In November 2009, Senate Banking Committee Chairman Christopher Dodd advanced a radical proposal: to create a super-regulator that would take over most of the bank supervision that had been done by the Federal Reserve System, the Federal Deposit Insurance Corp. and other agencies.
Dodd had been a harsh critic of the Fed and its chairman, Ben S. Bernanke, declaring in July 2009 that the central bank’s supervision of financial services had been an “abysmal failure,” Bloomberg Markets magazine reports in its October 2010 issue.
In January 2010, the U.S. Senate approved Bernanke for a second four-year term by a tally of 70 to 30 -- giving him the most negative votes any nominee had received since the chamber started confirming Fed chiefs in 1978.
Six months later, when President Barack Obama signed into law a 2,300-page bill overhauling financial services regulation, the super-regulator had been forgotten. Instead, the Federal Reserve had acquired new regulatory heft, and Bernanke had emerged as the most powerful Fed chairman ever -- with more authority even than his legendary predecessor, Alan Greenspan, who had chaired the Fed for 18 years.
For all of the heat Bernanke took for failing to see the gathering credit storm in 2007, lawmakers -- with a few exceptions -- have come to appreciate the actions he has taken to rescue the banking system and the economy in the past two years. He has pushed interest rates as low as they can go and vowed to keep them there until the employment picture improves. Last week at a Fed meeting in Jackson Hole, Wyoming, he said the Fed was ready to provide still more stimulus if needed.
Vote of Confidence
“When the dust settled, Congress realized that Bernanke and the Fed knew what they were doing,” says Mark Gertler, a New York University economics professor who did research with Bernanke, a former Princeton University professor, on the causes of the Great Depression. “The power of any Fed chairman is ultimately based on the perception by Congress that he will use it prudently. He has this reputation.”
Under the Wall Street Reform and Consumer Protection Act, known as the Dodd-Frank law, Bernanke’s Fed gains powers never before housed in one regulator. The central bank remains the supervisor of 5,000 U.S. bank holding companies and 830 state banks.
The law gives it new authority to control the lending and risk taking of the largest, most “systemically important” banks. Among them: investment banks Goldman Sachs Group Inc. and Morgan Stanley, which became bank holding companies in September 2008.
The Fed gains authority over about 440 thrift holding companies and will also regulate “systemically important” nonbank financial firms, including, analysts say, the biggest insurance companies, Warren Buffett’s Berkshire Hathaway Inc. and General Electric Capital Corp., the financial unit of GE.
The Fed is now required to look for evidence that practices in the banking system threaten the country’s financial stability and, if necessary, take action to put a stop to those practices. It’s also obliged under the law to administer stress tests at the biggest banks every year to determine whether they need to set aside more capital.
The law prescribes that those banks write so-called living wills, approved by the Fed, that would make it easier for the government to break them up and sell the pieces if they’re suffering from a Lehman Brothers-style meltdown.
Bernanke’s Fed will also house and fund a new federal consumer protection agency, although it will operate independently. The Fed will even have the power to tell U.S. banks how much they can charge merchants when a consumer uses a debit card to buy a suit or a sack of groceries. Regular credit cards will be the responsibility of the new consumer agency.
“There are an enormous number of powers given to the Fed,” says Vincent Reinhart, who was the Fed’s chief monetary policy strategist from 2001 to 2007. “The Fed has a very powerful and very broad mandate.”
That kind of power was just what Senate opponents of the financial regulation bill wanted to deny Bernanke, who declined to comment for this story.
“Augmenting the Federal Reserve’s authority risks burdening it with more responsibility than one institution can reasonably be expected to handle,” Alabama Senator Richard Shelby, the ranking Republican on the Senate Banking Committee, said at a hearing in July 2009. “In fact, the Federal Reserve is already overburdened with its responsibility for monetary policy, the payment system, consumer protection and bank supervision.”
Shelby also raised the issue of the inherent conflict between the Fed’s role in setting interest rates and its job of bank supervision.
“The mixing of monetary policy and bank regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy decisions,” Shelby said.
The Fed’s role as a bank regulator dates to its creation in 1913, in the wake of another financial crisis: the Panic of 1907. It originally supervised only state banks that chose to operate under a Federal Reserve charter.
Its bank supervisory duties were expanded with the 1933 passage of the Glass-Steagall Act, which, in addition to splitting apart commercial and investment banks, established the FDIC to insure deposits and required bank holding companies to submit to audits by the Fed.
One opponent of giving the Fed new regulatory power is former chairman Greenspan.
“The additional power that the Fed has been given I had not been in favor of,” he told Bloomberg News on July 16. “I do not think they can actually prevent the next crisis.”
As Bernanke, 56, assumes his new responsibilities, he continues to take bold and unprecedented steps in the Fed’s traditional areas of responsibility: managing the money supply and setting interest rates. To rescue the banking system and stimulate economic activity, the Fed has for more than two years been buying bank and government debt, swelling its balance sheet to more than $2 trillion.
With the crisis past, the Fed by early 2010 had decided to let the securities-buying program wind down, shrinking its balance sheet as the bonds it held matured. The Federal Reserve Bank of New York estimated in March that more than $200 billion of agency debt and mortgage-backed securities held by the central bank would mature or be prepaid by the end of 2011.
Bernanke reversed the decision to stop buying securities on Aug. 10. The central bank’s Federal Open Market Committee announced it would replace maturing bonds with longer-term Treasuries, explaining that the economy had weakened since June and it didn’t want to add to the problem by driving up interest rates.
Jackson Hole Assurance
“In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly,” Bernanke said Aug. 27 at the Kansas City Fed’s annual monetary symposium in Jackson Hole.
Buying bonds pushes yields on Treasury notes lower, which forces down mortgage rates and other long-term borrowing costs. The average rate of a 30-year fixed-rate mortgage dropped to a record low of 4.36 percent in the week ended on Aug. 26, from 4.42 percent the week before, according to mortgage packager Freddie Mac, which began compiling the data in 1971.
The yield on 10-year Treasury notes touched a 19-month low on Aug. 25. The yield dropped to 2.52 percent on Aug. 30 from 2.65 percent late on Aug. 27.
Sending a Message
“The simple option of reinvesting the proceeds of maturing assets will not have a huge impact on the scale of market liquidity,” says Lena Komileva, an economist at Tullett Prebon Plc, a London brokerage firm. “But it will send the message that the Fed is still in easing mode, which may create an appetite for risk and borrowing.”
William Ford, a former president of the Federal Reserve Bank of Atlanta who now teaches at Middle Tennessee State University, calls the Fed action “a wrong move” that will have little impact except to increase the losses the Fed suffers on its portfolio of long-term Treasuries when interest rates rise.
“They are sticking their foot deeper in a liquidity trap,” Ford says. “It will not cause any lending.”
Bernanke’s use of nearly every tool at his disposal to stimulate economic growth could conflict with his new job as regulator-in-chief, says former Fed Governor Lyle Gramley. “If the regulators were to get very tough right away and make major changes in liquidity and capital requirements, that could be a problem,” he says.
Hitting GDP Growth
Mark Zandi, chief economist at Moody’s Analytics, says any move by the Fed to increase reserves against bad debt will hurt economic growth.
“The higher the capital ratios, the greater the hit to bank profitability, credit growth and GDP growth,” he says. “The near-term consequence will be to slow growth.”
Bernanke says his examiners are working with the nation’s financial institutions to minimize the economic impact of tougher regulation.
“Our message is clear,” he said on July 12 at a meeting of small-business owners. “Consistent with maintaining appropriately prudent standards, lenders should do all they can to meet the needs of creditworthy borrowers. Doing so is good for the borrower, good for the lender and good for our economy.”
Bernanke and his supporters triumphed over the opponents of expanding the Fed’s regulatory power by exploiting the institution’s historical prestige.
“The Fed ended up on top because Democrats and Republicans can agree that its independence is more significant than that of any other agency,” says John Silvia, chief economist at Wells Fargo Securities and former chief economist for the Senate Banking Committee.
Bernanke says it’s important that the Fed continue to be the country’s main bank regulator because no agency knows the banks better.
“Because of its wide range of expertise, the Federal Reserve is uniquely suited to supervise large, complex financial organizations,” Bernanke told a hearing of the House Financial Services Committee on March 17.
The Fed chief has taken his message to the public in a series of appearances, including a profile on CBS TV’s 60 Minutes in March 2009 and a half dozen speeches and question-and-answer sessions.
On Aug. 2 of this year, he spoke in his native South Carolina to an audience of Southern state legislators, defending the Fed’s role in the bailout of big financial firms like Citigroup Inc. and insurer American International Group Inc.
‘It Wasn’t Pretty’
“In September and October 2008, our financial system came as close as it has come since the 1930s to utter meltdown,” he said. “I am not just talking about the United States but the entire world. We did what we did -- it wasn’t pretty -- to prevent the collapse of the global financial system because we knew what effect that would have on Main Street, not on Wall Street.”
Bernanke’s supporters see the financial regulation bill as a gesture of trust in the Fed chief, who has been working with the Fed since 1987, when he began several stints as a visiting scholar at regional Fed banks. Dodd, 66, a five-term Democrat who is retiring in January, was one person Bernanke brought around in the months Congress spent wrangling over the financial regulation bill.
“I have real concerns about how the Fed responded at a time they should have been more aggressive,” he says. “But I think Ben Bernanke learned a lot from it and I have a lot of confidence in him today to lead.”
Frank Backs Bernanke
Bernanke also won the backing of Barney Frank, the Massachusetts Democrat who is head of the House Financial Services Committee, and of Obama, who signed the Dodd-Frank law on July 21.
Former Fed Governor Gramley says Bernanke was just one of many financial regulators who didn’t see the buildup of bad debt that brought the economy low.
“Bernanke has to take his lumps along with everyone else who missed the boat,” says Gramley, now senior economic adviser at Potomac Research Group in Washington. “But were it not for what a few people like Bernanke did to keep us from going over the deep end, we would now be in the midst of a catastrophic depression. So Ben comes out a hero in my book.”
Bernanke saw no catastrophe on the horizon in 2005, when he was serving as head of President George W. Bush’s Council of Economic Advisers, a post he resigned from the Fed Board of Governors to take. At a briefing for reporters in August of that year, he was asked about the rapid rise in home prices.
Bernanke the Optimist
“Housing prices certainly have come up quite a bit,” he said. “But I think it’s important to point out that house prices are being supported in very large part by very strong fundamentals.”
Bernanke remained an optimist in the first year after he was sworn in as Fed chairman, in February 2006. On March 28, 2007, addressing what was by then a collapsing subprime housing market -- 13.3 percent of such borrowers made late payments in the fourth quarter of 2006 -- Bernanke told Congress’s Joint Economic Committee, “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”
Five months later, credit markets seized up. The Fed then began a long chain of actions that Bernanke would later say were necessary to avert financial collapse.
“The Fed was slow to appreciate the loss of liquidity in the global financial markets,” says Ernest Patrikis, a partner at law firm White & Case LLP and a former general counsel for the New York Fed. “Once the Fed got it, it truly got it. The Fed was creative, pulled out all the stops.”
Beginning in September 2007, the central bank repeatedly lowered the federal funds rate, which is the rate banks charge to lend to each other. It now ranges from 0 to 0.25 percent. The Fed also cut the interest rate it charges banks to borrow directly from the Fed, to 0.5 percent in December 2008 from 6.25 percent in August 2007.
In March 2008, the Fed directly intervened to try to still the crisis, lending $29 billion to buy toxic assets from failing Bear Stearns Cos. and facilitate its takeover by JPMorgan Chase & Co.
By December 2008, in the wake of the financial chaos triggered by the bankruptcy of Lehman Brothers Holding Inc., Bernanke’s Fed was flooding the financial system with money.
At the same time that Bernanke was taking emergency measures, he was imposing some regulatory discipline on the banks. Congress had given the Fed the authority to regulate mortgage lending in 1994, yet Greenspan’s Fed had never written the rules that banks must follow in issuing such loans.
Enforcing the Rules
In July 2008, the Fed finally signed off on new rules, and Bernanke announced that the central bank would enforce them rigorously.
“Far too much of the lending in recent years was neither responsible nor prudent,” he said, adding that “strong, uniform oversight of different types of mortgage lenders is critical to avoiding future problems.”
That same month, the Fed ruled that mortgage lenders must verify a homebuyer’s income or assets -- a detail that had been neglected in the era of the so-called liar loan.
In the wake of the financial breakdown, the focus in Congress was on which agency of government should be charged with searching out systemic risk. During July 2009 hearings by the Senate Banking Committee, Shelby said the one body that shouldn’t have the job was the Fed.
“I believe anointing the Fed as the systemic risk regulator will make what has proven to be a bad bank regulator even worse,” he said.
Clash of Tasks
William Poole, a former president of the Federal Reserve Bank of St. Louis, says Bernanke has to deal with the conflict between his bank supervision duties and the orchestration of monetary policy. The clash was apparent as early as the 1970s, when the Fed was battling both high inflation and growing problems in the savings and loan industry, he says.
“There was concern about raising interest rates, which would put further pressure on the savings and loans,” says Poole, who was at the St. Louis Fed from 1998 to 2008 and who is now a senior economic adviser to Palo Alto, California-based Merk Investments LLC. “You don’t want monetary policy decisions to be dominated by what’s a side issue.”
Poole’s view isn’t popular among his Fed colleagues, he says.
“I’ve never believed that it’s essential for the Federal Reserve to have supervision authority,” he says. “I know my Federal Reserve colleagues will regard me as a traitor if you publish that. I don’t think it’s essential.”
Killing the OTS
It was partly to answer this argument that Dodd, in November 2009, proposed the creation of a super-regulator to replace the Fed, the FDIC, the Office of the Comptroller of the Currency and the Office of Thrift Supervision. The only agency that ended up getting axed was the OTS, whose responsibilities were divided up among other agencies, including the Fed.
While Congress was debating the fate of the Fed’s bank supervision powers, Bernanke took to the streets and airwaves to repair the central bank’s image. In March 2009, he agreed not only to sit for an interview with 60 Minutes’ Scott Pelley but also to travel with Pelley to his hometown of Dillon, South Carolina, where his father and uncle once ran a drugstore. Bernanke talked about the damage the financial crisis had done to Dillon’s economy.
In July 2009, he made a town-hall-style appearance on PBS television in Kansas City, Missouri. In May 2010, Bernanke toured a Philadelphia shipyard and a Tasty Baking Co. factory in a part of the city that is being redeveloped.
‘An Inspiring Morning’
The Philadelphia visit, well covered by local media, had the aura of a political campaign tour.
“It was just an inspiring morning for me,” Bernanke said afterward.
Bernanke chatted with ABC News’s Sam Donaldson at a June 7, 2010, dinner in front of a live audience. Two days later, he traveled to Richmond, Virginia, to meet with 20 students at J. Sargeant Reynolds Community College, where he praised job training programs as a way to help the unemployed.
“I call that the summer-of-love tour,” former Fed monetary policy chief Reinhart says. “He recognized the voting public was angry and they were angry at the Federal Reserve. He came out of this recognizing that the Fed’s legitimacy depended on how it was viewed by the public.”
Other members of the Fed Board of Governors and the leaders of the 12 regional Fed banks were also busy in the spring and summer of 2010 defending the Fed’s bank supervisory power, particularly its jurisdiction over 830 banks with state charters.
Fed President Lobby
On May 5, four regional Fed presidents -- Kansas City Fed President Thomas Hoenig, Minneapolis Fed President Narayana Kocherlakota, Richmond Fed President Jeffrey Lacker and Philadelphia Fed President Charles Plosser -- traveled to Washington to urge Congress not to enfeeble the Fed.
They “argued very vociferously” that a Dodd proposal then on the table to strip the Fed of supervision of smaller banks would make Fed regulation “too New York-centric,” says Senator John Ensign, a Nevada Republican.
Dodd recalls that the regional Fed presidents’ arguments resonated with Congress.
“The regional banks did a lot of work on this that had a lot of influence in various parts of the country,” he says. “That clearly caused some people to change their views. It became a local issue.”
As the July vote on financial regulation approached, Bernanke himself pleaded the Fed’s case over and over. From Jan. 1 until the vote, he spent at least 35 hours testifying at congressional hearings, meeting with members of Congress and talking to them on the phone, according to congressional records and Bernanke’s personal calendar, which is periodically released by the Fed.
Bernanke dealt with the conflict issue head-on.
“The Federal Reserve’s participation in the oversight of banks of all sizes significantly improves its ability to carry out its central banking functions, including making monetary policy, lending through the discount window and fostering financial stability,” Bernanke said at the Mar. 17 hearing of the House Financial Services Committee.
Now that the Fed has won the argument over who should regulate the banks, Bernanke must answer those who worry that his newly vigilant agency will throttle the financial system with new restrictions, NYU’s Gertler says.
Striking a Balance
“The Bernanke Fed is acutely aware of the need to strike a balance,” Gertler says. “Some increase in costs from regulatory protection is entirely justifiable. But the trick is to not overdo it.”
Bank of America Corp. says the section of the law covering debit cards is an example of overdoing it. The law says banks must cap fees to merchants so that they are “reasonable and proportional to the cost” of the transaction. The Charlotte, North Carolina-based lender interprets that to mean it isn’t allowed to make a profit on such transactions.
The bank planned to take a charge of $7 billion to $10 billion for the third quarter in anticipation of a fee reduction.
Richard Bove, a banking analyst for Stamford, Connecticut-based Rochdale Securities LLC, says bank regulators have already done too much.
“If they don’t ease up on bank capital restrictions and requirements for liquidity, they are going to continue to see declines in money supply, and that will create another recession,” Bove says.
He blames regulators for a contraction in lending. As of mid-August, U.S. banks had cut back credit for 16 of the past 17 months, according to data compiled by the Fed.
The new regulatory regime will have its own bureaucracy. The law calls for the president to name a new Fed vice chairman for bank supervision, who will be subject to confirmation by the Senate and will supervise a staff of at least 3,000 people.
The career civil servants will be led by bank supervision chief Patrick Parkinson, a Ph.D. economist who joined the Fed in 1980. Parkinson, 58, works from an unmarked office building on Washington’s K Street, eight blocks from Fed headquarters.
“One of the lessons we learned from the financial crisis is that we need higher capital, and better quality capital, especially at the largest institutions,” he says. “There is no doubt we need to be very sensitive about imposing too strict standards too soon.”
Part of the vice chairman’s job will be to oversee the annual stress tests. Fed bank examiners will subject all banks with $50 billion or more in assets to the tests. As of June 30, that would have included 36 U.S.-based firms, compared with 19 tested last year, when the cutoff was $100 billion.
The Fed staff will look at each bank’s risk of failure under three economic scenarios: base line -- that is, no crisis -- adverse and severely adverse. The 2009 tests, formally known as the Supervisory Capital Assessment Program, resulted in a Fed demand that 10 of the banks increase their capital cushion by a total of $75 billion.
Big nonbank financial firms will, for the first time, have to meet Fed standards for capital reserves. A new council of regulators will designate which nonbank firms are systemically important.
Two likely to face Fed examinations are Berkshire Hathaway and GE Capital, says Christopher Whalen, managing director at research firm Institutional Risk Analytics and a former New York Fed official.
Through the Wringer
“It is the nonbanks that will really go through the wringer,” Whalen says. “With Berkshire Hathaway, it will be a significant annoyance and they will have to report a lot of data. GE will have to raise capital levels and have a more centralized risk-management regime, which goes against the entrepreneurial, more decentralized regime that has been their strength.”
General Electric Co. Chief Financial Officer Keith Sherin says GE Capital isn’t worried about any Fed demands.
“We feel confident that we’re going to be able to meet whatever the requirements are to be well capitalized,” he said in a July 16 conference call with investors.
Berkshire Hathaway, 29 percent of whose revenue comes from insurance, declined to comment on the possibility that it will come under the Fed’s sway. CEO Buffett, though, has a high regard for Bernanke.
Out of the Abyss
“Paul Volcker was essential to this country coming out of that 1979 to ’82 period like we did,” Buffett told PBS and Bloomberg Television talk show host Charlie Rose in November 2009, referring to the economic crisis of 30 years ago. “Ben Bernanke was essential to keeping us from going into the abyss last September.”
Now, Bernanke’s job is to lay down stiff new banking rules and make them stick. It won’t be easy, says Edward Kane, a professor of finance at Boston College.
“Once the rules are defined and put in place, then the loopholes will also be defined,” says Kane, who’s a senior fellow at the FDIC’s Center for Financial Research. “The new system means a new system of getting around the rules.”
Bernanke told Congress on July 21 that the outlook for the economy is “unusually uncertain.” The same might be said for his prospects as the new master of financial regulation.