Bull by the Horns

by Sheila Bair

  But the extreme downsizing was really just one symptom of a much more serious disease. That disease was the deregulatory dogma that had infected Washington for a decade, championed by Democrat and Republican alike, advocated by such luminaries as Clinton Treasury Secretary Robert Rubin and Federal Reserve Board Chairman Alan Greenspan. Regulation had fallen out of fashion, and both government and the private sector had become deluded by the notion that markets and institutions could regulate themselves. Government and its regulatory function were held in disdain. That pervasive attitude3 had taken its toll at the FDIC, which had built a reputation as one of the toughest and most independent of regulators during the savings and loan crisis of the 1980s.

  With more than $4 trillion in insured deposits, a robust regulatory presence was essential to protect the FDIC against imprudent risk taking by the institutions it insured. But the staff had been beaten down by the political consensus that now things were different. Quarter after quarter, banks were experiencing record profitability, and bank failures were at historic lows. The groupthink was that technological innovation, coupled with the Fed’s seeming mastery of maintaining an easy monetary policy without inflation, meant an end to the economic cycles of good times and bad that had characterized our financial system in the past. The golden age of banking was here and would last forever. We didn’t need regulation anymore. That kind of thinking had not only led to significant downsizing but had also severely damaged FDIC employees’ morale, and—as I would later discover—led to the adoption of hands-off regulatory philosophies at all of the financial regulatory agencies that would prove to be difficult to change once the subprime crisis started to unfold.

  The FDIC’s flirtation with lighter touch regulation had also exacerbated tensions with our Office of the Inspector General (OIG). Virtually all major federal agencies have an OIG. These are independent units generally headed by presidential appointees whose job is to detect and prevent fraud, waste, abuse, and violations of law. War was raging between our senior management team and the FDIC’s OIG when I arrived at the FDIC. I must have spent at least twenty hours during my first week in office refereeing disputes between the OIG’s office and our senior career staff. I was amazed to learn that the FDIC OIG totaled some 140 people, which was many times the size of OIGs at other federal agencies.

  Fortunately, in sorting out and resolving the raging disputes between FDIC management and OIG staff, I had an ally in Jon Rymer, a bank auditor by background, who had been confirmed as the new FDIC IG at the same time I was confirmed as chairman. So we were both entering our respective jobs with fresh perspectives and no axes to grind. Jon was intelligent, soft-spoken, and highly professional. His bespectacled, mild-mannered appearance and demeanor belied a steely toughness, cultivated no doubt by his twenty-five years in active and reserve duty with the army.

  Jon and I were able to develop a good working relationship, and over time, we achieved better mutual respect and understanding between FDIC executive managers and the OIG. There was still tension, as was appropriate. But I actually came to enjoy the fact that we had this huge OIG that was constantly looking over our shoulders. It helped keep us on our toes and was one reason why when the financial crisis hit and we were forced to quickly put stabilization measures into place, we received clean audits and widespread recognition for our effective quality controls. In giving speeches, I would brag about the size and robust efforts of our OIG. And its investigation division would later play a lead role in ferreting out and punishing the rampant mortgage broker fraud that had contributed to scores of bank failures.

  The agency’s focus on downsizing and deregulation had also created major problems with its union, the National Treasury Employees Union (NTEU). Predictably, the NTEU had fought the downsizing tooth and nail, but it had other major grievances as well. One was a recently instituted pay-for-performance system, which forced managers to make wide differentiations among employees in making pay increase and bonus decisions. This was arguably an improvement over the old system, which had been akin to Lake Wobegon, where “everybody is above average,” and basic competence would routinely result in a salary increase and year-end bonus. But the new system required managers to force employees into three buckets. The top rated 25 percent received sizable salary and bonus packages. The middle 50 percent received a more modest amount, and the bottom 25 percent received nothing. In essence, the system assumed that each division and office had 25 percent stars and 25 percent flunkies, with everyone else in the middle. Managers hated it. Employees hated it. The only people who liked it were the management consultants the agency had paid a pretty penny to create it.

  The union was also outraged at a deregulatory initiative called Maximum Efficiency, Risk-Focused, Institution Targeted (MERIT) examinations, which severely limited our supervisory staff’s ability to conduct thorough examinations at thousands of banks. By law, most banks must undergo a safety and soundness exam every year. These exams traditionally entail bank examiners visiting the banks on site and doing detailed reviews of loan files to determine whether the loans were properly underwritten and performing. In addition to reviewing loans, the examiners also look at a bank’s investments and interview staff and senior executives to make sure policies and procedures are being followed. As any good examiner will tell you, it is not enough to simply examine a bank’s policies to know whether it is being operated prudently; individual loan files must also be examined to make sure that the bank is following its procedures.

  With MERIT, however, the FDIC had instituted a new program that essentially said that if a bank’s previous examination showed that it was healthy, at the next exam, the examiners would not pull and review loan files, but instead would simply review policies and procedures. Prior to MERIT, examiners had been encouraged and rewarded for conducting thorough, detailed reviews, but under the MERIT procedures, they were rewarded for completing them quickly, with minimal staff hours involved. Career FDIC examiners derisively called MERIT exams “drive-by” exams. Their protests escalated as they became more and more concerned about the increasing number of real estate loans on banks’ balance sheets. They knew, even in the summer of 2006, that real estate prices wouldn’t rise forever and that once the market turned, a good number of those loans could go bad.

  As it turned out, though I took the FDIC job because of my love for financial policy issues, I found that a substantial part of my time was spent dealing with management problems. In grappling with those issues, I worked closely with our chief operating officer, John Bovenzi4, a ruddy faced, unflappable FDIC career staffer who had worked his way up to the top FDIC staff job. I also relied on Arleas Upton Kea, the head of our Division of Administration. A lawyer by training, Arleas was a savvy, impeccably dressed professional, toughened by the fact that she was the first black woman to have clawed her way up the FDIC’s management ladder. Finally, I relied heavily on Steven App. Steve had recently joined the FDIC from the Treasury Department, where he had worked in a senior financial management position. I had known Steve when I was at Treasury and had tremendous respect for him. He would later play a key role in ramping up our hiring and contractor resources quickly, as well as working with me to manage the considerable financial demands that were placed on the agency as a result of the financial crisis.

  At Arleas’s suggestion, we hired a consultant and conducted detailed employee surveys to try to get at the root causes of the low staff morale. The surveys showed that employees felt that they were disempowered, that their work wasn’t valued, and that they were cut off from any meaningful input in decision making. To counter their feeling of disempowerment, I created a Culture Change Council whose primary duty was to improve communication up and down the chain of command. I instituted quarterly call-ins for employees. We opened the phone lines and invited all employees to ask me any question they wanted. The first few calls were somewhat awkward. Most FDIC employees had never had a chance to interact directly with the chairman, and they weren’t quite
sure what to ask. So I found myself fielding questions on how to get a handicap parking space at one of our regional offices or how to sign up for our dental plan. Eventually the employees started focusing on broader, agencywide matters, and I found the calls tremendously helpful in learning what was on the minds of the rank and file. When I took office, the FDIC was ranked near the bottom of best places to work in the government, a ranking based on employee satisfaction surveys conducted by the Office of Personnel Management each year. Based on a survey completed before I left office, it was ranked number one. It took a lot of time to restore employee morale and trust at that disheartened agency. But we did it, and that best-place-to-work ranking is one of my proudest achievements.

  Ultimately, we would revamp the pay-for-performance system, scrap MERIT exams, and begin hiring more examiners to enforce both safety and soundness requirements and consumer protection laws. We also started increasing the staff of our Division of Resolutions and Receiverships—the division that handles bank failures—which had been cut to the bone. These rebuilding efforts took time, and within a year I would find myself still struggling to revitalize an agency at the cusp of a housing downturn that would escalate into a financial cataclysm. It takes time to hire and train examiners and bank-closing specialists. We had to replenish our ranks just as the financial system started to deteriorate. In retrospect, those “golden age of banking” years, 2001–2006, should have been spent planning and preparing for the next crisis. That was one of the many hard lessons learned.

  CHAPTER 2

  Turning the Titanic

  As demanding as the FDIC management issues were, there were also important policy decisions to be made. Regulation had become too lax, and I found myself fighting to change course on a number of fronts.

  Most of our major policy decisions had to be approved by the FDIC board of directors. Virtually all of the FDIC staff reported to me, and I had the power to set the board agenda and control staff recommendations that came to it for approval. But board approval was required for all rule makings. I soon learned I had a deeply divided board, one that ran the full gamut of regulatory and economic philosophies.

  The FDIC board is made up of five individuals, no more than three of whom can be of the same political party. In addition, by statute, the Office of the Comptroller of the Currency, which regulates the largest national commercial banks, and the director of the Office of Thrift Supervision5, which regulates the major national mortgage lenders, sit on the FDIC board.

  The board also has a vice chairman and one internal director, who must have a background in state banking regulation. Because the president usually appoints members of his own party to head the OCC and OTS as well as the FDIC chairman, the vice chairman and internal director are generally members of the other party. That was the case with the FDIC board in 2006. John Dugan, the comptroller of the currency, and John Reich, the director of the OTS, were both staunch Republicans with long industry experience, Dugan as a banking lawyer and Reich as a community banker. Our vice chairman, Marty Gruenberg, on the other hand, was a lifelong Democratic Hill aide, having spent most of his career with Senator Paul Sarbanes. Our internal director, Thomas Curry, was a former Massachusetts banking supervisor. Though a registered independent, Tom had close ties to the Senate Democratic leadership and Sarbanes’s office.

  On the policy front, my first major challenge was to issue for public comment rules that would require all banks to start paying premiums for their deposit insurance. The FDIC has never been funded by taxpayers. Even though the FDIC’s guarantee is backed by the full faith and credit of the U.S. government, it has always charged a premium from banks to cover its costs. However, in 1996, banking industry trade groups convinced the Congress to prohibit the FDIC from charging any premiums of banks that bank examiners viewed as healthy, so long as the FDIC’s reserves exceeded 1.25 percent of insured deposits. This essentially eliminated premiums for more than 90 percent of all banks, which in turn created three problems.

  First, because of those limits, the FDIC was unable to build substantial reserves when the banking system was strong and profitable so that it would have a cushion to draw from when a downturn occurred without having to assess large premiums.

  Second, it created a “free rider” problem. There were nearly a thousand banks chartered since 2006 that had derived substantial benefits from deposit insurance without having had to pay a cent for this benefit. That was grossly unfair to older banks, which had paid substantial premiums to cover the costs of the S&L crisis.

  Finally, it did not allow us to differentiate risk adequately among banks. Like any insurance company, we thought that banks that posed a higher risk of failure should pay a higher premium, in much the same way that a life insurance company charges higher premiums of smokers or an auto insurer charges higher premiums of drivers with a history of traffic violations. Based on historical experience, we knew that even banks with high supervisory ratings (known as “CAMELS6”) can pose significantly different risks to the FDIC. For instance, a bank may appear to be well run and profitable, thus warranting a good supervisory rating. However, we know that new banks that have grown rapidly are statistically more likely to get into trouble. In addition, the way banks get their funding can impact risks to the FDIC. For instance, brick-and-mortar banks with “core” deposit franchises—that is, those with established customers who have multiple loan and deposit relationships with it—are more stable and pose fewer risks to the FDIC than those that rely on a broker to bring them deposits and thus lack a personal relationship with their depositors.

  In early 2006, after years of pushing by the FDIC, Congress finally passed legislation permitting us to charge all banks a premium based on their risk profiles. The legislation also gave us flexibility to build the fund above 1.25 percent to 1.50 percent, at which point the agency would have to pay dividends from its reserves back to the industry. It was now time to propose rules to implement those new authorities, and we were already getting serious pushback from the industry.

  The FDIC staff had already been working on a new system that would require all banks to pay a premium for their deposit insurance. The effort was led by our highly competent head of the Division of Insurance and Research (DIR), Arthur Murton; his deputy, Diane Ellis; and Matthew Green, a DIR associate director who had once worked for me at the Treasury Department. They had crafted a rule that relied on a combination of CAMELS scores, financial ratios, and, in the case of large banks, credit ratings. Their proposal also gave FDIC examiners the ability to adjust a bank’s CAMELS score if we disagreed with the score assigned to the bank by its primary regulator. That was consistent with our statutory authority to serve as backup regulator for banks we insured. The base annual rate for most banks would be 5 to 7 basis points, or 5 to 7 cents on each $100 of insured deposits. That would bring in an estimated $2 billion to $3 billion in assessment income per year. At the time, our reserves stood at around $50 billion, or 1.22 percent of the $4 trillion in deposits we insured.

  To the board’s credit, all of the members recognized the imperative of moving ahead with rules to implement the premium increases, notwithstanding industry opposition. The industry was still experiencing record profits (indeed, by the end of 20067, annual banking profits had reached an unprecedented $150 billion). The clear mandate of the legislation—at the behest of the FDIC—was to build up reserves while the industry was profitable, so that we could have a surplus to draw upon if and when a downturn occurred.

  However, directors Reich and Dugan were opposed to the staff proposal because they did not want FDIC examiners to be second-guessing the CAMELS scores their own examiners assigned to OTS- and OCC-regulated banks. The board had been at a stalemate for months on this issue, with Vice Chairman Gruenberg and Director Curry supporting the staff. The staff was hoping that the new chairman would support them as well.

  I was sympathetic to the staff position, but I also did not want my first board meeting to be a split vote. I had
worked in Washington for many years and knew that closely divided votes lacked the authority of consensus positions and invited scrutiny and second-guessing by the private sector and in Congress. That would set a very bad precedent. I went ahead and scheduled a meeting so that the board knew I was serious about moving ahead, but at the eleventh hour, I was able to broker a compromise. I agreed that the FDIC would not alter another regulator’s assigned CAMELS score, but we would preserve the right to adjust the premium up or down if we didn’t think the CAMELS score accurately reflected the risk of the institution. In my view, that was a distinction without a difference, but it did the trick. Within two weeks of my assuming office, on July 12, 2006, we proposed the new rule on a 5–0 vote.

  The attack from the industry was severe. Steve Bartlett, the president and CEO of the Financial Services Roundtable, which represents the largest financial firms, argued for the status quo, claiming that “given the insignificant risks8 that such institutions present in the modern regulatory scheme, it is unnecessary to impose any new assessment on the safest, best-performing members of the FDIC system.” James Chessen, the chief economist of the American Bankers Association, was even more vehement: “The banking industry9 is in exceptional health, and there is no indication that large amounts of revenue are needed by the FDIC. Additional money sitting idly in Washington adds little to the financial strength of the FDIC, but has real consequences for the communities that banks serve. That money would be better used supporting loans in the local community.”

  It was not the first time I would hear that our regulatory initiatives would hurt lending. Throughout my tenure at the FDIC, that was the standard refrain from industry lobbyists virtually anytime we tried to rein in risky practices or ask the industry to pay for the costs of bank failures. Of course, later, as the crisis hit and the Deposit Insurance Fund (DIF) became depleted, industry lobbyists argued that banks were too stressed to pay premiums. So there you had it: in good times, we shouldn’t collect because we didn’t need the money, and in bad times, we shouldn’t collect because the industry was stressed.