Dudley Tries to Do Right - Analyst Blog

In a long speech, William Dudley, President of the New York Federal Reserve, addressed his economic outlook and the lessons learned for last year’s financial crisis. I present key excerpts from the speech about the lessons learned below as well as my assessment of them. However, the speech is worth reading in its entirety and can be found here.

"The actions undertaken by the Federal Reserve over the past two and a half years have been critical to stabilizing the financial system and preventing the extraordinary distress in markets from causing a deeper and more protracted economic downturn. Much of the Fed’s ability to respond as effectively as it did during this crisis, whether it was from a monetary policy, a 'lender-of-last resort' or a supervisory perspective, came from its breadth and depth of knowledge and experience with financial institutions, financial markets and financial market infrastructure, both inside and outside of the United States.

"That said, there is also no question that the Federal Reserve and other regulators could have done more to prevent this crisis. That is why, even as the Fed has engaged in extraordinary efforts to stabilize the financial system over the past couple of years, it has also been moving quickly to make the internal changes necessary to strengthen our effectiveness. In addition, the Fed has been working with other regulators in and outside of the U.S. to craft and implement the broader changes in regulation and supervision that are necessary to make our financial system more robust and resilient going forward.

"With the benefit of hindsight, it is clear that the Fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and the large number of self-amplifying mechanisms that were embedded within the system. Likewise, we did not appreciate all the ramifications of the growth of the shadow banking system and its linkage back to regulated financial institutions until after the crisis began."

It is not like there were no warnings -- it was more like a willful refusal to hear them. True, until everything hit the fan, the linkages were still theoretical and not known facts.

"Of course, understanding now what we did not understand then is only half the battle. We need to respond to ensure that ongoing changes in our financial system do not threaten the stability of the financial system in the future."

Yes, it would be nice if we both learned something from this debacle and also applied the lessons from it in the future.

"For one, the crisis is provoking a reevaluation of our views on how to respond to asset bubbles. For years, central bank orthodoxy has been that you cannot identify asset bubbles very well. Thus, the strategy has been to move aggressively to clean up such bubbles after they have burst."

Sometimes true, but not always. There are some long-standing metrics of value, that if asset prices deviate substantially they should give policymakers a clue that things are amiss. In the case of housing, for example, it was clear that relative to both rents and incomes prices started to get far above the historical norms starting in early 2003, and were seriously out of whack by 2006. On the other hand, in the case of equities, prior to the mid-1950’s it was always assumed that the dividend yield on a stock would be higher than the same firm’s interest rate on its debt, since equities are more junior securities.

"I think our level of confidence in that approach has been considerably reduced in the wake of the crisis that we have just experienced. The costs of cleaning up after the fact have been immense."

Yeah, if you see your seven-year-old carrying open cans of paint from the garage into the living room, it might be a good idea to tell them to stop, rather than trying to clean up the mess afterwards.

"But make no mistake -- developing an effective, more proactive approach is not easy. Among the important questions that need to be answered:

"1.    How does one identify bubbles -- which I’ll define here as persistent large deviations in asset prices from their fundamental value -- in real time?

"Perhaps by assuming that reversion to the mean is a powerful force in terms of valuation metrics. Part of the problem is that a bubble by definition goes too far, and people who are riding the wave of bubble expansion half-way up will not be happy if you pop the bubble prematurely.

"2.    What instruments can be used to limit the development of bubbles and/or allow bubbles to deflate in non-catastrophic ways that will not damage the economy in other ways?"

This is a very serious issue since the tools available to the Fed are more like chainsaws than scalpels. Regulation is perhaps the most delicate of the instruments that they have and the regulated always seem to be two steps ahead of the regulators. This is particularly true when the regulated have the ability to shop for the regulator of their choice, as is currently the case with financial institutions. Changing that is one of the big steps forward in the current regulatory overhaul bills.

"Turning to the first issue, identifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles -- especially credit asset bubbles -- may be less daunting.

"To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable. Presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a bubble were to burst. This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst."

A VERY good idea. At the peak, the big investment banking houses like Lehman Brothers and Morgan Stanley (MS) were levered more than 30:1, which meant that just a decline of about 3% in the value of their portfolios could wipe out their capital all together. For the survivors, that level has come way down closer to 10:1, and should not be allowed to return to those lofty leverages.

Part of the problem as well was that much of the leverage was hidden though accounting tricks such as using off-balance-sheet special-purpose entities. The need for transparency in the financial statements of financial institutions, particularly large systemically important ones, is huge.

"Turning to the second issue of how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process.

"For example, it might be appropriate for the Federal Reserve -- working with functional regulators such as the SEC (Securities Exchange Commission) -- to monitor and limit the buildup in leverage at the major securities firms and the leverage extended from these firms to their clients and counterparties."

In the wake of the turmoil, the biggest investment banks -- Goldman Sachs (GS) and Morgan Stanley -- became bank holding companies, and other major investment banks were absorbed into commercial banks -- Bank of America (BAC) and Merrill Lynch, for example. Thus, at this point the Fed should have the regulatory authority it needs, but working with the other regulators is a good idea.

"Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.

"Whether it would be more effective to limit leverage directly by regulatory and supervisory means or via monetary policy is still an open question. But it is becoming increasingly clear that a totally hands-off approach is problematic."

I would favor the regulatory approach since it is far more targeted and would have fewer side-effects on Main Street.

"I also believe we could have done better in our supervision of the large complex commercial banking organizations. For example, the recent reports issued by the Senior Supervisors Group (SSG), which is composed of regulators from five major countries, indicated that the banking regulators both here and abroad should have been tougher in the assessment of the quality of management, of governance, and in terms of these banks’ risk management capabilities.

"We should also have pushed harder for better management information systems and more simplified corporate organizations and structures. We should have done more to identify best practices in terms of risk management, liquidity, capital and compensation and pushed harder to force the laggards to move to best-practice standards.

"We are learning a lot about how to do supervision better, and are working aggressively to apply those lessons to our current practices. The Supervisory Capital Assessment Process, or SCAP, is an important example of the value of broad, horizontal examinations. In the SCAP, the Federal Reserve worked in conjunction with other U.S. regulators to assess the impact of a stress economic environment on the 19 largest banking organizations in the country simultaneously.

"This approach made the SCAP a particularly powerful exercise. It allowed supervisors to ensure that the collective results of the individual banks were consistent with a top-down assessment of revenue and credit losses generated from an adverse stress scenario for the macroeconomy. We are incorporating these types of broad, horizontal reviews more deeply into our supervision process."

I would go further, and make the SCAP, or "stress tests," as they were known at the time, a regular annual part of regulatory oversight. This would make them routine, and not a big show for the financial press, but would give the Fed and other regulators (and investors as the data becomes public) the data they need.

"So, what else are we doing going forward? There are a large number of initiatives under way to make our financial system more robust to shocks and more resilient to the inevitable swings in activity and sentiment. These initiatives include several aimed at strengthening bank capital requirements. When these initiatives are fully implemented, they should prevent some of the practices we witnessed during the crisis -- for example, a banking organization paying out dividends to demonstrate that it is strong when, in fact, by depleting capital, such an action is making it weaker."

Stock buybacks and huge bonuses also deplete capital.

"One important initiative in this regard is to better capture all the sources of risk in the capital assessment process. This, for example, includes the trading accounts of banks. Some institutions had clearly not set aside adequate levels of capital given the risks that were embedded in their trading positions."

The problem with requiring more capital, particularly equity capital, is that it reduces the ROE of the financial institutions. That is a trade-off I would be willing to make -- a less profitable banking system (for equity investors), but one that is safer and more stable.

This seems to be a good place to take a breather. We will pick up the remainder of the topics in William Dudley's speech in a separate blog post.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.
Read the full analyst report on "GS"
Read the full analyst report on "MS"
Read the full analyst report on "BAC"
Zacks Investment Research