Harvey Rosenblum Executive Vice President & Senior Economic Advisor Liz Organ Research Analyst

1. Harvey Rosenblum Executive Vice President & Senior Economic AdvisorLiz OrganResearch Analyst • A Failure to Communicate: The Pathology of Too Big to Fail • October3, 2013 • Community Banking in the 21st Century • St. Louis, MO The views expressed are those of the speaker and should not necessarily be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

2. Cool Hand Luke (1967) “What we’ve got here is failure to communicate” • Number 11 on AFI’s “100 Years… 100 Movie Quotes” list SOURCE: Cool Hand Luke (movie, 1967)

3. Crisis Communication Technique …at times of crisis, Geithner said the government had to get both the substance and the theater right. Bernanke, Geithner, and even more so, Paulson muffed the theater. Because they didn’t tell a convincing story… or offer a clear explanation… other accounts of varying plausibility filled the vacuum… - David Wessel, In Fed We Trust, p. 7-8

4. Fed Statement Word Count Word count More words, not necessarily more meaning or understanding NOTE: The shaded area is the period of the FOMC’s unconventional monetary policy with interest rates at the effective lower bound of near zero. SOURCE: Wynne, Mark A., “A Short History of FOMC Communication,” Federal Reserve Bank of Dallas, Economic Letter, Sep. 2013.

5. In theory, monetary policy and regulatory policy are separate. • In practice, they are the same. • Both require clear communication.

6. Conventional Monetary Policy Decision to ease/tighten policy Target Fed funds rate Market interest rates Bank capital linkage Confidence linkage Exchange rate channel • Asset prices and wealth channel • Collateral values • Net worth • Bank loan channel • Interest rates • Credit standards • Securities market channel • Interest rates • Debt issuance Strong consumer and business confidence Well- capitalized banks SOURCE: Rosenblum, Harvey, Jessica J. Renier, and Richard Alm, “Regulatory and Monetary Policies Meet ‘Too Big to Fail,’” Federal Reserve Bank of Dallas, Economic Letter, Apr. 2010.

7. Unconventional Monetary Policy Decision to ease policy Fed funds rate near lower bound Large-scale purchases of long-term assets (QE) Market interest rates Bank capital linkage Confidence linkage Exchange rate channel • Asset prices and wealth channel • Collateral values • Net worth • Bank loan channel • Interest rates • Credit standards • Securities market channel • Interest rates • Debt issuance Strong consumer and business confidence Well- capitalized banks SOURCE: Rosenblum, Harvey, Jessica J. Renier, and Richard Alm, “Regulatory and Monetary Policies Meet ‘Too Big to Fail,’” Federal Reserve Bank of Dallas, Economic Letter, Apr. 2010.

8. Easy Monetary Policy Adds to Housing Bubble • From 2002-05, in the midst of the housing bubble, FOMC dissents were limited and erred in the wrong direction • Only 4 dissents, all in favor of looser policy Can we expect better from the FOMC in the future? Percent Target Fed Funds Rate Average (‘02-‘05):~1.85% SOURCES: Federal Reserve Board; Wynne, Mark A., “A Short History of FOMC Communication,” Federal Reserve Bank of Dallas, Economic Letter, Sep. 2013.

9. Recovery in Per Capita Output Weaker than in Previous Cycles Average of prior cycles Current recovery is 11% below average 2007:Q1–2013:Q2 NOTE: The shaded area indicates the range of major recessions since 1960, excluding the short 1980 recession. SOURCE: Luttrell, David, Tyler Atkinson, and Harvey Rosenblum, “Assessing the Costs and Consequences of the 2007-09 Financial Crisis and its Aftermath,” Federal Reserve Bank of Dallas, Economic Letter, Sep. 2013.

10. Recovery in Per Capita Output Weaker than in Previous Cycles • Weak recovery despite the most easy, expansionary monetary policy in history • Cannot overcome undercapitalized banks and weak confidence • Repeat: monetary and regulatory policies are notindependent

11. Crisis Dramatically Lowers Income Expectations Median,Apr. ’03-Apr. ‘08:9.8 Net percent of respondents that expect their income to increase Median,May ’08-Aug. ‘13:-3.0 NOTE: Gray bars indicate recessions. SOURCE: The Conference Board; Atkinson, Tyler, David Luttrell, and Harvey Rosenblum, “How Bad Was It? The Costs and Consequences of the 2007-09 Financial Crisis,” Federal Reserve Bank of Dallas, Staff Papers, July 2013.

12. Cost of the 2008-09 Financial Crisis • Lost Output: $6-14 trillion • Lost Income per household: $50-120 thousand • Reduced consumption: $15-30 trillion • Plus: psychological and other trauma costs Bottom Lines: • At least one year of output down the drain • Better communication could have reduced these costs SOURCE: Luttrell, David, Tyler Atkinson, and Harvey Rosenblum, “Assessing the Costs and Consequences of the 2007-09 Financial Crisis and its Aftermath,” Federal Reserve Bank of Dallas, Economic Letter, Sep. 2013.

13. Too Big to Fail: Never Fixed • “…the largest financial institutions are a dagger pointed at the heart of our economy.” • Richard W. Fisher and Harvey Rosenblum, Dallas Morning News, Sep. 13, 2013

14. Why the Persistence? • A subsidy, once given, is nearly impossible to remove, and the TBTF subsidy is huge • “Smart regulation” is a worthy goal, but difficult to achieve • Unlike in other industries, most banks, but especially large banks, are legally protected from changes in corporate control

15. Why the Persistence? Public policy makes banks special • Federal Deposit Insurance (Safety) • Access to Federal Reserve liquidity—Standing Credit Facility/Lender of Last Resort • Limited entry (supports profitability) • Separate resolution (bankruptcy) process • Provide means of payment (liabilities are MONEY) • Dominate the networked payments system (critical that the payments system be “open and operating” 7x24x365 • Conduit of monetary policy • Lender of first resort to small businesses—Standing Credit Facility • Minimum capital requirements imposed by law and regulation, which in practice restricts dividend, salary and bonus payments

16. Why the Persistence? Since 2008, public policy makes megabanks super-special • Triage regime: Giant banks first to be “saved” by first responders • Escape hatch: After their “Lehman Moment,” Goldman Sachs and Morgan Stanley chose to become bank holding companies • SIFIs: Label codifies the “systemic importance” of certain financial institutions

17. What Do the Markets Say? The stock market suggests the need for simplifying, right-sizing and reorganizing – But Nobody’s Listening! Average price-to-tangible book value ratio Huge, complex banks (JP Morgan, BofA, Citigroup, Goldman, Morgan Stanley) Large but less complex banks (Wells Fargo, U.S. Bancorp, BB&T, SunTrust, Fifth Third) SOURCE: Bloomberg.

18. The Virtues of Community Banking • Community banking model is largely based on long-term relationships rather than short-term gains • During the subprime crisis, community banks had fewer loan quality problems (across loan types) and less asset impairment than bigger banks • Small banks focus on lending to businesses, particularly small ones, that larger banks do not, and their business loan volume held up better during the crisis • More recently, small banks have grown their loan books more: In Q2, loans at small banks grew at an annual rate of 4.7%; the comparable rate for the 25 largest banks was less than 1% SOURCE: “Special Report” essays from the Dallas Fed’s 2012 Annual Report; Federal Reserve Board H.8 data.

19. A Lopsided Financial System • Community and regional banks: 99.8% of all banking institutions • Subject to discipline from regulators and shareholders/creditors • Can fail and be resolved with relative speed (faster for smaller institutions) • Megabanks: 0.2% of all banking institutions • Limited discipline from any source • Not allowed to fail, but would take a long time to resolve if they ever were SOURCE: “Special Report” essays from the Dallas Fed’s 2012 Annual Report.

20. The Dallas Fed Plan • Limit safety net protection to traditional commercial banks • Require creditors to acknowledge that they have no federal guarantee by signing a simple disclaimer • Encourage management to restructure large institutions so that banking entities are “Too Small to Save”

21. Moving in the Right Direction, but Too Slowly • Recent spinoffs: Citi shedding some “alternative assets,” BofA closing out its ownership stake in China Construction Bank, and GE divesting its credit card business • Some banks have begun exiting business that are “reputationally or ethically problematic” • Patrick Jenkins, “HSBC mindful of sharp edges on its ‘sword of Damocles,’” Financial Times, Sep. 16, 2013 • Not just regulatory policy: Banking institutions hold about 90% of our money supply and the dollar is a faith-based currency NOTE: Currency and travelers checks only account for 10.6% of the total M2 money stock, leaving the other 89.4% at banking institutions in the form of demand, savings, and time deposits and retail money funds.

22. Dallas Fed Plan Not All That Radical • The penalty is proportional to the downside risks imposed by TBTF • One year of output down the drain, again? • Half measures will not work and will not result in a credible regime shift • Stock market prices underscore need for Dallas Fed Plan • Far less radical than quasi-nationalizing many megabanks in 2008-09

23. Why We Cannot Rely on Dodd-Frank • “Simplify and codify quickly.” • Harvey Rosenblum, Dallas Fed’s 2011 Annual Report • Cannot enforce if rules unwritten

24. The Pathology of TBTF Adverse feedback loop

25. The Pathology of TBTF How to break the adverse feedback loop: Dallas Fed Planeliminates this destructive ambiguity

26. Conclusion • Communication and action needed to alter the perception that giant banks are forever TBTF • Dallas Fed Plan clarifies that no banking institutions are TBTF • Why? Because reorganization and downsizing of the giants makes this statement credible