Kansas City Fed President Thomas Hoening’s speech yesterday is one of the most encouraging things I had heard from a central banker in a couple of decades:
“…I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.
To more fundamentally address this issue, we must go beyond today’s Dodd-Frank. We must confine the use of the safety net to its original intent. We must reduce the artificial complexity of existing financial structures. The rewards of success must be balanced against the credible consequences of failure. In achieving such goals, we will enhance the stability of the fundamental mechanism through which monetary policy is conducted and the economy depends.
The U.S. economy is the most successful in the history of the world. It achieved this success because it is based on the rules of capitalism, in which private ownership dominates markets and individuals reap the rewards of their success. However, for capitalism to work, businesses, including financial firms, must be allowed, or compelled, to compete freely and openly and must be held accountable for their failures. Only under these conditions do markets objectively allocate credit to those businesses that provide the highest value…
After the Great Depression, the Federal Deposit Insurance Corp. was created to provide limited deposit insurance to protect small depositors and to further increase the resiliency of the financial system.
Then, over the past 30 years, this safety net has expanded far beyond its original intent. More recently, Glass-Steagall was repealed, giving high-risk firms almost unlimited access to funds generated through their new access to the safety net. Finally, following a series of crises during the late 1980s and 1990s, the government confirmed that because of systemic impact, some institutions were just too big to fail—the largest institutions could put money in nearly any asset regardless of risk, and their creditors would not be held accountable for the risk taken. Predictably, the industry’s risk profile increased dramatically. The SIFI was born…
Now, with their bailout costs amounting to billions of taxpayer dollars, SIFIs are larger than ever. Strikingly, they are arguing that they should not be held to stronger capital standards if the United States hopes to remain globally competitive. That assertion is nonsense. The remainder of my remarks today will describe how the United States can achieve a stronger, more stable financial system in order to secure its future as a global economic leader.”
He goes on to make some key points that include (my words):
1. Financial institutions cannot self-regulate, never could, never will.
2. Restoring Glass-Steagall-type boundaries is crucial so that institutions that have access to the government safety net are restricted to the core activities that the safety net was intended to protect—making loans and taking deposits—and related activities. All other risk-seeking and magnifying activities must be left to the self-insurance of those seeking the profits. When they blow up they fail on their own dime.
3. The shadowing banking system must be reformed in its present use of the repo market.
“The financial system has become far less competitive and far more volatile with the onset of systemically important institutions. Though large firms remain a critical part of our economic system in the United States, they should not become so dominant that they become unaccountable to our capitalistic system. We can make the necessary reforms to end the unique status of the SIFI and, in doing so, restore much of our global competitive vigor. Only from a position of financial strength can the United States remain the global economic leader.”
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