Banking Reform Hasn’t Fixed Perverse Incentives on Wall Street: Ex-FDIC Chair Bair

May 5, 2016 2:00 PM

Financial reforms undertaken after the historic crisis of 2008 have raised bank capital standards to more adequate levels, but the new rules are still too reliant on regulators’ judgment of risk rather than simpler measures of bank leverage, said Sheila Bair, former chair of the Federal Deposit Insurance Corporation, now president of Washington College in Virginia.

New bank legislation known as Dodd-Frank also failed to curb perverse incentives for Wall Street traders to take excess risks at the potential expense of taxpayers, Bair said as she delivered the 2016 Annual O. John Olcay Lecture on Ethics and Economics at the Peterson Institute for International Economics this week.

Starting off on a lighter note, Bair said: “I’m going to begin by defending capitalism a little bit. I tell people I’m a capitalist, I’m still a capitalist – and they don’t believe me. But I am. I view capitalism as an instrument of moral behavior, not an obstruction, if incentives are aligned the way they should be.”

As FDIC chair, Bair played an active role in managing the response to the financial crisis—and was not shy about disagreeing with fellow regulators when she felt it was necessary.

At the PIIE event, Bair praised legislative reform efforts for their focus on raising capital, which she said was woefully inadequate at financial institutions before the crisis. However, she remains leery of an insistence on so-called risk-weighted capital, which includes not only shareholder equity, which does not need to be repaid, but also certain forms of debt deemed safe by bank supervisors. She noted their judgment had failed miserably in the precrisis era.

“Regulators through this risk-based capital regime decided what was risky and what wasn’t. And they were wrong, they were completely wrong,” Bair said. “In Europe they said sovereign debt wasn’t risky. In the US we said mortgage securitizations weren’t risky, and that credit default swaps weren’t risky, and actually that credit default swaps were somehow reducing risk.” (Securitization refers to the bundling of mortgages and other types of bonds and their resale to investors, a process that broke down during the mortgage crisis. Credit default swaps are a type of derivative instrument used to hedge against the risk of a firm’s or country’s default.)

Bair added: “I think we should scrap risk-based capital. Just have a stress-testing process and a leverage ratio”—the proportion of debt a bank holds relative to its outstanding equity.

She said the complexity of Dodd-Frank, which is a hefty 848 pages, benefited large banks, whose large legal teams are able to find loopholes and ultimately settle cases that, she said, if prosecuted more aggressively, might have led to actual criminal prosecutions. The lack of big executives who have gone to jail despite widespread mortgage fraud documented during the financial crisis has been a large source of populist, anti-bank anger in the United States, and continues to be a hot-button issue in the presidential election debate.

“It does trouble me—look at these headline multi-billion dollar settlements—it’s almost all being paid for by shareholders,” Bair said.

“The financial sector…the traders and the people that are really out there taking the big risks and trying to reap the big profits, they’re going to understand two things: They’re going to understand poverty or they’re going to understand jail,” she said. “To say we’re going to have a new code of ethics and change the rules and link arms and have a big kumbaya moment is not realistic.”

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Pedro Nicolaci da Costa Former Research Staff

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