This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists and policymakers
Central banks across the world, most notably in the US, are struggling to tame inflation with higher interest rates. But the more rates climb, the more stress they put on the broader economy — and the greater the chance of an accident in the financial markets.
As head of the US Federal Deposit Insurance Corporation from 2006 to 2011, Sheila Bair helped lead the response to the 2008 financial crisis. So she is unusually well qualified to explore what could go wrong in banking and the financial system.
In this interview, Bair suggests that banks are more resilient and less leveraged than they were before 2008, though she notes that the post-crisis reforms have never really been tested by a sharp recession.
She also warns that regulators have never really got to grips with private equity, hedge funds and private lenders, collectively dubbed “shadow banks”. That means pension funds, endowments and other investors that put larges amounts of money into private funds over the past decade are at risk of unexpected losses. If the turmoil then spills into public markets and the banking system, it could endanger global financial stability.
As an American banking specialist, Bair is particularly concerned about the Biden administration’s approach to making housing more affordable. She warns that making it easier for marginal buyers to get a loan would simply tempt vulnerable people into the market right before an expected contraction. Instead, she urges the White House to look at increasing supply, which would bring down prices more gradually.
Brooke Masters: It’s been a while now since your efforts to strengthen the banking system post-2008 and we’re in the first really big, lasting down cycle. So, stepping back, what has really worked well and what has not worked?
Sheila Bair: So, the banks are clearly more resilient. They’re less leveraged. I tend to think maybe not as much as they should be, but they’re stronger. In the US, in particular, consumer protections are better. The Consumer Financial Protection Bureau has been a huge plus. In the mortgage space at least, we have much more resilient homeowners. The vast majority have 30-year mortgages and significant equity in their homes.
The weaknesses are obviously in the non-bank sector. In Dodd-Frank, the financial reform law, I pushed for regulators to be able to provide more oversight of the shadow banking sector, and those authorities largely have not been used.
This stuff always comes back. You can’t insulate banks from instability in the non-bank sector. In the financial crisis, banks got blamed and they were responsible for a big part of it, but at the origination level it was primarily non-banks that were making unaffordable mortgage loans and securities firms played a big role in subprime securitisations. Non-banks were a clear driver during the financial crisis.
So it’s surprising and disappointing that we haven’t done more now to address that. There has been a lot of talk, a lot of studies, a lot of reports.
BM: It sounds like you definitely believe that we’ve just moved the risk around. We haven’t actually managed it.
SB: I’ve got a very bad feeling about it. There’s not a lot of transparency around so-called private funds: hedge funds, private equity, venture capital. They can perform useful functions in our economy, but the risks they pose are not transparent or well understood. I used to be a college president, and our investment adviser had put our endowment into multiple private equity funds. It drove me crazy. I couldn’t really tell what the true market value was, and I didn’t know how much leverage they had.
I worry about that because if we start seeing losses in that segment, it could flow back to the banks, but also hit the portfolios of a lot of pension funds, college endowments, non-profits. So, I think that’s going to be a big problem.
BM: Do you think the end-holders, the endowments, the pension funds, know what’s going to hit them?
SB: No. At a lot of municipalities or pension funds, the people with fiduciary obligations to these funds are so outmatched in terms of expertise and understanding. It’s hard even for sophisticated people to really know what’s going on and they’ve had a monetary gun to their head, because they needed to take on more risk to generate higher returns somehow.
BM: What are these products and where are the problems?
SB: They’re financial intermediaries that don’t use deposits. They use market-based funding or investor dollars to fund their assets. Some are publicly traded so there’s a bit more transparency, but not so with the private funds and those have experienced the most dramatic growth. Market-based funding is not stable, so you get a problem of liquidity in times of stress. Bank deposits actually grow during a crisis, but market-based funding, investor funding, can disappear pretty quickly. If you use deposits, you get tonnes of regulation and oversight and of course deposit insurance, but if you fund through the market, you don’t.
BM: During the period of the financial crisis reforms, there was a big focus on, “Let’s protect depositors because they’re innocent, and it’s OK if market-based finance is a little less protected because those investors can afford to lose money and the taxpayer won’t have to worry about them”. Do you think we were too sanguine about that?
SB: There’s nothing wrong with investing in illiquid assets, if you’re transparent about it, if your investors have their eyes wide open about where you’re invested and how much leverage you are using. I don’t think we have that transparency with shadow banks. They create expectations that may not be consistent with what they’re actually doing with your money.
BM: So you think banks are safer than they were, but other things are not safer?
SB: Regulated banks are safer, but they’ve never been tested. They like to boast about their performance during the pandemic, but I don’t have any confidence that they would’ve remained stable if the US Federal Reserve hadn’t stepped in with massive support. Similarly, the big asset managers and private funds have not been tested because of the Fed’s massive support. Market-funded lenders — fintechs — have not really been tested. I don’t have a lot of confidence in their resilience in a severe downturn.
BM: The UK has had this interesting experience with liability driven investing, which saw the pensions industry exacerbate turmoil in the gilt market. Have you been following this? It was obviously a specific small corner of the market. Do you think that’s the tip of the iceberg? Are there going to be other LDIs?
SB: I think there could be. It’s reminiscent of the misuse of credit derivatives in 2008. Maybe misuse is too strong a word. It was the financial engineering around derivatives blowing up: we thought the derivatives were going to help manage the risk, instead they exacerbated the risk. That concerns me. We have a little better oversight of over-the-counter derivatives now, here in the US, but it’s probably not what it should be.
I would say this to people who manage pension funds, or others who are getting pitched on complex derivatives: don’t believe some smart banker who comes in and says, “Through financial engineering, you can maintain your asset-liability mismatch. Take on a little more leverage and invest in higher-risk, less-liquid assets and this derivative’s going to take care of you”. Usually he or she gets a nice fat fee for that. And it works, until it doesn’t.
Just manage your assets and liabilities, so you don’t have a mismatch. That’s the easiest and safest way to do it. But there’s always some smart person in the room trying to pitch a derivative.
BM: Is there any way to stop people from always turning to derivatives?
SB: There’s not much oversight. The standardised stuff now has to be centrally cleared, but the higher-risk, the idiosyncratic stuff is still bilaterally cleared, and a lot of that’s done within depositor institutions, which concerns me. Look at credit derivatives.
A credit default derivative is insurance you take out on a broad sector like mortgages, or it could be on an individual company like IBM or GE. If you’re invested in that particular sector or company, it is good to get a credit default derivative that will help pay you something if they default. Basically, it’s a hedge.
The problem is that most credit default swap users are not hedging. They are using them to speculate, take on more leverage or move risk off balance sheet. Regulators could rein it in, by defining where and how you can use credit default derivatives to require that you have an insurable economic interest. But they have not wanted to go there.
We could constrain the leverage more by trying to force more derivatives into centralised clearing with higher margin requirements. A clearing house is capitalised by a group of usually very large financial institutions that put capital in and collectively stand behind the transaction.
This won’t help with speculative abuse of derivatives or with unsophisticated counterparties being surprised by losses. But it does help make sure that your counterparty will make good on its obligation. During the 2008 crisis, AIG was holding a lot of this exposure and they were completely unstable. There was no chance they were going to be able to make good on all these credit default swap contracts they had made. So, that led to a big bailout.
But again, the law only requires centralised clearing if the derivative is standardised enough that the clearing house will accept it. And of course, the clearing house will take the safe stuff. The higher-risk, idiosyncratic, complex stuff will still be done bilaterally.
BM: People will normally take out insurance if they’re lending to a public company. Does all this private credit that everyone’s been investing in have any protection at all?
SB: Probably not. Again, with the lack of transparency, we don’t really know, but it would surprise me if they had. Private lenders love to use a lot of leverage and minimise cost, and they’re not held accountable the way a publicly traded company is. So, unless their own investors ask them, how are you hedging against this exposure or that, they’re probably not going to tell.
BM: Sounds like it could be a real problem if the private credit is extended to companies that can’t pay back, and then there’s no recourse.
SB: The question is how the big banks interface with these non-transparent investment funds. Have the banks written a lot of credit default coverage for them and their investments? And, if so, then those losses are going to come back on the banks’ balance sheets. The transparency around all of this is just not good.
BM: What do you think should be done about this?
SB: There is systemic weakness in the bank interface with very large non-public, non-transparent funds. We should be requiring better disclosure and, frankly, some indirect regulation of those funds.
The bank regulators have been reluctant to do this, but if JPMorgan Chase wants to have a huge exposure to, say, Blackstone, there should be standard prudential requirements, liquidity and capital, that apply to the counterparty as well as the bank. That would be really controversial, but I think it would help.
Years ago, when the leveraged loan market was taking off, the regulators tried to impose some leverage constraints on the entity applying for a leveraged loan from a regulated bank. It wasn’t huge, it was six times earnings. But the industry pitched a fit about it, and they watered it down.
If I go into a bank and apply for a mortgage, and I get a mortgage, the bank examiner wants to make sure that the bank has looked at my total debt levels, cash flow, credit history, net assets and level of equity in my home. Having that same mindset — taking a holistic view of the creditworthiness and stability of these large, non-transparent institutional customers of regulated banks would help a lot.
BM: Do you think that would have helped with the 2021 Archegos meltdown, where it turned out many banks were lending to the same family office and didn’t know it?
SB: Yes. There needs to be a way to consolidate and assess the aggregate debt exposures of bank counterparties. That’s the mindset I think that we need to approach this problem of non-bank oversight. It’s elegant.
Trying to directly regulate all these non-banks would be really hard to do. If some private fund wants to take wild bets, or shoot the farm, fine. But we need to make sure that it is not going to flow back to the regulated sector, where it could disrupt the provision of services that the public needs. Regulated, taxpayer-insured banking organisations do not need to support it.
BM: The post-crisis reforms created the ability to declare non-banks to be systemic. Is it worth another run of trying to do that?
SB: These are multitrillion-dollar asset managers. Yes, they probably need a systemic designation. But I think it’s even more important to provide some oversight of systemic activities. That’s because it’s a sector problem. If there’s an individual institution doing something dumb, probably five others are doing something dumb, too.
BM: Right after the financial crisis, Europe tried to have some serious capital requirements for funds. The industry pushed back and had an utter meltdown. How bad a mistake was it to let go of that idea?
SB: We’re going to find out next year, if we get a global recession, which seems increasingly likely. Look, I feel for the regulators. You’re damned if you do and damned if you don’t. You try to regulate, and you get all this industry pushback. Even if you go ahead, there’s not much of a reward mechanism. A screw up will be called out. But just having a rule that actually prevents something bad from happening won’t be recognised.
That’s why it’s really important to maintain the independence of regulators, and put people in there that are professional in the sense that they understand these markets, they understand these institutions, they understand what their public policy goals are. I think that’s your best protection.
BM: You’ve mentioned that there are a lot of signs that a global recession is coming. Where would you look for stress?
SB: Government debt markets. We’ve already had a couple of disruptions in the US Treasury market in recent years. We saw what happened with the UK gilt market. The fundamental problem is there’s just too much government debt out there, and central banks are easing themselves out of being the support for that market. Unless private players are willing to step in, you’re going to have increasing illiquidity problems.
BM: Do you think it’s the major G20 economy debt markets where we really need to worry?
SB: Absolutely. I think there’s going to be trouble in the US Treasury market. The Fed is raising interest rates, and also gradually letting their portfolio run off. But I don’t think they’re going to be able to exit. Banks need the liquidity that their reserve accounts provide to support the Treasury market. Similarly, non-banks like money market funds will continue to need access to the Fed’s reverse repo facility.
The other problem with this is that the Fed is raising interest rates by basically paying financial institutions not to lend and it’s starting to cost a lot of money. Total reserve and reverse repo balances are well north of $5tn, and I question how much that can shrink without impacting liquidity in the Treasury market. Paying 5 per cent or more on those balances is hundreds of billions of dollars a year, potentially, to these large financial institutions, basically for doing nothing. The optics of taking us into a recession to fight inflation, while they are paying banks not to lend, I just think that’s politically unsustainable.
BM: Switching to another subject, crypto. What do you think of the FTX mess?
SB: It makes me sad for all the people who’ve lost money. It’s part of a larger ecosystem that’s really targeting young people to take risk. Most crypto is just a vehicle for speculation. That, in turn, was fed by cheap money. When borrowing costs go up, leverage is constrained, and lower-risk assets provide better returns. In these very high risk markets you see corrections, and that’s what we’re seeing now. It’s so spectacular because there’s really no intrinsic value.
I don’t think there’s going to be much knock-on impact on the real economy. That’s the good news and the bad news about crypto. It’s never really had any real-world applications.
BM: You’ve talked a little bit about how young people got seduced by this. What can investors do to protect themselves?
SB: There needs to be more financial education. I write a kids’ books series called Money Tales on money basics, and I have one about Ponzi schemes. It sure sounds to me like more adults should be reading that. If it sounds too good to be true, it probably is.
It’s not hard to understand how to build wealth. What’s harder is to resist misuse of products or falling for scams — overborrowing, late fees and the compounding interest of unpaid debt and running credit card balances. There are so many things that people do that cost them money, that impede their ability to build wealth, and speculating in crypto is at the top of my current list.
BM: Do you think, now that interest rates are rising, that will help, or will it just mean people will drown faster?
SB: Capital should cost something. Then there’s discipline around it. It makes you smarter about whether you’re going to borrow and how you’re going to spend that money. It is the same with companies. There’s been dramatic capital misallocations because of these distorted interest rates. Over time, this is going to lead to smarter financial decision-making, and it’s also going to start rewarding the savers again.
BM: It sounds, at least in the short term, as if the governments and companies are vulnerable going into recession. Where would you start to look for the risks to emerge?
SB: As we’ve discussed already, the shadow sector and then the interface of the shadow sector with the regulated banks and I think disruption in the government debt market. If the Treasury market disrupts, that creates illiquidity everywhere because so much is keyed off of Treasuries. Consumers are better off. And thank goodness, you have much more resilient homeowners now.
I do worry that the Biden administration has been taking steps to lower entry costs for home ownership. It’s going to increase demand when we’ve got terrible housing inflation already.
Plus, mortgage originators are desperate for volume right now. They’re desperate to make new loans. So I worry that they’re going to go to less sophisticated first-time homebuyers, and say, “Now’s the time to get in”. And of course, now is exactly the wrong time to get in, because home prices are on the cusp of a correction. Encouraging demand in the more vulnerable segments of the population right now, I think is really ill-advised.
The focus should be on supply. Home prices have reached unaffordable levels for the vast majority, because the residential housing market has been supply-constrained since the great financial crisis. Both parties should work together to address zoning restrictions. Permits to build new housing are so expensive that it skews construction to the high-end stuff because the profit margins for the homebuilders are higher.
The Biden administration has the ability to tie certain kinds of government support to zoning reform and deny it to jurisdictions that have restrictive zoning. Housing inflation is 40 per cent of the core consumer price index, and so if you could get housing prices down by increasing supply, it would reduce inflation.
BM: Stepping back to the most important question, “Are we any safer?”
SB: I think we are safer, and I’m hoping and praying the Fed can tame inflation with a very mild recession, and we don’t have big problems. The mild recession, though, could turn into a deep recession if we trigger a financial crisis because of these hidden risks that we’re talking about, in the shadow sector in particular. That’s what we need to worry about the most.
BM: Is there anything we can do to try to prevent that from happening?
SB: Banks’ exposures to shadow banks I think should be heavily scrutinised. I’m not convinced by the stress tests. There’s a lot of bravado around, “Oh, the banks are so well-capitalised”. Compared with what?
A lot of people in the Trump Fed were my friends, and I respect them, but they let bank capital erode. The Fed now needs to stress test how well banks can survive in a situation where you’re in a recession, but you still have high interest rates. The models for the 2022 stress test assumed interest rates will go back to zero again. That’s not the assumption they should use for a realistic stress test.
Getting overconfident, and listening to your own rhetoric about how well-capitalised the banks are is a real danger for bank regulators. Because there’s a lot of exposure they don’t fully understand. If the Fed takes us into a recession through monetary tightening and the big banks get into trouble again because they don’t have enough capital to absorb unexpected losses, then the Fed is going to have to do another bailout. That means it’s going to have to lower interest rates, open credit facilities, start printing money to pump the system with liquidity. That’s going to be inflationary.
The worst possible thing they could do to people in the real economy is to have them suffer through a recession ostensibly to beat inflation, only to revert to inflationary monetary policy to bail out the banks. We have had enough political instability already. For that to happen again would be way worse than 2008. That’s what I hope regulators, day and night, are thinking about preventing.
The above transcript has been edited for brevity and clarity