November 22, 2010
Good afternoon. I thank Princeton University, the Woodrow Wilson School of Public and International Affairs and Governor Corzine for inviting me to speak today at the Financial Institutions and Regulation Colloquium.
I had the privilege of working with Jon both in the private sector and in public service. I’ll share just one special memory of working with Jon: He offered the first bill in the Senate Banking Committee to reform accounting oversight after Enron collapsed, and he played a significant role in what later became the Sarbanes-Oxley Act. In fact, when the full Senate voted on the bill, if memory serves, Jon was sitting in the presiding chair and I was staffing Chairman Sarbanes on the floor.
I also want to express best wishes to Jon and Sharon, as tomorrow is their wedding day. Jon, your life has changed a lot since our days together on a trading floor if this is your idea of a bachelor party.
It is an honor to speak alongside Andrew Ross Sorkin, who has been a thought leader on finance and business issues for the New York Times. I have closely followed his reporting on the 2008 financial crisis. I look forward to the upcoming movie adaptation of his book “Too Big to Fail.”
You’ve asked me to speak today about “Banks, Shadow Banks, and the New Face of Wall Street.” For the purposes of this discussion, I’d like to first identify a term that will be relevant: “financial intermediation.” The term covers all of the topics – banks, shadow banks and Wall Street. Financial intermediation, so critical to the economy, is about two important functions:
Banks, other financial institutions and markets perform both these functions, standing between those who have and those who want money and between those who have and those who are willing to take on risk. As these needs don’t always naturally align, banks and other financial institutions retain and manage many risks. They transform different desires for maturity, liquidity and credit. For instance, households and corporations generally want to borrow money for longer periods of time for mortgages and loans than the same households and corporations want to lend money through deposits or money market investments. This leaves financial institutions and the economy with a basic mismatch.
As we approach the holiday season, many of you may recall the classic, “It’s a Wonderful Life.” Jimmy Stewart played George Bailey, who ran the Bailey Building and Loan Association. Though not technically a bank, Bailey Building and Loan provided services traditional of banks. In the movie, there was a run on the Building & Loan, and George takes $2,000 that he had saved for his honeymoon with Mary and uses it to satisfy depositors’ needs and restore confidence.
“It’s a Wonderful Life” was filmed in 1946, but the modern financial system struggles with the same challenges of runs on short term funding. There remains a basic mismatch between a depositor’s desire to be able to withdraw his or her money on “demand” in a crisis and the banks’ desire to use the deposited money to lend money for longer periods of time. As George told his depositors, “the money’s not here… Your money’s in Joe’s house… And in the Kennedy house, and Mrs. Macklin’s house, and, and a hundred others.”
But a lot also has changed. Thanks to some wonderful figures kept by the Federal Reserve in their Flow of Funds reports, let me share some comparisons between the financial system today and the system in George Bailey’s time.
Back then, 98 percent of bank liabilities were made up of deposits. Today it’s just 63 percent. Along the way, the banking sector also became far more concentrated. In George’s time, legal restrictions on branching and interstate banking kept the industry quite diverse. The top ten bank holding companies now have more than $11 trillion in assets, about two thirds of the sector’s totals.
Total banking liabilities – those of banks, savings institutions and credit unions – in 1946 were $152 billion. It sounds small, but that was actually 69 percent of the country’s gross domestic product. Today’s banking liabilities add up to $14.7 trillion, representing a total approximately equal to GDP. Total credit markets have grown far faster – from about 1.6 times the size of the economy to 3.6 times in 2010. So banks, though larger, now make up a smaller piece of the pie than they did back in 1946.
One change is that there are many alternative ways for money and credit to flow through our economy other than banking. Today, “shadow” or “alternative” banking includes money market funds, asset backed and mortgage securitizations, government sponsored enterprises, repo and securities lending and open market paper, such as commercial paper. This has all grown to $16.4 trillion – larger than bank liabilities. That figure does not even include the $1.6 trillion with finance companies, the $1.9 trillion with securities brokers, the $1.8 trillion with hedge funds or the $1.5 trillion in private equity and venture capital, all of which might also be considered part of “shadow” banking.
Another key part of the story since George Bailey’s time has been the significant growth of markets where one can buy and sell debts and pools of loans. Even back in the 19th century, markets existed for corporate bonds and commercial paper. These markets remained small in comparison with banks: about 18 percent in relative size in George Bailey’s time. These secondary markets, usually in the securities market, help investors and financial institutions access liquidity for the loans they have made as well as help borrowers gain the benefits of new sources of capital. Securities markets and secondary markets also can provide greater transparency into the pricing of loans, facilitating what economists call the price discovery function.
So banking has changed a lot since the George Bailey era. It has become much more concentrated, though over the same time money and credit have come to be allocated through more vehicles, markets and types of financial intermediaries.
The changes in how the financial system intermediates money is only part of the story. There also have been significant changes in how it intermediates risk. Though risk is intermediated as part of the intermediation of money and credit, it also is done so with the use of derivative contracts. For example, futures started trading in the 1860s to help farmers and merchants hedge the risk of the future price of grains. By the 1970s, futures were helping people hedge risks in the energy and financial markets as well.
It was not until the 1980s, though, that the over-the-counter (OTC) derivatives markets emerged. In 1981, an investment bank, Salomon Brothers, facilitated a swap between the World Bank and IBM. The World Bank wanted Swiss Franc and German Deutsche Mark, but was constrained by borrowing limits. IBM had existing Swiss and German debt that they wished to refund with US dollar borrowings but was constrained by call premiums and other costs. Salomon Brothers arranged a swap between the two, which achieved each of their funding goals. Interest rate swaps emerged shortly thereafter, helping hedgers and borrowers protect against interest rate changes. More recently, we have seen the emergence of a new class of derivatives called credit default swaps (CDS) used to protect against the risk of default of a loan or borrower.
Derivatives are used by banks and by the alternative banking sector, as well as throughout the economy. Derivatives – and in particular currency swaps, interest rate swaps and credit default swaps – have come to serve important roles in the credit markets as well. Today they are intertwined with many of the client relationships and risks of a bank. Based upon figures compiled by the Office of the Comptroller of the Currency, the largest 25 bank holding companies currently have $277 trillion notional amount of over-the-counter derivatives – representing more than 20 times these bank holding companies’ combined total assets.
As we have moved away from the more traditional banking model of George Bailey’s time, there have been both benefits and challenges. We saw these challenges in a very real way in 2008. The financial system failed and the financial regulatory system failed. They failed, in part, because the regulatory structure didn’t stay abreast of the new forms of financial innovation. OTC derivatives, for example, were not regulated in the U.S., Europe or Asia.
Derivatives, of course, were not the only cause of the crisis. We also experienced an asset bubble in housing. But any study of the $11 trillion housing finance market would include a look at the intersection of derivatives with that market.
Mortgage originators were increasingly able to originate loans while using credit default swaps, interest rate swaps and the securitization markets to shift default, prepayment or interest rate risk to other parties. Banks and shadow banking both were involved with the product innovation and segmentation so notable in the housing finance and derivatives markets. They used asset backed and mortgage securitizations, CDS and collateralized debt obligations in increasingly sophisticated ways. Risk was thought to be broken up into various pieces to be held by different market participants. There was a significant failure, however, in understanding the relationship and correlations of all of the underlying risks and products and, in particular, the reliance on the absolute level of prices in the housing market. Furthermore, too often the writers of credit default swaps were ineffectively regulated, as we all saw with AIG.
Derivatives, meant to mitigate and help manage risk, can heighten and concentrate risk. The total credit exposure (including netted current credit exposure and potential future exposure) for U.S. commercial banks’ derivatives activities is currently $1.1 trillion. Derivatives dealing also is very concentrated, with the five largest bank holding companies having about 95 percent of the total notional amount outstanding.
Instead of George Bailey’s honeymoon money propping up the Building and Loan, this time it was the taxpayers – through the Federal Government – that stepped in to stem a run on the modern financial system. In the midst of the crisis, swaps contributed to a financial system so interconnected that institutions were not only “too big to fail,” but “too interconnected to fail.”
I’m honored to chair the Commodity Futures Trading Commission. We swim in the derivatives lane. Since the 1930s, the Securities and Exchange Commission has overseen the securities markets, and we have overseen the futures markets, which are now roughly $33 trillion in notional amount. This summer, the President signed historic legislation, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which will bring many of the key regulations from the securities and futures markets to the swaps market.
At the CFTC, we are currently working on rules to implement the Dodd-Frank Act. To lower risk and increase transparency in the derivatives markets, swap dealers will be regulated and standardized swaps will be moved onto transparent trading platforms and into clearinghouses. These reforms will be for all swaps and swap dealers, whether within banks or within so-called “shadow” banks.
Congress has determined that it is incumbent upon regulators to update to the reality that we no longer live in George Bailey’s time. We must oversee a banking system, shadow banking system, derivatives marketplace and Wall Street that continue to change and pose new risks. We don’t have the luxury to turn back the clock, but we do have the responsibility to update our oversight for the financial system of the time.
Thank you again for inviting me to speak today. Before I turn it over to Andrew, I’d like to wish you a happy Thanksgiving.
Last Updated: January 18, 2011