Interview of William Isaac for the Central Banking Journal

The former chairman of the Federal Deposit Insurance Corporation tells Robert Pringle that procyclical accounting and capital rules lie at the heart of the crisis.

What is your verdict on the Obama administration’s proposals for the reform of financial regulation in the United States?

The Obama Administration’s proposals are disappointing on several levels. First, they rushed them out in June without first doing a proper post mortem on the causes of the current crisis. Congress enacted and President Obama signed in May of this year a law establishing a bipartisan commission to study the causes of the financial crisis. I don’t understand why the administration felt it necessary to propose reform legislation before the bipartisan commission could even be established, much less complete its work. Getting the right reforms in place, no matter how long it takes, is much more important than enacting the wrong reforms in a hurry.

Second, the proposals addressed issues that had nothing to do with the crisis, such as creating a new consumer advocacy agency and eliminating the industrial loan company charter, while ignoring things that were at the heart of the crisis, such reforming Fannie Mae and Freddie Mac. Moreover, it’s difficult to understand the proposal’s rationale for elimination of the thrift charter in the middle of a depression in the housing sector.

Third, the proposals don’t address the enormous problem of highly procyclical regulatory and accounting policies. The Basel capital rules use backward-looking models that don’t require sufficient capital in good times and demand too much capital in difficult times. The same is true of loan loss reserving policies. Banks pay little to no deposit insurance premiums in good times when the FDIC fund is strong and are required to pay excessive premiums when the banking industry is struggling. Mark-to-market accounting is horribly procyclical, inflating bank earnings and capital in good times and senselessly destroying earnings and capital in downturns like the current one. These issues are at the heart of the current crisis and must be addressed.

Fourth, the proposals risk creating greater moral hazard by permanently extending bank-type regulation and the bank safety net to large non-bank firms.

What about the proposals for a Systemic Risk Council?

Unfortunately, the administration’s proposal doesn’t treat this seriously. Potentially, the creation of a strong and effective Systemic Risk Council should be the most important reform of all. But the administration’s proposal would create a Systemic Risk Council dominated by Treasury. It would rely on Treasury’s staff and the Secretary of the Treasury would be its chairman. The Treasury has had a hand in creating any number of banking crises over the centuries and is one of the most important agencies that must be monitored by the council. The council needs its own staff – probably running into the hundreds – and should have an independent chairman appointed by the president and confirmed by the Senate for a six-year term.

What were the most serious policy mistakes made in handling the crisis?

We handled the crisis in an ad hoc fashion with highly inconsistent actions that caused most people to question whether anyone was in charge and whether we had a plan to stop the contagion effect. For example, when IndyMac, a large thrift in California, failed only the insured depositors were made whole. When Washington Mutual, a very large thrift, failed both the insured and uninsured depositors were made whole, but $20 billion of bonds were exposed to losses, and $7 billion of equity that had been infused by investors just months prior to the failure was wiped out. On the other hand, everyone was protected at Wachovia. Everyone was protected at Bear Stearns, while everyone was wiped out at Lehman. AIG was rescued, including its bank creditors, while the preferred shareholders at Fannie and Freddie were hit with big losses.

The first priority in the midst of a banking crisis is to maintain order and confidence. There are other important policy considerations – such as minimising taxpayer expense, protecting the deposit insurance fund, and limiting the creation of new forms of moral hazard – but those concerns must take a back seat to maintaining public confidence. I don’t believe we took care of priority number one during this crisis.

Would you say, then, that official actions made the crisis worse?

In September, 2008, they did. Senior officials went to congress and very publicly demanded $700 billion of taxpayer funds on an emergency basis to avert financial Armageddon. I believed then, and continue to believe, that this legislation was not needed and had the effect of panicking the public. The American economy fell off the cliff in October, following this very public spectacle. Consumers and businesses slammed shut their wallets and check books and have yet to re-open them. The rationale for the $700 billion funding was to purchase toxic assets from the large banks. None of the money was in fact used for this purpose, which underscores how poorly thought-out the legislation was.

How should policymakers deal with the moral hazard created by banks and
other institutions deemed too big to fail?

We have faced this issue for decades without resolution, and it’s not clear to me there is a solution. There will always be some firms that are too large and too complex to be allowed to fail – at least in an uncontrolled fashion. When I was chairman of the FDIC we “rescued” Continental Illinois, the nation’s seventh largest bank at the time. We literally kept the bank from failing, but we did so in a way that replicated the most important aspects of a failure, while maintaining order and stability in the financial system. For example, the shareholders of Continental were wiped out, and the senior management and most members of the board of directors were replaced. At the same time,we issued a blanket guarantee that all general creditors would be protected against loss or delay in receiving their funds. A lot of large banks went down during the 1980s, including nine out of the ten largest banks in Texas, but they were handled in a way that maintained confidence in the financial system. I believe we made some serious mistakes during the current crisis, but rescuing large institutions, such as Bear Stearns and Wachovia, was not one of them.

But surely the safety net that the US has very publicly put under the big banks has created enormous moral hazard and a licence to gamble with taxpayers’ money to a far great extent than ever before?

My advice would be to stop fretting about too-big-to-fail and accept that it will be with us forever. Everyone has always known that no major government is going to allow its major financial institutions to collapse. I believe our focus should instead be on preventing our largest institutions from getting to the point of failure. Higher capital is a critical step, as is getting rid of the procyclical Basel capital models and the highly procyclical mark-to-market accounting. Having a strong, effective, and independent Systemic Risk Council is also a very important step. We should take a very close look at the off-balance sheet activities of banks and require capital against those activities to the extent appropriate. Being much smarter about supervision of banks is also very important. For example, allowing banks to purchase massive amounts of fully insured brokered deposits is not good supervision. Prudential regulators should devote greater attention to incentive pay arrangements in banks to make sure the arrangements are rewarding the right things and not encouraging the wrong things.

Aren’t some banks too large and complex to manage? Shouldn’t these be broken up?

If the management of a large bank demonstrates that the institution is too large and complex to run in a prudent manner, then the regulators should not hesitate to make changes in management and/or force the institution to divest businesses and shrink to a more manageable size. I believe that boards and regulators must be smarter and firmer in their oversight of these companies. It’s really not about size, its about complexity and the ability to understand and manage that complexity. It’s also about making sure the companies have plenty of capital and reserves to weather any storms, including those that can arise from off-balance sheet activities. It’s also about ensuring that management has the incentives to do the right things and not the wrong things in running the company. I don’t believe in breaking up financial institutions just because they are large.

It seems that the competition authorities both in Europe and the US may be prepared to take a tougher view of anti-trust issues in finance. Would this be helpful?

I have always seen a lot of merit in sensible anti-trust enforcement. Anti-trust enforcement was a major issue in bank acquisitions and mergers in the 1960s and 1970s. Anti-trust enforcement became an anachronism beginning in the 1980s, as policymakers seemed to decide that there were too many small banks and the system would be stronger if we allowed significant consolidation.

What would be the objective of such anti-trust action?

Well, this is a difficult issue. During the 1960s and 1970s, the goal was to prevent excessive concentration in specific markets, such as Cleveland, Ohio. When this was coupled with the inability to expand out of state, it resulted in a large number of regional banks around the country and no dominant players on the national level. Nationwide banking has eliminated large numbers of larger banks, producing Central Banking greatly increased concentration of the banking system. One can argue that the current system is more competitive in that giant firms from around the globe are competing more aggressively for consumer and middle market business. This is probably correct. So those who argue for stronger anti-trust enforcement are probably not trying to promote more competition, but to prevent major concentration in the financial sector. It’s not clear to me how one puts that genie back in the bottle.

Do you agree that there is a need for international agreement on procedures for dealing with failing systemic institutions in a crisis?

It’s not a pressing issue in my mind. Simpler is better in government, just as it is in the private sector. International supervisors need to have good lines of communications, but if we force them to have committee meetings during a financial crisis, I am pretty sure that will not be an improvement over a system in which each country takes responsibility for cleaning up its own messes. I would remind those who propose even greater international structure that the colossally bad Basel II capital standards are a product of that system, along with a number of other bad ideas, such as mark-to-market accounting.

Several commentators have proposed that each systemically significant firm
should develop a plan for winding up its operations quickly in a crisis. What
is your view?

I suspect those commentators have never held a significant position in banking or bank regulation and have never dealt with a banking crisis.

Alternatively, other systemically important institutions could commit to resolution procedures and provide accompanying financing if any of their members were to fail, shielding taxpayers from the costs.

In the United States, we have such a system today, and it’s called the federal deposit insurance system. The banks are jointly liable for all losses suffered by the FDIC and must restore the FDIC fund within a few years after a banking crisis subsides. The government guarantees this system, as it must, but it’s clearly paid for by the banks. In addition, we have the Federal Reserve System to provide liquidity. Also, the Fed and the FDIC typically use a fair amount of moral suasion to get banks to support those in trouble. Insurance companies also have a mutual protection system at the state level for protecting policy holders when a company gets into trouble.

Moving to capital requirements, as you know this has been exhaustively discussed among regulators for many years, yet policymakers have in practice allowed banks to hold less and less capital. How did this happen?

I’ve been involved in the banking industry for 40 years, and capital has been an important issue during that entire period and beyond. Bank regulators lost their bearings in the 1990s when they decided to implement the Basel capital accords to use capital models to equalise bank capital requirements throughout the world. I pin the responsibility for this on the Federal Reserve and the Treasury. They were so eager to equalise capital in banks throughout the world that they were willing to reduce US standards in order to achieve parity. The FDIC argued strenuously against the Basel capital rules. It’s time to return to some higher absolute standards, below which no bank may go. And it’s time to allocate appropriate amounts of capital to off-balance sheet exposures.

One idea at present is to introduce countercyclical capital ratios but there are huge difficulties involved in developing practicable proposals to implement the idea internationally. What is your view?

This is not some new-fangled idea. It’s the essence of good bank supervision. Prudential regulators should always lean against the prevailing winds. The Fed was notorious for doing that in the 1960s and 1970s. When the economy was overheating and bubbles were developing, the Fed would adopt a go-slow approach and require banks to increase their capital. When the economy was in a slump, the Fed would ease its capital demands. Regulators did not micromanage the credit -granting process, but they did require banks to build stronger buffers, including loan loss reserves, when things appeared to be overheating.

Will a systemic regulator not suffer from the same swings in euphoria as market participants?

It should not, if it’s structured properly with good leadership. Its raison d’etre will be to monitor and alert the regulators, congress, the media and the industry to developing systemic risks.

If, as seems inevitable, some body has to take on these so called “systemic”
responsibilities, it will doubtless in most countries be the central bank. Wouldn’t
that get them too close to politics and threaten their independence?

I don’t believe any single agency has the wisdom and experience to carry out this duty, and I believe in checks and balances. Plus, I believe in a strong central bank with complete political independence. Anointing the Fed as the systemic risk regulator would be wrong on all counts. I believe we need to establish a Systemic Risk Council that is independent from any single agency. Its board would be comprised of the Secretary of the Treasury, and the chairmen of the Fed, the FDIC and the Securities and Exchange Commission (SEC). It’s chairman would be independent of those agencies, would be appointed by the president and confirmed by the senate for a six-year term, and would have a great deal of autonomy, as the board would be Central Banking advisory in nature. The council would have it’s own staff and would have access to all information the government possesses regarding the financial system, including confidential exam data and classified information. Finally, the council would undertake the SEC’s current responsibilities for overseeing the Financial Accounting Standards Board (FASB).


Would it not be much better to revert to traditional, tried and tested central banking crisis management policies: lender of last resort, constructive ambiguity and tough punishment for bank managements and banks that fail?

Yes, we need to get back to the basics. But we should not stop there. We need other safeguards as well, such as the Systemic Risk Council; simpler and stronger capital and loss reserve regulation; elimination of procyclical regulatory and accounting regimes; less reliance on models and greater reliance on on-site examinations and judgment in bank management and regulation; and making sure the incentive compensation models are encouraging the right behaviours.

What is your view of the argument put forward by Simon Johnson, former chief economist at the IMF, that the banking lobby has become too powerful?

I don’t know how to measure the validity of that assertion. Banking has always had a reasonably strong lobby, which it has needed as banking is a favourite political target. But I couldn’t say that banking is more powerful than the trial lawyers, the teachers’ union, retired people, trade unions, or any number of other potent lobbies. As long as they are playing by the rules, we cannot do much about it in a democracy.

In your testimony to congress on 12 March you emphasised what you see as the disastrous role of mark-to-market accounting in this crisis. If you are right, it seems incredible that governments should have allowed banking systems to come close to collapse and economies to sink into recession just for want of enough common sense to suspend this rule. What is the explanation? What has been the response to your testimony?

I believe the FASB and SEC went down the path toward mark-to-market accounting with good, albeit terribly mistaken, intentions. They were warned not to do so in the early 1990s by the chairmen of the Fed and FDIC and the Secretary of the Treasury, cautioning them that mark-to-market accounting would be highly procyclical and make it difficult to get out of downturns, as we learned during the Great Depression, when we abandoned mark-to-market accounting in 1938. Once the crisis began in 2007, it was very difficult for the FASB and the SEC to turn around on the issue for two principal reasons: first, it would be an admission that they were wrong and played a large role in creating the crisis, and second, they were concerned that the markets would react negatively to the accounting change, because it might be viewed as a cover-up of the problems.

When I began calling publicly for suspension of mark-to-market accounting nearly two years ago, it was difficult to get any attention on the issue, as most people never heard of it much less understood it. We have done an enormous amount of education and most people have now heard of mark-to-market accounting and know it’s a very bad thing. That’s great progress. Now we need to finish it off. It’s utterly bad accounting with no redeeming virtue. It’s better disclosure that we need, and that can be provided in very clear footnotes to balance sheets. We should not be destroying hundreds of billions of dollars of bank earnings and capital simply because markets stop functioning properly.

How would you compare the official management of this crisis to the Savings and Loans Crisis of the 1980s in which you were involved as chairman of the FDIC?

I don’t believe the comparison is very favourable in terms of the handling of the current crisis. Very serious economic problems in the 1970s led to extremely serious problems in the financial system during the 1980s. The Fed raised interest rates to over 21% to break inflation’s back. This in turn bankrupted the entire thrift industry due to their large portfolios in long-term, fixed-rate mortgages and bonds. It also led to a depression in the agricultural sector, as farmers could no long afford to operate and service their debts. A very serious recession ensued in which unemployment reached double digits. The major banks in the country were loaded up with third-world debt for which there was no market, because it was feared widespread defaults would occur.

The result was massive problems throughout the banking system. Approximately 3,000 banks and thrifts failed, including a number of the largest banks in the country. The list of “problem banks” still stood at 1,500 by the end of 1991, even after 3,000 failures. The Federal Savings and Loan Insurance Corporation, which was the thrift counterpart of the FDIC, was badly insolvent and was taken over by the FDIC. During the 1980s, very significant economic problems led to widespread problems in the banking system. Government policymakers handled the banking problems in a way that maintained confidence in the system. Indeed, once the recession of 1981-82 ran it’s course, we began the longest peacetime expansion in history, despite our having to handle thousands of banks and thrift failures.

At the onset of the current crisis, there was barely a cloud on the economic horizon when problems in the financial system emerged. Highly procyclical regulatory and accounting policies magnified the problems in the financial system. Poor crisis management by the government made matters much worse and led to a general loss of confidence in the financial system. This, in turn, caused businesses and consumers to stop spending and investing, leading to a serious economic downturn.