The Regulator’s View
A conversation with Michael Krimminger ’82, partner, Cleary Gottlieb Steen & Hamilton, former general counsel, FDIC
"I don’t believe that we necessarily need to break up the large banks or companies, but I believe that we need to make sure that they pay the actual social cost of their size and complexity."
— Michael Krimminger ’82
As deputy to the chairman for policy and, from November 2010 to May 2012, as general counsel of the Federal Deposit Insurance Corp., Michael Krimminger helped the agency address domestic and international banking issues and develop regulatory changes and policy initiatives in response to the financial crisis. In a nutshell, Krimminger describes the financial meltdown of 2008 as a “perfect storm” of opaque transactions; the evaporation of investor confidence in the markets; a highly-leveraged system in which risk was grossly underestimated; and an inadequate statutory infrastructure. The long period of unusually favorable market conditions also led regulators themselves to ignore danger signals and fail to take action to stem excessive risk-taking by regulated financial companies, he says. In combination, this led to both the markets and regulators failing to take action against a growing shadow banking and mortgage-origination system until the bubble burst and the crisis spiraled out of control. As Krimminger describes it, the inadequacies of the statutory frameworks to deal with such a broad market disruption led to necessary, but unfortunate, actions to prevent an even greater destabilization of the financial system.
In late March, Krimminger, now a partner at Cleary Gottlieb in Washington, talked to Duke Law Magazine about the regulatory reforms that have emerged in the wake of the meltdown. An excerpt of the conversation follows.
Duke Law Magazine: What have been the most significant regulatory improvements since 2008?
Michael Krimminger: I would point to four things. First, there is now a framework in place to provide for an additional level of advance planning — resolution planning — and prudential and market oversight by the Financial Stability Oversight Council. This is provided by Title I of Dodd-Frank [the Dodd–Frank Wall Street Reform and Consumer Protection Act]. That’s something you didn’t have before. Bank holding companies over $50 billion, of course, were always subject to oversight, but now you also have a framework that can subject designated non-banks, so-called SIFIs [systemically important financial institutions] to an additional level of oversight.
The caveat to Title I is that it is very much dependent upon what the regulators actually do with it — whether or not they take action to make it work. … In short, it remains to be seen whether regulators will be able and willing to take timely action in the future.
The resolution-planning element is a significant development. Under Section 165(d) of Title I, the FDIC and the Federal Reserve have adopted a joint regulation requiring the largest financial companies to prepare detailed resolution plans demonstrating how they could be wound down under the Bankruptcy Code. This will require the companies to take a hard look at how they do business and whether they need to take action to simplify their operations to provide a credible plan for their resolution under the Bankruptcy Code. That’s a tough standard. And I think we need to make sure that’s implemented in a very aggressive way.
The second major thing is that there are now a series of steps being taken to improve the resiliency of the financial system. It includes things like moving derivatives over to central counter-party systems where possible, trying to reduce dramatically the use of over-the-counter derivative transactions — you can’t eliminate them entirely — and reforms such as the Volcker rule, which can have some impact on de-risking parts of the system. These reforms remain under development through rulemakings — and as with many other parts of Dodd-Frank it all depends on how those rules are finally adopted and how they are actually implemented. The best rules in the world are useless unless they are actually enforced.
The third major area that’s really vital for change is the Title II resolution authority. Under Title II of Dodd-Frank, if the Bankruptcy Code is viewed as creating too great a risk of contagion effects across the market if it is used to wind down a financial company, the FDIC can be appointed as a receiver and resolve the company in a way to minimize the disruption from the failure while making sure that shareholders and creditors bear the losses. It’s done in a way that would support the market’s overall liquidity and keep the market functioning. That’s something we didn’t have in 2008 and that’s why Treasury chose to propose TARP and why the FDIC participated in providing support to certain companies. That cannot be repeated. If the market understands there is a viable and credible process for closing down these firms, then investors and the market will be more likely to internalize a new reality that these firms are no longer too big to fail and to actually make them pay the freight for the risk they pose to the system. Market participants must come to view the largest, and most complex, financial companies as potentially subject to failure and, therefore, to look at their credit quality on a true market basis, rather than with the expectation of government support. This is critical if we truly believe in free markets.
And that relates to the fourth element — addressing the cross-border operations of the largest financial companies. I’m pleased to say that the level of cooperation and the working relationships on the international stage — often behind the scenes — between the regulators and resolution authorities around the globe have shown tremendous improvement and development. These developments are particularly critical in the key jurisdictions where U.S. companies have the vast bulk of their cross-border operations and exposures. Of course, some people still say, “You can’t deal with these international [problems] because U.S. firms have operations in 100 different countries.” … While true on its face, the fact is virtually all U.S. firms, no matter how involved they are internationally, have more than 95 percent of their exposures and operations in fewer than 10 countries. And 80 percent, roughly, consist of operations in the U.K. or through the U.K. So we have been focused specifically on developing relationships and developing joint planning and parallel reviews for resolution planning for British firms and U.S. firms with U.K. authorities. There has been a tremendous amount of progress. … It’s an effort closely coordinated with the Federal Reserve and the OCC [Office of Comptroller of the Currency] and other regulators.
The key thing from a U.S. perspective is that the key reforms very much reflect the resolution regime that was adopted in Dodd-Frank and it is built very fundamentally on the FDIC’s resolution process for banks that’s been in place for 70-plus years. In effect, the Dodd-Frank and FDIC resolution process is the international model.
I [was] a member of the Resolution Steering Group for the FSB and the Cross-border Crisis Management Working Group, and a number of other multilateral efforts. These efforts, in my view, have made a big difference. Europe is moving ahead with reforms that will help implement these things. The British are very aggressive in moving ahead with planning and reforms. And this is something that is going to be a major effort over the next few years. It’s going to make the likelihood of a cooperative resolution of a major financial firm, if one gets in trouble, exceedingly more likely than it’s ever been in the past.
DLM: How has Dodd-Frank changed the prospects for future bailouts of troubled financial firms?
Krimminger: Dodd-Frank modified Section 13(3) of the Federal Reserve Act in one significant way, but mostly in fairly benign ways.
The significant way is that you can’t provide liquidity support or bailout support for a specific company. That’s a good thing. Look at it this way: At the end of 2008 and in 2009 as the smoke was clearing from the rubble, we had maximized moral hazard and minimized market discipline because we essentially guaranteed the capital structure of the 19 largest financial firms in the United States. To address that, we needed to put market discipline back in and minimize moral hazard. Really, the only way to do that is to say “We’re not going to be doing bailouts in the future.” So Section 13(3) needed to have a restriction put into it so that you couldn’t do an individual firm bailout.
But 13(3) continues to give very broad terms for the Fed to provide system-wide liquidity support. And that can be done in a variety of ways as has happened in the past. It just can’t be targeted on a single company.
This all has to be viewed as part of a reform package that includes a new resolution regime. My view is this: If you believe in a free market, you have to believe in the freedom, so to speak, to fail. And financial companies should not be put on any kind of golden pedestal any more than any other company. We have to make sure that we have the ability to provide liquidity to the system — which is what 13(3) does and what the provisions for the debt guarantee program that the FDIC can offer under Dodd-Frank does. And if you can’t survive based on overall liquidity to the system, then you need to be closed and resolved. We just need to make sure you can be closed and resolved in a way that doesn’t create a catastrophe for the system itself. That’s what Title II is about.
DLM: It’s January 2013 and the president, whoever it is, asks you to make two recommendations for improving the overall system further. What still needs to be done?
Krimminger: I think I would want to make sure that there is complete administration support and aggressive advocacy for implementing the additional capital and systemic stabilization efforts that we put into place as a result of the crisis. There should not be a backing off of that. That includes things like making sure that the Basel III capital standards are put in place; making sure that liquidity standards are put in place; making sure that you put in place a more realistic structure for money-market mutual funds, commercial paper and other things. That would be one of the key areas that I would say [needs improvement]. Some of that involves making companies pay the cost they would impose upon the system if they were to crash, and therefore would lead to some simplification of financial companies.
I don’t believe that we necessarily need to break up the large banks or companies, but I believe that we need to make sure that they pay the actual social cost of their size and complexity. And if they can operate efficiently after paying the social costs, then that’s fine. If they can’t, they need to de-risk or reduce themselves in size so they can be a more functioning part of the normal financial system. …
The second thing I would suggest is a real drive by the administration at the highest level to ensure that there is a cooperative effort brought to bear on cross-border issues with other countries across the globe. This should entail taking a real hard, fresh look at the global financial system and identifying how we can make sure that it is more resilient in a way that promotes economic growth but doesn’t do that at the cost of creating a boom-bust cycle internationally. … Right now the international infrastructure is very much focused on a North American and European framework, with the addition of Japan and some other countries. We need to bring into the international/global financial system, in a very clear, cooperative way, countries like India and China that are becoming more involved, but we need to make sure that they see the current international infrastructure and framework as being very much in their interests. I don’t rely upon people’s good faith or countries’ good faith, but I think that if you make something in someone’s interest, they will be more predictable in their reactions to it than they would be if it wasn’t.
DLM: Are there limits to the ways regulation can address problems with transparency that may be due to complexity?
Krimminger: There are definitely limits to regulation. That’s why I’ve always been a big advocate of a supportive infrastructure that does two things. First, it has regulation in place that requires certain standards to be met. Of course, regulations can be gamed and you have to understand that this is just part of life, because people are very smart in the financial markets.
The other thing you need to do is make sure the market infrastructure supports the regulatory goals. An example would be that you need to have certain requirements regarding risk retention and securitization so that people have skin in the game and also requirements that transaction structures and reporting are sufficiently transparent so that the risks can be understood by investors. And then you ensure that the market infrastructure puts in place a sort of risk/reward incentive for that. So you make sure there’s transparency. And if there’s transparency the market will — if you believe in markets — be more likely to reward the “smart money” than the “dumb money,” because people will have an advantage if they can actually understand what’s underlying the transaction. I think transparency will help lead to a somewhat reduced level of complexity. I would even go so far as to have some limitations upon the level of complexity you can have in securitization deals. There are a lot of other types of transactions, of course — credit default swaps and collateralized debt obligations and others can be incredibly complex, but I think you can’t do it just by regulation. That just creates other opportunities. You have to make sure the market structure itself supports the regulatory goal.
Sometimes it’s very easy to be cynical and dismissive of reforms or say that they should have waited for further studies of why a particular crisis occurred, or that the reforms didn’t go far enough. But I think we’ve got to look at the broad picture. We had a tremendous crisis, and many of the people around Washington and New York, particularly, want to forget we had the crisis. We need to push ahead with reforms that will make a difference in the areas that are most significant to that particular crisis. It may not prevent the next crisis, but it will probably mean that we have a more resilient system going forward. And that’s all to the good and is certainly something we should support as opposed to saying it didn’t go far enough or, as some people would argue, it went too far.