Ben Bernanke - Washington interview
As Chairman of the Federal Reserve from 2006 to 2014, Ben Bernanke was central to the response to the global financial crisis. He talks to IBA Director of Content, James Lewis, about how the banking panic got out of control, and the ongoing reforms to ensure a healthy financial industry ten years on.
James Lewis (JL):I want to take you back to the 2005-07 period. Why was it so difficult to foresee the events that led to the financial crisis?
Ben Bernanke (BB): People talk a lot about the housing bubble and subprime mortgages in the United States. By 2006-07, we saw that house prices were coming down, there were issues with subprime mortgages, foreclosures were rising, and the like. What we and others did not anticipate was that the subprime mortgage crisis and problems in other credit markets would create a broad-based financial panic.
It was the panic, the fear, the run of short-term lending that brought down, or nearly brought down, so many large financial institutions and that transformed the crisis into a global financial crisis.
And I think nobody fully appreciated the vulnerability of the broad financial system. Once we understood that, we approached it very aggressively. But we and many others still saw the system as broadly stable and did not anticipate how badly that crisis would spread.
JL: So was that panic in some way misplaced?
BB: No, it wasn’t misplaced. In the 19th century, bank panics were runs of bank depositors who lost confidence in their banks. In this case, it was electronic runs, with sophisticated investors pulling out commercial paper and other types of short-term lending. And there were areas – for example, in the repo market – where short-term investments were collateralised. We thought that would be stable because people had collateral, but in fact they had lost confidence in the collateral, in the borrowing firms, and they panicked and pulled out their security.
A banking panic is like a fire in a crowded theatre: it’s not rational collectively for everybody to run, but for any individual to run when everyone else is running is understandable. There was a broad-based panic where fear dominated the financial system and brought it nearly to a halt.
JL: It wasn’t isolated to one country or one aspect of the financial system. The difficulties and problems were systemic. What were the most dysfunctional aspects then, and what remain the most dysfunctional?
Nobody fully appreciated the vulnerability of the broad financial system. We did not anticipate how badly that crisis would spread
BB: We’ve done a lot to increase the amount of capital in the banking system, so banks have more reserves to deal with problems, and we’ve strengthened their funding. Very importantly, there is now a set of policies in place that will help policymakers unwind a firm that comes close to failure. In 2008, we were dealing with failing financial giants without any adequate tools for either stabilising them or unwinding them in a way that would be safe for the system as a whole.
In the US, we now have the Orderly Liquidation Authority. We have living wills. We have requirements that banks and other financial holding companies hold not only adequate capital equity but also convertible bonds, or bonds that can be shifted into equity in extremis. I’m not saying the problems are gone, it’s still a work in progress, but at least now there is a framework for dealing with these unstable situations that did not exist in 2008.
There are many things that still need to be improved. In the US, for example, one of the first events in the crisis was the government taking over Fannie [Mae] and Freddie [Mac], which are the two government-sponsored enterprises that securitise mortgages. Those two companies are still wards of the state, and there have been a number of discussions of how they can be changed but none of them have made it past Congress. That’s an area where reforms are incomplete.
We were dealing with failing financial giants without adequate tools for stabilising or unwinding them safely for the system as a whole
JL: There’s a whole list of areas that came together in that 2005-7 period. I’m thinking of areas like the credit rating agencies, which played an important role in rating things as ‘triple A’ when they certainly weren’t, and derivatives, which have been described as ‘weapons of mass financial destruction’. Looking back, were there things that perhaps ought to have been done to adopt preventative measures? Perhaps stopping excessive risk-taking, something Christine Lagarde spoke about in her keynote speech.
BB: Part of the source of the crisis was that a lot of things went wrong in an interactive way and they reinforced each other. Derivatives, for instance, are sort of a two-edged sword: they allow companies to better share risks and reduce transaction costs, but they can also be used as a way of obscuring exposures, obscuring transactions. That’s the difficulty.
The reforms that have taken place have focused on making derivatives more transparent so there’s more information about who owns what and what exposures there are, and banks have been forced through the stress-testing mechanism, for example, to better understand their own exposures to different types of fundamental shocks.
The other change is that financial institutions are being strongly pushed to trade derivatives on central counterparties who stand between them, rather than on a purely bilateral basis, which makes the trading more transparent but also means that, if there are losses, they won’t be transmitted as quickly to the counterparties.
One of the key issues with derivatives is getting international coordination, because these transactions take place across borders. They need to be done in a way which is coherent.
JL: The Dodd-Frank Act was very important in this area. It was going to be quite robust with derivatives, but seems to have been diluted. A lot of the big financial institutions have delayed on their derivatives activities. Does it concern you that the intentions of the legislation perhaps haven’t been delivered?
BB: Dodd-Frank laid down hundreds of rules and studies, and it specified that they should all be completed within a few years. But for some agencies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), the law did not include any extra funding, so they’ve had to do these rule-makings at the same time as normal enforcement activities. Many of the changes have involved substantial adjustments by the firms themselves. So it’s been a slow process, but it’s not stalled. Ultimately, you need political support for what agencies are doing.
JL: Is that political support lacking?
BB: We’ll see where things go, but under the current Administration, support has been pretty good. There’s always going to be resistance on certain elements. And then there’s also the legal system and the nature of these complex regulations which include a certain amount of discretion for the regulators in terms of how they implement them and how they react in a crisis situation.
On the other side, you want to have due process. You want to have a clear administrative process so that the firms that are being regulated understand what’s going on. So, we’ve seen a certain amount of legal pushback. An example would be the MetLife case, where this insurance company was designated by the government as being systemically important and therefore subject to additional regulation. They have succeeded at least thus far in resisting that legally. So, there’s an example of the legal system and the complexities of the regulatory process, not politics, creating at least a temporary setback.
Overall, Dodd-Frank is a pretty coherent framework in the sense that the main elements fit together and most of the key issues are addressed. While it is true that the financial system is very complex and the process of implementing the rules has taken a long time, I do think it’s fundamentally a coherent framework. Now, I think, there should be various big course corrections and fine-tuning, and maybe more.
JL: Let me put it to you that the big financial institutions are so powerful that they are able to ensure that there is a return to business as usual. What’s your view?
BB: I think the markets are saying that the valuation of financial institutions is much lower than it was before the crisis. Market-to-book ratios are way down, and the low interest rate environment, competition from other types of firms and technologies, and regulatory change, have made life tougher for some of these firms.
We want them to continue to serve their function of providing credit and financial services, so we don’t want to make it impossible for them to be profitable by any means. But there’s been a big sea change in terms of the constraints they feel from the regulatory environment, relative to where they were ten years ago.
JL: So you think those constraints are real and that we’re in a different environment?
The financial system is very complex and implementing the rules has taken a long time, but it’s fundamentally a coherent framework
BB: Many people are very cynical about this and I understand the basis for it. These are complex problems. We’ll never be really sure that they’re completely solved until perhaps the time comes to test these tools. It’s really important that we remain vigilant to make sure we’re attacking these issues. The crisis was only eight years ago, we don’t want to forget that.
At the same time, I can’t agree with those who say that ‘nothing has been done’ and ‘things are just like they were before the crisis’. That’s not true. Is it an ongoing task that will continue essentially indefinitely? Yes, that is the challenge we face if we want to have a vibrant, innovative financial sector that will support economic growth but is also safe.
JL: You’ve suggested regulators like the SEC are under-financed. If they’re not well-funded and staffed, how can they be effective when encountering very powerful financial institutions?
BB: It’s not just a question of power, it’s a question of capability. You have people in the financial industry who are very sophisticated and highly paid, and outnumber the regulators by thousands to one in some cases.
The enforcement of any law – whatever it might be – depends not just on what’s on the books, but how well and effectively it is enforced in practice. So, I agree that to make the financial reforms work we need to have highly competent, reasonably well-funded regulators. It’s a false economy to squeeze the budgets of the SEC, for example. Putting enough resources into this is extremely important because we’ve seen how dangerous a crisis can be.
JL: It sounds like such a simple magic bullet to fund these agencies properly, to staff them, to give competitive salaries and to attract the best brains. Why doesn’t this happen?
BB: I guess it’s politics. In the US, there’s a general anti-regulatory view in some areas, and I think one has to understand that regulation can be excessive, burdensome and ineffective. The right answer is not to defund all regulation, but Congress and legislators need to make sure that the regulators – whatever their area might be – are doing the right job, and doing it effectively and transparently.
So, I have sympathy that regulation can be counterproductive if it’s excessive or poorly done, but we do need it. Particularly, the financial system needs to have some regulatory oversight, and Congress ought to fund those regulators appropriately.
JL: Are you perturbed that financial scandals continue to emerge?
BB:Yes, I am. It’s another reason to have adequate regulation, not just for financial stability, but for consumer and investor protection. It also goes without saying that the companies themselves need to operate under an appropriate ethical framework.
JL: One would have thought the shock in 2007-08 would have rectified some of the unethical behaviour, but it’s clearly still happening?
BB: I hope leaders of financial institutions appreciate – I’m sure many do – that an ethical approach that makes the first considerations the wellbeing of customers and the stability of the system are the best for business. That deceptive policies or unethical policies, even if they generate short-run gains, are not the best way to have a healthy industry and a healthy firm in the longer term.
This, by the way, is why one of the changes in Dodd-Frank was to try to make executive compensation more back-loaded and more contingent, so that money could be clawed back potentially if actions taken turn out to be inappropriate or excessively risky. Whether this is working is still early to say, but that’s an example of a kind of change that potentially could help executives and the financial industry persuade their employees that the long-run perspective is what is most productive for them.
JL: A lot has been written about the shift from bonuses to salaries. If salaries just shoot up to compensate for bonuses having to be reduced, you have the same in the short-term perhaps?
BB: Well, it’s not quite the same. It depends how the income is determined. If the bonus depends on the latest trade and the salary depends on maintaining good relationships with customers, then the incentives are different. It’s not so much the overall amount, but the incentives and whether or not the right behaviour is being induced.
JL: Back in 2008, extreme action needed to be taken. A bailout plan was drawn up to use $700bn of public money to buy distressed assets. Why was this felt to be the right thing: to use public money, rather than sharing that between the public sector and the private sector?
BB: Because the system was collapsing and there simply wasn’t any private money involved. It’s the very nature of a panic that everybody who has any money is going to hoard it and hold it as close as possible, and certainly not be interested in investing in banks.
The public money was invested broadly in the banking system. That stabilised the system, after which the banks were able to get private funding. All the money was paid back with interest. So, the net financial cost of that programme to the public was $0. Of course, much of it went also to other purposes. Some went to supporting the car companies and housing, for example.
We needed a powerful tool that would address the overall instability. You can’t do it institution by institution. Once that money was available, capital investments were made in these firms to stabilise them in October 2008. By the spring of 2009, the system was pretty stabilised, and we were in a process of doing stress testing of the banks to find out how much capital they had. Once that was clarified, generally speaking they were able to raise private sector capital to replace the public capital. By June 2009, the economy was beginning to grow again.
JL: Is there anything that you or others could have done differently?
BB: We didn’t see the full range potential for a panic that would almost bring down the entire system and we were slow to respond to it. Once we understood the full nature of the thing by, say, the fall of 2007, we were generally pretty aggressive. I wouldn’t say every single thing we did was exactly right, but we did use all the tools that we could come up with, so the system went from being in almost complete paralysis to functioning again.
JL: There is that perception that the bailout was in favour of Wall Street, and had too great an impact on ordinary working people. Part of it is the problem of growing inequality.
BB: That’s something that has gone on for a very long time and has probably made the situation worse in the sense that people are even more prone to say, ‘I haven’t benefitted from the recovery of the economy because I’m lower in the income distribution and bailouts are very unfair’. So, yes, I think that probably has exacerbated those attitudes.
JL: What can be done about inequality?
BB: It’s not an easy problem. There’s a list of things. Skills and training, trying to get people to improve their market value in the labour market, tax and transfer policy – an example is earned income tax credit which pays low-income workers. It will take a long time and a lot of commitment by policymakers.
JL: How close did the world economy come to complete collapse in 2007-08?
BB: There’s little doubt in my mind that the very sharp decline in global economic activity following the collapse of Lehman Brothers and the near-collapse of American International Group (AIG) was very closely tied to the chaos and uncertainty in financial markets. In the end, though, only one firm – Lehman Brothers – actually failed. Without our intervention, many more would have failed and globally the financial system would have been in chaos for a considerable time. I think we came very close to having a collapse of the financial system that would have done enormous damage to the global economy, much worse than what we actually saw.
JL: Why was Lehman allowed to fail, or why did it fail when others were bailed out?
BB: One of the big changes in Dodd-Frank is that there are all these tools now that are given to regulators to deal with a failing firm. We did not have any tools back then, and the firm was absolutely insolvent. And it failed before the $700bn bailout, so we had no way to put capital into it. We tried to find another firm to buy it, as we did with Bear Stearns in March 2008, but because it was so deeply in the red nobody wanted to.
The only option left was for the Federal Reserve to lend it money, but only against collateral, and our assessment was that we could only lend to a firm that was solvent and could repay. Again, we didn’t have the tools to save Lehman. We did have the tools, fortunately, to save AIG. It was a question of capability.
JL: If there had been a fundamental failure of the world economy, what would that have looked like?
BB: I think it would have been like what we saw, except much worse. We would have had a much deeper and more protracted downturn with a much higher unemployment rate. We would have had a lot of long and protracted declines in asset values, including housing values. These are things that I infer from the history of financial crises.
It would have been an extraordinarily chaotic and deep recession, and would have depended a lot on the response: whether or not the global policymakers could have been able to put the system together somehow.