An Afternoon at the Treasury
By John Lounsbury.
I was privileged to attend a meeting at the Treasury Department in Washington on Monday afternoon, August 16. The two hour plus meeting was hosted by Senior Treasury Officials. There were three discussion leaders:
- Michael Barr, Assistant Secretary for Financial Institutions, led the first 45 minutes;
- Matthew Kabaker, Deputy Assistant Secretary for Capital Markets, next 45 minutes;
- Secretary Timothy Geithner led the final 45 minutes of discussion, which actually went overtime from the scheduled 30 minutes.
Other senior officials present:
- Mary John Miller, Assistant Secretary for Financial Markets;
- Jake Siewart, Counselor to the Secretary;
- Lewis Alexander, Counselor to the Secretary.
There were seven guests. In addition to yours truly, they were (alphabetical order):
- Tyler Cowen, Holbert C. Harris Professor of Economics at George Mason Univ. (Vita) and a contributor to The New York Times and Slate, as well as co-author of Marginal Revolution blog.
- Philip Davis, a top ranked Seeking Alpha contributor and publisher of Phil’s Stock World.
- Michael Konczal, Roosevelt Institute Fellow, Rortybomb blog author and Seeking Alpha contributor.
- Yves Smith, who publishes the widely followed Naked Capitalism blog.
- Alex Tabarrok, Bartley J. Madden Professor of Economics at George Mason Univ. (Vita) and co-author of Marginal Revolution blog.
- Steve Waldman, Interfluidity blog author and Seeking Alpha contributor.
The Treasury Department has established a program inviting various financial bloggers to have open discussion meetings with senior Treasury officials 4-6 times a year. Meetings are designed to be small, informal, unscripted and open to all relevant (even peripheral) thoughts, ideas and questions from the invited guests. The meeting I attended was held in the Treasury Secretary’s conference room with seating around a table that could hold a maximum of 22-24 participants.
My comments are based on very cryptic notes I took during the meeting and will be subject to revision or expansion by what other attendees have to say. Links to posts by other attendees will be appended at the end of this article. If other posts occur after this article is submitted I will provide links in a later Instablog at Seeking Alpha.
It was agreed that no attributed quotes were to be disseminated without obtaining specific review and clearance from the Treasury Department. This resulted in an exchange which was far different from a typical interview or press conference session. It was more like a brainstorming session and ideas were flying around the room in a very stimulating way.
A number of guests raised confrontational topics and some defensiveness by Treasury officials did occur, but my impression was that defensiveness was limited and open exchange occurred when questions that would have been deflected in a press conference setting received much more consideration in this forum.
Treasury seems to be very enthusiastic about the new FinReg (Dodd-Frank Financial Reform Bill) recently passed into law. It is clear that they see the GSEs (government sponsored enterprises) as the next reform effort required. Officials defended the proposition that progress had been made to avoid a similar course of events experienced in the 2008 financial crisis because the Treasury now has the legal authority to unwind an insolvent super bank in a manner somewhat similar to the FDIC process for smaller banks.
What remains in question with this analyst is: After the authority, where is the process?
Too Big To Fail
When I suggested a problem for the administration is that they have not addressed the problem that TBTF (too big to fail) institutions still exist. I said there was no confidence that there was a plan to end the problem. I was referred to a speech by Michael Barr in Chicago on August 10. From that speech:
We will–once and for all–fully end the market’s perception of "too-big-to-fail" firms, when we build a system that is capable of absorbing the failure of the next AIG or Lehman Brothers; a system that constrains risk-taking by major financial firms, strengthens the basic shock absorbers and transparency in the financial system, and provides the government with credible tools to manage effectively the failure of major financial firms while at the same time safeguarding the broader economy.
To fully end "too-big-to-fail" we need to make our financial system safer for failure. We cannot rely on the hope of perfect foresight–whether by regulators, or by managers of firms, private sector gatekeepers, or other market participants. Financial activity involves risk, and no one will be able to identify all risks or prevent all future crises.
However, robust capital, leverage, and liquidity requirements can prevent the build-up of risk, ex ante, and insulate the system from unexpected shock events, ex post. Imposing higher prudential standards on the largest, most interconnected firms will require them to internalize the risks they impose on the system by virtue of their size and complexity. The largest and most interconnected firms cause more damage to the system when they fail, so they need to hold more capital against risk. That is based on a principle of fairness and also of economic efficiency. It internalizes their costs of failure and provides incentives for firms to limit their size and reduce their leverage.
In reading this speech I found that some of the comments in discussion by Treasury officials on the 16th were very similar in wording to the text of the speech on the 10th. So I guess the discussion was not entirely unscripted. I make that as a simple observation and not to be snide.
The intent appears to make capital requirements and regulation for “super-sized” banks more demanding than for smaller banks in order to make size a detriment to flexibility of operation and profitability. I believe it was Yves Smith who pointed out that multiple studies have found that efficiency and profitability of banks declines beyond a size much smaller than our largest banks and that has not stopped them from becoming behemoths.
Phil Davis raised the question of bogus bank accounting standards and the general sense of the response was that FinReg will enable the enforcement of higher capital standards. This led to Prof. Tabarrok asking just how would “AAA” be determined. If there was a clear answer I missed it. (I told you my notes were sketchy.)
The sense I took away from this part of the discussion was that much depends on (potentially hundreds of) studies authorized by FinReg. The Treasury is charged with forming an Office of Financial Research to conduct research to guide future regulation implementation. This really translates to me that we are still in the process of conducting a Grand Experiment.
There was some discussion of how compensation plans can distort corporate actions. I threw out the idea that the problem was that our systems, especially in finance and health care, are too heavily focused on pay for transactions rather than pay for outcomes. I didn’t have the presence of mind to bring instant gratification into the discussion, but that would have certainly made my thought process clearer.
This topic brought a comment from Yves Smith that the highly profitable trading activities that create large, quick rewards would be difficult to wind down for the banks that have become addicted to the “fast buck” (my terminology, not Yves’). The sense I got from Treasury was that they feel trading activities would be wound down over time.
Late in the session I threw a question on the table about how tax policy could influence compensation. If taxation of capital was decreased and on income or consumption was increased could the ratio between production and consumption components of GDP brought more in balance? That hot potato pretty much stayed on the table without significant discussion.
Solvency and Profitability for Banks
In one brief exchange an interesting thought emerged. The fact that bank stocks are trading at or below book value seems to be in conflict with the fact that banks are having little trouble in selling bonds. The thought was expressed that the bond market is looking at solvency and the stock market is looking at future profitability. Markets now are telling us that investors are not worried about insolvency but do have questions about profits in coming years.
I have thought about this after the meeting and wish I had asked the question if there is still some backstop mentality in the bond market – the government will not let these banks fail. That thought relates back to an earlier point in the session where criticism was raised of the protection of bond holders at the expense of stock holders in the financial crisis.
Perhaps the term GSE (government sponsored enterprises) should be changed to GOEs (“owned” substituted for “sponsored”), but that was not mentioned in the meeting. Treasury officials gave the impression that, although this is the next big financial reform effort, studies are needed to start defining the end game. This gets us back to the Office of Financial Research. I got the impression that the process to be started might be termed “search and discovery”.
Other factors related to this “end game” for Fannie and Freddie include how much government footprint should remain in the mortgage market, how will external factors (such as the new Basil agreements) effect resolution, and how will regulation of banking and non-banking mortgage markets, as well as consumer protection, be coordinated.
I was too busy enjoying the discussions to take better notes. I hope that other attendees will cover many aspects of the discussion that I missed and clarify things that I may have reported improperly or incompletely. This was a very worthwhile experience for me. I went to the meeting not really knowing what to expect. The quality and openness of the discussion was far beyond anything that I had imagined going in.
Other posts on this meeting:
Only one so far: Alex Tabarrok