because they’ve done a very good job.

So I think that needs to be said. Also the institution that I advise today and work with is a Portuguese bank and I think it would be very helpful if we got away from the nomenclature of calling countries by the names of certainly animals.

MS. BAIR: Yeah, I know. I default to that a couple of times too and I apologize. I think you’re right.

Q: I think at least to get into that regulatory kind of mindset because even the Federal Reserve in its interest to make sure that we are protecting our own tends to go after. Please tell us exactly what your exposure is on sovereign PIG-related countries. I mean, this is not helpful by any means. And so we do need a better dialogue across the Atlantic.

MS. BAIR: Right, we do.

Q: And I find myself spending about 99 percent of my time with the decision-makers on trying to explain the regulatory not only process but the culture in this country and we do have a cultural problems which is exacerbated by the events that are getting a little bit out of our own capacity to preempt, control or somehow even in fact understand.

So that’s why I really do hope you will stay engaged in this process because we need more of that. And a question which is completely, you know, I think relevant given all of what I’ve just said is how do you think the transition will go from Trichet to Draghi?

And I do believe this is the first time it’s going to make a very real impact in terms of how the markets and how even Europeans are going to see the ECB going forward.

MS. BAIR: Right.

MR. KEMPE: And also the definition of what the ECB thinks it’s responsible for the debate over buying of bonds, et cetera.

MS. BAIR: Well, I think it’ll be a friendly transition. I don’t think there will be any philosophical shifts. I would certainly put Mario more in the bond-buying camp than in the German don’t do this camp.

So I don’t see any big changes. I think it’s going to be difficult for Mario coming from one of the troubled countries – we’ll call them the troubled – potentially troubled countries, the PIIG, maybe get them in there.

But I don’t see any philosophical shifts and I think there will be – my guess is there will be a tendency towards more activism not less with the ECB and dealing with this situation.

MR. KEMPE: You know, on behalf of the audience I want to thank you. But I want to say a couple of things in thanking you. First of all, I want to echo Brian’s call for your continued engagement, though I don’t think we need to call for that. I think you’re going to continue that. You know, and hope we see you much more here as well when your book does come out. We’re happy to help you sell a few here if you want to make a return – if you want to make a return engagement. As you know, we’re a radically bipartisan, nonpartisan institution.

MS. BAIR: Yes, right.

MR. KEMPE: You’re someone who was able to bridge Republican, Democrat administrations. You have praise from Democrats and Republicans on Capitol Hill at a time when that’s not the easiest thing to pull off.

MS. BAIR: It wasn’t. That’s for sure.

MR. KEMPE: That’s a notable thing in this partisan town. And we think that also helped you empower the FDIC where of course your track record is commendable, especially considering the time that you had to pastor it. So we thank you for taking the time with us.

MS. BAIR: Thank you. Thank you.

MR. KEMPE: And if we can be helpful in your future efforts, please let us know.

MS. BAIR: I appreciate that. Thanks. I enjoyed it.

MR. KEMPE: Thank you. (Applause)


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