The compensation system gives too much incentive for bankers to take risks, and the University has promoted the view that the markets generally take care of themselves, Paul Volcker ’49, former chairman of the Federal Reserve, said in a panel discussion on Friday.
“We have a department at this great University … teaching people how to get around every rule you can conceive of to make big bonuses at big banks,” Volcker said, referring to the Operations Research and Financial Engineering department.
Richard Herring GS ’73, professor of international banking at the University of Pennsylvania’s Wharton School, said governments typically bail out banks for one of four reasons: they are too big, they are important to key markets, they are interconnected with other important financial institutions or they’re complex.
Citibank, with over 3,000 affiliates in 80 or more countries, is an example of a complex bank whose bankruptcy process would be “mind-boggling,” Herring said.
Central banks traditionally use the doctrine of “constructive ambiguity” to avoid the problem of moral hazard by making it unclear whether a central bank will intercede, he explained.
Herring noted the existence of an “apocryphal story” about Volcker when he was chairman of the Federal Reserve. Volcker allegedly told a bank president, who had asked whether he could rely on his support if the bank went bankrupt, that he would discuss the matter with the bank president’s successor.
However, the Federal Deposit Insurance Corporation and other organizations have been working extensively in the wake of the financial crisis to make it easier to wind down the operations of insolvent banks in an orderly fashion, Donald Bernstein, partner and head of the insolvency and restructuring practice at Davis Polk & Wardwell LLP, said.
In this regard, an important measure has been the requirement of the Dodd-Frank Act for financial institutions to make “living wills” that keep regulators updated on detailed technical information about banks’ operations that should allow them to close or sell an insolvent bank on a less ad hoc basis than the forced sale of Bear Stearns in March 2008, he explained.
However, the Dodd-Frank Act’s capital requirements may not be sufficient to solve an illiquidity crisis similar to the 2008 one because the stress tests to which banks are subjected do not ensure that the banks would be able to withstand an event similar to that of 2008, he added.
The financial system has changed drastically since the 1970s because the six largest banks now hold 54 percent of assets, Martin Gruenberg, chair of the FDIC, said. The conventional wisdom before the crisis failed by assuming that these banks’ diversification of operations and geography would prevent them from failing, he explained, adding that these supposed benefits turned out to be liabilities when they did face insolvency.
Gruenberg, who was on the board of the FDIC during the crisis, said that regulators ultimately overlooked the risks that these firms posed and that their judgments were simply wrong about banks’ exposure to risky assets and their ability to attract capital and liquidity.
However, the FDIC’s expanded authority to place non-bank but systemically important firms into public receivership upon the emergence of a crisis has helped to make the financial regulatory regime more comprehensive, he said.
“If the question is, ‘Have we ended too-big-to-fail,’ I would say, ‘No,’” Gruenberg said. “Have we made some progress in the area? I think the answer is, ‘Yes.’”