Gregg Gelzinis on Reforming FSOC and How to Limit Future Financial Crises

David Beckworth: Our guest today is Gregg Gelzinis. Gregg is a policy analyst at the Center for American Progress. Gregg's work focuses on financial institutions, financial markets, consumer finance policy, and financial regulation more generally. Gregg joins us today to discuss these issues. Gregg, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

Gregg Gelzinis: Thanks for having me on.

Beckworth: Glad to have you on. You've done some interesting work. I had a chance to read some of your papers. I'm looking forward to our discussion today about financial regulation. I think financial regulation is one of these issues that is under most people's radars. Many people know about other issues like monetary policy, even if it's just a minimal amount, but they'll know about monetary policy. But financial reg is something that's hard to wrap our minds around. You have to get in the weeds. So how did you get into it, because it's not easy to get into this field.

Gelzinis: Yeah, that's absolutely true. When I am talking to my family at Thanksgiving or even walking through the halls at Center for American Progress where I work, I mention something like the enhanced supplementary leverage ratio, everyone's, "All right, Gregg. Have fun," and they walk away and try not to talk to me anymore because I bore them with those word. 

But in terms of how I got into this, I think, in short, the financial crisis. I was coming of political age during the acute phase of the crisis, and so I'm sitting there getting my bearings in the world and starting to ask myself the bigger questions. "How is it that the financial system or risk-taking on Wall Street can have such an incredible impact on not only the global economy but for me, very personally, looking at family, my own family, looking at friends, looking at local businesses in my community that are all shuttering because of risk-taking in this far-off land of Wall Street.

And then the secondary question, "How did our political leaders, our policymakers, regulators, create or preserve a system that that could be possible, that this sort of economic destruction could be possible?" So those thoughts are swirling in my head as I go into college. And in college, I realize that I have a real passion for politics and policy, sort of an intellectual fascination with the financial system on its own. It's, I think, really interesting and complex, and then had an opportunity to piece all those things together about seven years ago at an internship in the office of Senator Jack Reed, who is a proud Banking Committee member and got to work under and observe and shadow his policy advisors that handled his banking portfolio. So it was that experience that pieced all of my interests together, and I realized that I wanted to pursue this, at least in the early part of my career.

And then fast-forward a little bit during grad school, I completed a fellowship at the Treasury Department in the office of financial institutions during the last year of the Obama administration. And then an opportunity came up to join the Center for American Progress on work on financial regulation there, and that's where I've been for a little over three years now. And it's been an interesting journey because I joined right before the 2016 election where everything top of mind in financial regulation was, "Okay, how can we finish the post-crisis rule-makings? How can we build on the progress of Dodd-Frank and financial reform?" Then November 2016 happens, and it's like, "Okay. We need to defend every blade of grass from what comes next."

Beckworth: Okay. So you worked your way into this area of financial regulation, and it's a big area. There's lots to think about. And I think there's a lot of agreement on both sides of the aisle in terms of some basic principles regarding the US financial system. And let me just mention a few observations. Number one, I think there's a lot of agreement on the need for banks and other financial firms to fund with more capital, so there's a bigger equity cushion should there be some other panic. I know we're better than we were before 2008, but there's still a lot of room for improvement.

Gelzinis: Definitely.

Beckworth: A second observation I see a lot is that we want to make our financial system more run proof. So I've had Morgan Ricks on the show several times. He has a proposal for making any kind of financial liability that's money-like in nature something that's protected by the FDIC. He has a very radical proposal, or, moreover, he wants to open up the Fed's balance sheet to depositors. Any event, his proposal is a way to deal with this run problem.

So I think most people would agree that is a cause of financial crises, runs on the financial system. And we have runs on the financial system because we don't have enough equity in the financial system. So there's agreement on those points, but how do we start thinking about those in practical terms? Where do we start? What are our first principles? So how would you begin to chew on that? Where would we start? If you could start things all over from scratch, how would you begin to tackle that?

Gelzinis: Sure. So I think the lodestar that's embedded in your question is that financial crises are really damaging economically. They can have incredible spillover effects onto the real economy, impact businesses and households, and we want to limit them in terms of their frequency, but we also want to mitigate their severity when they do happen because we probably won't be able to prevent every financial crisis from happeninG.

So I think starting from there, the question then is, "Okay, what's the regulatory framework in place to achieve that goal?" And I think the biggest thing that we can do, you pointed on, which is bank capital or capital if we're talking ... which we'll talk about later, non-bank financial companies that could pose systemic risk to the financial system. And so bank capital, as I'm sure the listeners know, refers to the loss-absorbing capacity of a financial institution.

So you have two forms of funding. You have debt liabilities, and you also have equity funding. And equity funding can't run, and it can absorb losses in a way that your debt cannot. So I think that's first and foremost, and I would say that there's certainly agreement on both the left and parts of the right on bank capital. Folks in, I think, the more academic community, certainly some policymakers on the Hill. You mentioned Jeb Hensarling's Choice Act, which would have called for a 10 percent leverage ratio at big banks.

But there's, I would say, more of the corporate element of the right and, to some extent, the left as well that represents the financial industry that has fought that for time immemorial. So I think-                                                                       

Beckworth: They're not excited about it.

Gelzinis: ...there's not consensus on it. If everyone thought we needed higher bank capital and that was a good thing, we would have, I think, progressed farther than we have since the crisis, because, like you said, better off, but I think we're not. We're safer, not safe enough, as one of your former guests, Tom Hoenig, a huge bank capital advocate, has mentioned in the past. 

And then Morgan Ricks is exactly right in his money view philosophy where he zeroes in on that private money creation element and the runability of that short-term money-like claims. So I think that's probably 1A and 1B in terms of bank capital and run risk. But I think, as we'll talk about in my proposal, you can also look at other factors as well that contribute to the systemic risk profile of both entities and markets. And we'll talk about this later, but there's a framework, which with I think about this. The FSOC has thought about this. The Financial Stability Board has thought about this in terms of how is stress transmitted throughout the financial system?

There are three primary channels for that. One is the counterparty exposure channel. So if I'm a firm and I fail, I'm going to place losses on my creditors. I'm going to place losses on my counterparties, whether they be derivatives counterparties or otherwise, because I can no longer fulfill those obligations. Then you have the second transmission channel is the asset liquidation transmission channel. So here, if creditors flee and I need to generate cash quickly, then I'm going to need to sell assets quickly in order to get that cash to pay off my creditors, and I may have to resort to selling off very illiquid assets at fire sale prices in order to come up with that cash very quickly.

That can erode my own equity capital levels because I'm selling these assets below their fundamental value, so I'm taking on losses when I sell those off. I'm placing losses on other firms that have similar holdings of these assets because I'm depressing the price of the asset. And I'm also impacting firms who rely on these specific funding markets because if I'm selling off in that market and pulling back from the market, then there's going to be less funding available. And so the price of funding will go up for those firms.

And then the third is called the substitutability transmission channel, and this is if I provide a critical service. So perhaps custodial service or payment service or I'm a really big insurance company in a certain line of insurance and there aren't others. If I fail and no one can easily step in and provide that financial intermediation that I was providing, then the cost of financial intermediation will rise. And that will drag GDP and you can spillover effects that way. 

So that's the framework I look at it, and you can see bank capital embedded in that ... or capital broadly embedded in that framework. Look at the counterparty channel. If you're less leveraged, you have fewer counterparties, and you can absorb more losses before you place losses on your creditors and counterparties. Morgan Ricks focuses on short-term money-like claims. That's front and center in the asset liquidation channel, that if I am an institution that relies on that source of funding or engages in that private money creation and they run from me, then I'm going to have to resort to those fire sales and transmit stress through that channel.

So you can see some of the things we've talked about embedded in that framework of thinking how failure or stress at a financial institution can then pass on stress to other institutions, destabilize the financial system, and then we all know that a destabilized financial system can have severe knock-on effects to the real economy.

Beckworth: Let me ask a follow-up question then. The Republicans that do care about capital, okay-

Gelzinis: Yes, which there are. I will say there are.

Beckworth: ...So I need to be more careful in how I say things. There are some who don't. But the ones that do, including my colleagues here at the Mercatus Center and myself, they tend to stress, "More capital, less rules." So minimize some of the regulations. In fact, the Financial Choice Act I think was kind of ... that was a core vision of it, which died with the last Congress. But the idea was, "Look. If you fund with more capital, that cushion there will absorb all the blows. We can minimize the rules and regulations.”

These points that you're making, these channels, do they mean that that's not enough, that just having more capital is not sufficient to avoid financial crisis?

Gelzinis: So I think, to some extent, yes. I will say personally I think the more capital you have, the less I think you need to rely on other regulations, whether they be liquidity requirements or risk management standards or single-counterparty credit limits, stress-testing, living wills, all of those other things that former-Chair Hensarling was talking about when he was talking about opting for higher capital and shedding all of these other Dodd-Frank regulations.

But it's a balance, so the higher you go in terms of capital, then the more comfortable I am in, if not completely eliminating, then winding down the stringency of some of those other rules. I think the problem, Gin my view, of the Choice Act was that that number wasn't high enough. It was a 10 percent leverage ratio. Personally, I think maybe a 10 to 12 percent leverage ratio is the appropriate amount of capital, with all of the other bells and whistles we have today.

Now, if you go beyond 12 percent, up to 15, which I know Steph Matteo Miller here at Mercatus has talked about as the optimal level of capital, or you go even higher than that to Professor Anat Admati, 20 to 30 percent capital. Then once we get into those upper echelons, then I'm okay really dialing it back a little bit. But the 10 percent offered in the Choice Act wasn't high enough for me to feel comfortable in getting rid of all of those other prudential rules.

Beckworth: Okay. So given the world we live in where there's going to be pushback from Wall Street and we're going to be fighting just to get six percent capital, then you see these rules as necessary, regulations as necessary. And maybe it'd be a better world if we could get to 10, but until we're there and even higher, it's important to have these other backstops in place.                                         

Gelzinis: Exactly, and they touch different parts of the balance sheet. So something, again, we may talk about later, the Volcker rule, that's an activities based rule that tries to prevent certain types of speculative trading in bank holding companies and their insured depository institutions. Liquidity rules focus more on that run risk, that, "Okay, if you do have short-term funding, which is just the nature of banking, then you need to have liquid assets on hand to mitigate that pressure you're going to feel to engage in fire sales."

And so these rules touch different parts of the balance sheet, different risks that banks pose. But I think capital does trump all else and that the higher capital we have, the more comfortable I am paring those back. But I will say you make a good point in that where we are today in terms of bank capital levels, banks are fighting furiously each and every day, both on the Hill and at the regulatory agencies, to pare down that capital and actually lower capital, which is something that we've been fighting quite a bit lately.

Beckworth: So you raise an interesting point about the different types of activities. So some people, including my colleague here. You just mentioned Tom Hoenig, former FDIC chair, former Federal Reserve Bank President of Kansas City, and a former guest of the podcast. He talks about what, in his view at least, the concerns should be shaped around what type of activity versus the size of the balance sheet. And not everyone shares that. I think Minneapolis Fed, their vision is to cut big banks down to size. So they would say, "No, size matters." I think Hoenig would say, "Well, the activity matters." I mean, where would you come down on that distinction?

Gelzinis: Yeah, so I think, look, everything, to some degree, matters here. So whether it's the size, the activity, the funding profile, whether they're asset diversification, whether they're concentrated in one market or many. I think all of that matters.

However, I am of the view that size is the best single indicator that we have of systemic significance, because if you think about size, if we have a $100-billion bank, that represents $100 billion of credit provided to the economy, whether through loans or holding bonds or treasuries or whatever, and it's just the single ... Everything else is typically correlated with size. So I think that's the single simplest, best measure we have of systemic risk.

I'm fine with using size and some other measures in order to determine the classification of firms in terms of how stringent the regulations that apply to them are. I'm not a fan of coming up with some extremely complex formula that takes into account five, six, seven different risk factors, spits out a number, and based on that number that it spits out, that's where it puts you, because I think the more complex you get with some of these rules, that's where these Wall Street banks and their lobbyists live. They live in the complexity, and they're able to tinker here, tinker there, and have real impacts.

Beckworth: Yeah, that's one of the critiques I often hear about financial regulation is that it requires added costs for financial firms, compliance costs. I mean, I recently talked to a small banker in Tennessee where I live, a small regional bank, and his biggest critique of Dodd-Frank was the added compliance costs. And he said, "Look, those banks on Wall Street, they can afford compliance officers. It's a real added cost for me." And they can play the rules. They can play the system. So there's a balance there. I mean, it's important to have them given these comments you've made, these concerns you have, but there's also, "How do you manage ... "

Now, on that point, there was some change recently done for banks of a certain size being relieved of some of the regulatory efforts. Is that right?

Gelzinis: Yeah, there are a few different proposals that are at different stages of being finalized, many connected to what we call the Dodd-Frank rollback bill of last, S. 2155, or the Crapo Bill. So some of those would lighten the compliance burden on community banks, so actual community banks, bank, depending on how you define it, banks under 10 billion or 2 billion or 1 billion.

And actually, one of those rules that's currently in the proposed stage and moving to be finalized is a community bank leverage ratio, which is almost exactly the type of bargain that we talked about earlier, that if you have a X leverage ratio, so in this case, they're debating between 8 and 10 percent, then you don't have to comply with all the other risk-weighted capital requirements, some of the complexity that comes with capital.

Then on towards the larger end, banks with between 50 billion and 250 billion in assets have seen significant relief under the Fed's implementation of S. 2155 and even banks above 250 billion that aren't quite G-SIBs have also received significant ... or in the process of receiving significant relief from certain rules, including some of the enhanced liquidity rules that were put in place after the crisis.

I think compliance is always something we should ... Compliance burden is something we should care about. I think personally it's a bit overblown in that the stringency of the rules, the compliance burden that flows from that that's placed on Wall Street banks is far more substantial than the burden that's currently being placed on community banks. I mean, I think the rules were pretty sufficiently tailored following the financial crisis to respect those differences in the risk profile of these firms.

Now, that being said, these are still firms that are backed by the US taxpayer when we're talking about community banks. They still have FDIC-insured deposits. They still have access to the Fed's balance sheet. So I think it shouldn't be the Wild West out there. And also, I would expect if compliance burden was really crushing these institutions, I'd expect that to show up on their income statements. But when we look at post-crisis profitability of community banks, it's actually been quite robust. And in some cases, their lending growth and profitability has outpaced some of the Wall Street banks in some quarters. So, I guess that's my retort.

Beckworth: No, that's fair because I have had some colleagues here who make the argument that maybe these small banks are getting a subsidy implicitly because they get relief, because they have different treatment, that in some ways it's a distortion. I mean, what do you think about that?

Gelzinis: Yeah, it could be the case. It's not a question that I've particularly focused on. But if you do look at the trend in community banks, it obviously has declined significantly really starting or at least accelerating in the 1970s, and it's stayed fairly consistent up until now. And that obviously deals with forces like economies of scale and scope that are just natural in banking. And if you look across the world, we're a bit of an outlier in the number of banks that we have. We're over 5,000 banks and a few more thousand credit unions in the United States. You don't really see that in other countries.

But yeah, I don't have a view on whether we are subsidizing community banks or not. But I do think compliance burden is something to consider. We shouldn't be regulating your local $500-million community bank like JP Morgan. That being said, I don't think we currently are.                    

Beckworth: Okay. Fair enough. Well, let me throw one other big question out there, and then I want to jump into your actual work on the actual legislation that we have, the institutions that we have. But I'm the macroeconomist. I pretend to know something about financial stability when I have guests like you on the show. So as a macroeconomist, I often think, "Man, it's unfortunate we have these events because they're very tragic. They have huge human cost, but we could have avoided them if we just had better macroeconomic policy in the first place. Had we avoided the Great Recession, we wouldn't have had ... There would still be problems in the financial system, no doubt, but I think one clear way, for me at least, to think about this is I look at Australia.

Australia has many of the same financial structures and issues we do. They have high household debt to GDP ratios, soaring real estate prices. And they didn't go through a Great Recession. Now, I know there's still problems over there, and they're lucky in some way because they export commodities. There's a lot of asterisks you could put behind Australian record. But I also think their central bank did a really good job during the Great Recession, they avoided some of the worst parts where I think, and people [who listen to the] show know, I'm critical of the Fed's policy during 2008 and I think made things worse. So I guess one pushback that I always have is, "Well, maybe we just need better macroeconomic policy."

Gelzinis: Yeah. I don't think better macroeconomic policy would hurt. I think that obviously that would be fantastic if we had the optimal macroeconomic policy to limit the chances and severity of macroeconomic downturns. But I think sometimes those downturns, that shock, can be from the financial sector itself. So you could have great macroeconomic policy in the broader economy, great monetary policy, but if JP Morgan and Bank of America start teetering at the same time because of excessive risk-taking, then that can then foil your plans of this outstanding macroeconomic policy because of the spillover effects that stress in the financial system can have on the real economy.

So I think better macroeconomic policy would help in the situation where a macroeconomic downturn then causes stress in the financial system that then exacerbates the macroeconomic downturn. I'm not entirely sure it would help with the excessive risk-taking in the financial system or any idiosyncratic failures in the financial system that can then spill over to the macro economy.

Beckworth: All right. I want to move to the real world, the world we actually have, not my dream macroeconomic policy world. I want to move to what I consider the mothership of financial stability, in the United States at least, and that's the Financial Stability Oversight Council, or FSOC. Lots of acronyms in this field of yours.

Gelzinis: Oh, many.

Beckworth: And that's why it's hard to keep up, to learn and understand everything. But FSOC. So folks, that's the Financial Stability Oversight Council. And you have a great recent paper on this called *Strengthening the Regulation Oversight of Shadow Banks*, subtitled *Revitalizing the Financial Stability Oversight Council or FSOC*. So this paper goes into the history of FSOC, its current status, what's happened to it under Obama, what's happened to it under President Trump, and moreover, what you would suggest it do going forward.

I mean, you make some claims in there that even if it weren't for the current administration, there would still be some structural problems with it. But why don't you start from the beginning. How did we get FSOC, and what was its original mission?

Gelzinis: Sure. So before the financial crisis, I think it was quite clear that a couple of things were true about our regulatory landscape. One, it was very fractured, that we had these disparate financial regulators that weren't adequately communicating with one another across their jurisdictions. They were quite siloed. And so as risks built up outside of any one regulator's jurisdiction or across jurisdiction, we didn't have a real full picture or readiness for the risk.

And then two there were a class of institutions, non-bank financial companies, shadow banks as I call them in the paper, which is hotly contested phrase that we can get into later. The financial industry does not like it. But that didn't face appropriate regulation and oversight for the crisis. I think your listeners will be very familiar with many of the names, AIG, Lehman Brothers, Bear Stearns. So our insurance companies, asset management firms, money market mutual funds, hedge funds. You can go all the way back to long-term capital management in 1998.

So these firms sat outside the traditional regulated banking sector, but they engaged in bank-like activities, whether it's leveraged maturity and liquidity transformation. They were, in Morgan Ricks's terms, engaging in that private money creation and then investing in longer-term illiquid assets, a fundamentally banking activity, heavily engaged in derivatives activities. These firms were complex, large, and they were highly interconnected throughout the larger financial system. So in that sense, they also posed the level of bank risk that we so deeply care about in the banking system and why we have the entire regulatory apparatus that we do for the banking system.

So these firms were drastically underregulated. They helped feed into the risk-taking during the financial crisis. They were at the heart of that subprime mortgage securitization machine. So not only did they feed into that risk before the crash, but they also then exacerbated the crash when they themselves experienced stress and failed. So AIG required $182-billion bailout because, again, extremely large, complex, and deeply, deeply intertwined into the larger financial system. If AIG went down, there were severe concern that other financial institutions that were counterparties to AIG or that held the same type of assets as AIG, think that transmission channel framework I discussed earlier, could have that really severe impact. And then a destabilized financial system would have a catastrophic impact on the real economy.

Lehman Brothers, the failure of Lehman Brothers and when they filed for bankruptcy, was arguably the most acute moment of the financial crisis and sparked a full-fledged run on the global financial system. So these firms I think undoubtedly were systemically important, but because of the way they were structured, chartered, the way their activities were conducted, they fell outside of the prudential regulatory framework that traditional commercial banks did, despite the risks that they posed.

And so following the crisis, I think one of the goals of Dodd-Frank really was not only to handle the banking side, because there were plenty of issues in the traditional banking sector. They were underregulated too. They had far too little capital. They didn't have liquidity requirements. They didn't have plans for their orderly failure. So not to say that we didn't have problems in banking. We did. We had really big problems. But Dodd-Frank and Title I of the bill wanted to also address these two issues of regulatory communication and coordination for risks outside of the traditional banking system and risks that cut across jurisdictions and also, the risk that these large, systemically important shadow banks could pose to the broader financial system.    

So they created the Financial Stability Oversight Council, which is a body of 10 voting and 5 non-voting members. It consists of the treasury secretary as chair, the heads of the eight federal financial regulators, and one insurance member with insurance expertise to provide that view. Those are the 10 voting members. And they were tasked with the mission to identify and mitigate threats to financial stability wherever they arise in the financial system. They were given some tools to complete that mission.                                    

The biggest tool, which I'll talk about today, is the designation tool. So if FSOC votes in a two-thirds vote with an affirmative vote of the chair, they can designate a non-bank financial company as systemically important if failure or near-failure of that firm could threaten the broader stability of the financial system. So what does that mean when a firm is designated?                              

It means it's brought under the prudential regulatory umbrella, if you will. The Fed has consolidated oversight over that firm. It is then required to apply tailored capital liquidity, stress-testing, living wills, risk management standards, single counterparty credit limit. So the full suite of prudential standards that apply to banks would apply to these firms that are designated. Important point here though they would be the same exact standards, same title, in that yes, we're going to apply capital liquidity requirements to these firms. But they wouldn't look exactly like bank capital and liquidity requirements would look because, look, these are different firms with different risk profiles than banks. I think that's an important point to make.

Beckworth: Okay. So who chairs this committee, the-

Gelzinis: Treasury secretary. Yeah. Treasury secretary serves as the chair of the council.

Beckworth: All right. So he chairs this important Financial Stability Oversight Council. You have all these regulatory authorities represented on the committee, including the Fed. And one question I had is, what if there is this agreement, or let's say they vote ... You said two-thirds have to approve it-

Gelzinis: Two-thirds and an affirmative vote of the chair.

Beckworth: Okay. So let's say the decision is brought by the committee and the Fed actually has to ... The Fed has the troops on the ground enforcing the decision, the designation. Just to be clear, the designation is you're a systematically important financial institution, or is the SIFI is what you call them?

Gelzinis: SIFI. Yeah. Non-bank SIFI is the typical term.

Beckworth: Okay. Non-bank SIFI. So SIFI is another acronym.

Gelzinis: Another ... I mean, it's a language unto itself.

Beckworth: Okay, so if you're designated a SIFI, you get added regulatory oversight directly from the Fed, and it's unique to you, your balance sheet, what you do, which puts added work on the Fed-

Gelzinis: Certainly.

Beckworth: ... added work and compliance costs on you as the firm, but the reason it's done is you're determined to be a risk to the entire US financial system.

Gelzinis: Yeah, that's correct. And if you want to think about how to frame that, quote, unquote, "Added cost," to you, you could argue that you're internalizing your externality, to use-

Beckworth: Oh, very, very good.

Gelzinis: ... I know this is a macro econ podcast, but-

Beckworth: Fair.

Gelzinis: Yeah, so there's a cost to the system that you're externalizing by being outside the prudential regulatory umbrella, and this is bringing you in there to mitigate the chances that you do fail and place that cost on the system.

Beckworth: Or another way of saying this is if you do crash the system, you're going to pay some of that cost upfront. You're going to invest, you're going to pre-pay-

Gelzinis: It's an insurance policy if you want to think of it that way. Yeah, absolutely.

Beckworth: Yeah, it's a way to prevent the worst-case scenario from happening. But back to, I guess, the politics, the mechanics of running this committee. What if the Fed has one vision and the Treasury has a different vision? I mean, the Fed is probably the most important regulator. Is that fair?

Gelzinis: So the Fed's the most important regulator that's on the committee. I still think because of the chair's unique role in setting the agenda, controlling FSOC staff, and the provision and statute that requires basically if you're going to do something, you need the affirmative vote of the chair, of the treasury secretary. So you’ve got the FSOC treasury secretary as most important, but the next most important is certainly the Fed because they've done obviously a lot of work on financial stability. They have a financial stability division. They put out financial stability reports, and they have this unique role and oversight of the designated firms.

Beckworth: So when FSOC meets, is it Randy Quarles that goes and sits on behalf of the Fed-

Gelzinis: It's Jay Powell. So Jay Powell is-

Beckworth: Oh, Jay Powell, actually does. Okay.

Gelzinis: ...Yeah. So the Fed chair is a voting member. It has been I guess practice and courtesy that the vice chair for supervision, Dan Tarullo, unofficially under Chair Yellen and now Randy Quarles all attend the FSOC meetings but are not official members of the council.

Beckworth: Okay. And the treasury secretary has a lot of influence, so he shapes the vision where they're going to go, which ultimately means elections matter-

Gelzinis: Absolutely.

Beckworth: ... and the President of the United States really gets to set the vision for the implementation of policies that flow out of this. So even if there is some grumbling among the ranks of regulators, they ultimately have to fall in line with the two-third votes and implement the policy, the designations, or the lack of designations issued by the FSOC.

Gelzinis: Yeah, so we've seen disagreement because when you have so many financial regulators on this council, all with differing terms ... So there's some overlap between administrations. So, for example, when Secretary Mnuchin took over the council after Trump's victory, there were still several financial regulators on the council that were Obama administration appointees, and they actually slowed the designation train down to the extent that they could and when votes were taken early on to de-designate AIG, several of the Obama administration officials voted against. But, like you said, when the chair has the votes, the chair has the votes. And so those dissents were helpful for people like me hand-waving about this, but the votes went through and certain firms were de-designated accordingly.

Beckworth: I imagine there's some politicking going on before the meeting actually takes place.

Gelzinis: Oh, definitely. Absolutely. And maybe this is an important point here in terms of the structure of the council. So you have the 10 voting members, 5 non-voting members. These are, in many cases, Senate-confirmed officials, the heads of regulatory agencies. But you also have ... This was a structure established during the Obama administration, these deputies committees, staff-level committees, that are in constant communication with one another that are probably talking to one another more frequently than the actual principals are. So it does run deeper, that connection between and communication between the agencies.

Beckworth: Okay. Now, there's also state banks represented as non-voting members. Is that right?

Gelzinis: Non-voting. Yeah, so in terms of the five non-voting members, one is the Director of the Federal Insurance Office, the new federal office created by Dodd-Frank to oversee the insurance industry, study it, and provide advice to the Treasury Secretary. No real regulatory authority domestically. There is some authority to negotiate international insurance agreements that can preempt state law. Then the Director of the Office of Financial Research, and then the three others are represent state banks, state insurance, and state securities regulators.

Beckworth: Okay. Now let's talk a bit about the history of what they've actually accomplished since its inception. I think we've got most of the structure down. So during the Obama administration, there were a number of non-bank financial firms that were designated as systematically important financial institutions, firms that could pose a threat to the entire financial system. So AIG, MetLife, GE Capital, Prudential. Am I leaving out any others?

Gelzinis: No. Those were the four SIFI designations. There were eight other market utilities. This is a less hotly contested area of the FSOC and their authority that were designated as SIFMUs, to add a systemically important financial market utility, to add another to our little acronyms-

Beckworth: Are these the clearinghouses?

Gelzinis: Yeah, basically. They're payments in clearing providers. They don't face the full suite of enhanced prudential standards that a designated firm, a SIFI, faces. They face heightened risk management standards, and then they may be given ... The statute gives the Fed the permission to allow them access to the Fed's balance sheet as well.

Beckworth: Okay. So let's go to the four big firms that were designated, AIG, MetLife, GE Capital, and Prudential. Why were they designated, and what's happened to them since?

Gelzinis: Yeah, so these firms were designated after a rigorous analysis by the Obama administration. There was a three-step process that was put in place. Step one was using certain quantitative thresholds to narrow the universe of non-bank financial companies that would be analyzed under the designation process. Stage two, which would take a closer look at those firms that triggered the stage one thresholds using publicly available information, information already collected by regulators to take a closer look. Again, thinking about this from the transmission channel framework, how can these firms transmit stress throughout the financial system through their counterparty exposures, through the asset liquidation considerations, and through substitute ability considerations.                               

And then if a firm piqued the FSOC's interest enough during that stage two review, then it could be voted into stage three. And that's the real meat of the process where you're requesting and receiving direct information from the firms themselves and undergoing a really careful review of their books and systemic risk profile before you engage in a final vote whether to designate that firm. So the three insurance companies and GE Capital were all designated after that thorough review process, and the FSOC basically stated in all of those that there were concerns in the counterparty exposure channel. These are extremely large institutions. AIG is about $500 billion at the time, Prudential about $700 billion, MetLife in that $700 billion range at the time as welL. 

So they had significant counter derivatives, counterparties. We all know the story of AIG's derivatives business-

Beckworth: Right. It's obvious.

Gelzinis: ...during the financial crisis, which provided a bit of a roadmap for how derivatives business as an insurance company could cripple the firm, and not only derivatives business but also securities lending, which is the forgotten about risk factor and cause of AIG's demise as well, which many insurance companies are engaged in. So those companies were designated after that review process. The FSOC tried to provide some transparency on the justification, so they put out 15-page analysis and explanation of why they underwent the decisions and looking at this transmission channel framework. Same can be said about GE Capital, which played a very interesting role during the financial crisis as well.

You could argue that the FSOC was looking at and should have looked at even more firms than it did under the Obama administration, but what was I think demonstrated by this extremely time-consuming process was that there were a lot of places where lobbyists could slow down the process, make hay on the Hill to then pressure the administration, and just that it took a long period of time. I mean, these reviews took years.

Beckworth: So it gives them plenty of time to chip away at the process. Okay. So they were designated. Now, under the Trump administration, they've been de-designated, so they've been taken off the list. And I know this has been controversial, so why were they taken off the list?

Gelzinis: So it's a good question. I don't think they should have been taken off the list. I think it was a political or ideological decision and not one based in the facts of the case. I'll use Prudential as the perfect example of this. So when Prudential was designated, it was about a $700-billion insurance conglomerate. Since it was designated, so in the five years since it was designated in the Obama administration to when it was de-designated, it grew by $100 billion. It grew from 700 billion to $800 billion, I think now operates in more countries globally than it did back then, increased its derivatives activities by somewhere near 30%, it's repurchase agreements by 45%, which again, short-term funding, important short-term funding market, securities lending had increased as well by a smaller percentage.

So on basically every single metric of systemic risk, it actually increased. So I think it poses more of a risk today than it did when it was designated back during the Obama administration. Yet, it was de-designated. So now this $800-billion global insurance company, their primary regulator, the New Jersey Department of Insurance. Not to criticize New Jersey, but they don't, in my opinion, my humble opinion, they don't have the resources, the incentives, the expertise, or even the authority to oversee and regulate this global insurance company, because remember, AIG's a lot of their trouble occurred in their London-based subsidiary. State insurance regulator doesn't really have a whole lot of authority to oversee and regulate foreign subsidiaries.

Beckworth: Well, is there any charitable cases you can make for, say, GE Capital? Any of those that you could make a reasonable case why they were taken off the list?

Gelzinis: Yeah, so it's important to differentiate. GE Capital was de-designated in the final year of the Obama administration. So GE Capital broke itself up, basically cut itself in half, was about a $500-billion institution, broke itself up to about 250, 225, in that neighborhood. So it took clear steps. You could make an argument that AIG and MetLife took some clear steps to reduce their systemic risk profile. I thought those were probably too modest to warrant a de-designation. These are still really large, complex, interconnected firms. But there was at least a story to tell, that AIG was a trillion dollars during the financial crisis. Today, it's $500 billion. It wound down certain business lines. MetLife spun off certain business lines. Prudential, I cannot make-

Beckworth: There's no story.

Gelzinis: I cannot tell a story as to why Prudential should have been de-designated.

Beckworth: Okay. So this a good segue into the problems with FSOC. So Prudential's a good poster child-

Gelzinis: Absolutely.

Beckworth: ...of why FSOC is not maybe working the way it was intended, and you have some proposals to reform FSOC. Why don't you walk us through those?

Gelzinis: Yeah, absolutely. So I think there's, in the designation process itself, there's an embedded bias against forceful use of this really important tool. So as we saw in the Obama administration, it took years to undergo this careful, analytical review. At many points, there were these veto points where industry lobbyists could have a real sway, again maybe going through the Hill to pressure the administration or pressuring the Treasury Secretary and the other regulators themselves directly. So it was a long, arduous process.

Then at the end of that process, the MetLife designation shows us that these are vulnerable to judicial challenge, that MetLife's designation was overturned by a court that, again, in my opinion and the opinion of administrative law scholars and the opinion of former congressmen that wrote the bill and the opinion of Ben Bernanke, who all filed amicus briefs in this case, read in requirements into the statute, things like cost-benefit analysis, that were not actually in the statute.                 

And so the fact that the FSOC did not perform a specific quantitative cost-benefit analysis was used as justification to overturn the SIFI designation. There's no cost-benefit analysis requirement in Dodd-Frank for SIFI designations. That's not uncommon in the financial regulatory space. The Fed doesn't have to provide very specific quantitative, rigid cost-benefit analysis. Certain financial regulators do, but they do because it's written into statute clearly.                                    

So the two problems that I was trying to solve in my proposal, one, takes forever to designate these firms. Two, they're subject to judicial challenge, and then relatedly, when another administration that doesn't really care about using these tools comes in, they can snap their fingers and de-designate these firms really quickly. And so you think that there's this sort of ping-pong between administrations. Progressive administration or a conservative administration that really cares about bringing these firms into the prudential regulatory framework comes in, goes through years-long process that's susceptible to judicial challenge. Then another administration that doesn't feel that way comes in and snaps their fingers and de-designates these firms.                                              

So those are the issues that I'm trying to solve here, so what I came up with was using an automatic designation trigger in statute. So if a firm meets a size threshold and then one additional quantitative risk threshold and these quantitative risk thresholds are things like derivatives liabilities, credit default swaps, that the entity is the reference entity in the default swap, a leverage ratio, short-term debt ratio, assets under management, so all these other risk factors. If you trigger the asset size threshold and then one of those additional risk factors, then you are automatically designated by statute. So no longer is it administrative action that's susceptible to legal challenge under administrative procedures act and the like, it's a designation by Congress by statute.                            

Now, I think one could argue that the firms that would be captured by this automatic designation, some of them really might not pose risks to financial stability due to their specific idiosyncratic risk profile and their business model. I think that's a fair critique, and so that's why in the proposal we built in the ability for firms to be de-designated by the council. Now, they have to meet a high bar in doing so and such de-designations can be challenged by the public, by private right of action that gives the public and interested parties clear standing to contest the de-designations. But that's my escape valve for over-inclusiveness and the automatic designation.                                  

And so all these firms, and it's roughly 15 to 25 firms, would trigger this automatic threshold would face the enhanced prudential standards, the suite of enhanced oversight, and regulatory safeguards that we talked about earlier. And these are the largest and most complex insurance companies. A few highly leveraged hedge funds would likely trigger this, asset management firms, stand-alone investment banks, although there aren't many left, many big ones left. So that's the problem I'm trying to solve and that's how I solve it with the automatic designation.                                    

I just think this flips the presumption, if you can see the way it works today versus the way it worked there. Instead of an opt-in model where you have to affirmatively go get these firms, it's an opt-out model where certain firms are presumed to be in and then you can undergo the rigorous process to release some of them.

Beckworth: So you're playing a little behavioral economics to FSOC.

Gelzinis: Yeah, exactly. Exactly. There are a few other elements of the proposal-

Beckworth: Yeah, I wanted to-

Gelzinis: We can stick on the designations. This really is the heart of it.

Beckworth: Yeah, the designation's the heart of it, but, as a researcher, there's a part that I really liked and that is the Office of Financial Research because they collect data, and Dino Falaschetti is there. I would love to give him the ability to create lots of great data for me for my research. It's a purely selfish thing, but there's good reasons from a public perspective why that office should be more robust.

Gelzinis: Yeah, exactly. And so in the proposal, we've included budget and staffing floors for both the FSOC and the Office of Financial Research and boost the OFR's ability to quickly demand and receive data from the other financial regulators. I think one of the things that we saw during Director Berner's tenure during the Obama administration is that certain agencies were a little bit probably slow in providing data over to the OFR, this new kid on the block, and these agencies are still can be, have that siloed mindset where they don't want to hand over information.                             

So on the budget and staffing floors, this is a direct response to what we saw during Secretary Mnuchin's tenure thus far. The FSOC had had its target staffing levels cut from about 36 full-time staffers to 18. The OFR saw its budget cut by 25% and staffing levels cut by 30 to 40%. The actual pink slips, people walking out the door. So that was unfortunate because these offices are funded through fees on systemically important financial institutions, both banks and non-banks, when they're designated. And the OFR has a really important research role to play here.                                    

So the idea that we would take in less money from systemically important financial institutions in order to fire researchers to me doesn't make a whole lot of sense. Mnuchin was literally returning money to banks and designated non-banks to fire systemic risk researchers. So I think for future de-regulatory administrations, if I can use that phrase, to provide a floor below which they cannot cut the budget and staffing to preserve the core importance of these institutions. And it's yet to be seen whether Director Falaschetti will reinstate the budget and staffing at the OFR. I really hope he does. He has the power to do so, and so we'll see.

Beckworth: Okay. Now one last area of FSOC I want to touch in before we move on from this topic, we touched on it earlier, are the clearinghouses. And I believe that's one of the areas of unfinished business from Dodd-Frank because the clearinghouses, I mean the idea, and correct me if I'm wrong, is to bring on to the market or bring and make transparent all the derivatives that were traded from firm to firm, counterparty, that no one knew for sure. And so when there was this big financial crash, we didn't know what to do, where to look. And this is to eliminate that, so you bring all these derivatives into one or to a couple, several settings, several clearinghouses.                        

But the problem is you are now concentrating risk all in one place, and the concern is, well, what if one of these clearinghouses fail? And there isn't something in place for those, is that right?

Gelzinis: Yeah, so that's correct. Before the crisis, obviously we had this dizzying web of risk in the derivatives market that was largely in the shadows. Like you said, we didn't know where to look. We didn't know how certain institutions were connected to others through this daisy chains of derivatives risks. And so we took those out of the shadows, largely put them in central counterparties to clear them. So you're right. In some ways, we did minimize risk by doing that because you're able to clean up the exposures between firms.                                    

So Firm A and Firm B could have a lot of complex exposures. It becomes easier to offset those when you concentrate it in one place. But you're right. We are concentrating systemic risk in these really critical nodes, so we better do a good job of regulating these firms, one, mitigating the impact of their failure, and certainly trying to limit the chances of their failure in the first place.                                   

Have we done enough? Probably not. It's a little bit outside the scope of this paper, but I think Title VIII provides the SIFMU designation and certain clearinghouses has been designated under that to have heightened risk management standards to limit the chances of their failure but more probably should be done there, some stress testing that CFDC has undertaken. I'm not entirely sure if that's up to snuff relative to the Fed's stress testing of banks. So I think there's a lot of work that we have to be done.                                    

But I will say the most important thing we can do to prevent a clearinghouse failure is preventing the failure of its members. So these clearinghouses, the way that they'd fail is if their members, systemically important banks, also fail and can't meet their obligations. So to the extent that we raise capital, liquidity, and prove our stress testing of the clearinghouse members themselves, we limit the chances that the clearinghouse will fail.

Beckworth: Okay. Let's move on from FSOC to a few other areas of financial stability in the time we have left. And we don't have a lot of time left, so we have to do these quickly. But I want to talk about stress testing and the Volcker Rule. Now, stress testing, the Fed was applying these stress tests to these big, important banks, and there's been some changes lately in how it's done. Can you tell our listeners what's been done?

Gelzinis: Yeah, sure. So this is actually one area of the financial regulatory framework that has seen a lot of change. Some of them have been finalized. Some are still in the proposed rule stage. So one of the new developments in the stress testing space is that the Fed is releasing far more information about its own internal models in the stress test, the formulas and variables that it takes into account when it's stressing ... when it's running its own models on bank balance sheets to determine what their capital levels are post-stress scenario. And so I think that's a very concerning element.                               

Look. I love transparency. Everyone loves transparency, but some transparency is dangerous, is more akin to giving the answers to the tests away before you actually apply the test in that these firms will be able to reverse engineer the Fed's own internal models, tailor their balance sheets, and modify their balance sheets over, again, this can happen maybe not in a year but over time to limit the losses that would be expected in the stress test and in turn, limit their required capital that stems from the stress test.                                   

You also are really concerned that if all these big banks have this information on the Fed's own internal models and they're all doing the same thing to optimize their losses under the models and optimize their capital that you're going to have this what's called monoculture, model monoculture, it's a tongue twister, where all these firms are doing the same thing and so you have this correlated risk-taking, which as you know when all banks are going in one direction and that direction turns out to be flawed then it just increases the impact.                                

Fed has also proposed removing a certain measure of capital, the leverage ratio, the supplementary leverage ratio, from the stress test. So that's one of the capital requirements that has tripped up some banks in the past, most recently Morgan Stanley and Goldman Sachs in 2018 were tripped up by coming too close on their leverage ratio requirements. And so by removing that measure from the test altogether, you just make the test that much easier to pass.                                    

The Fed has also removed what's called the qualitative objection from the stress test. So under the stress test, there used to be two avenues which your capital plan could be objected to. One, if you just your capital's too low after the stress scenario, the quantitative objection. But two, if your internal processes, your internal risk management and governance around capital planning were deficient, if the Fed looked at it and said just, "This is not up to snuff. You're not producing particularly good estimates of your capital needs in certain stress scenarios. You're not elevating this to senior level executives in the right way," then they could object on qualitative grounds even if you passed on quantitative grounds to say, "We're going to restrict your distributions to shareholders until you get your act together." They've removed that objection now. There are a couple other changes as well but these are I think those three are probably the most impactful changes that have been either finalized or are in the process of being finalized.

Beckworth: Yeah, so I was reading an article and preparing for this show about two of those concerns you mentioned. One is the over-reliance on a model that over time can create a sense of complacency, kind of like before the crisis, this VAR, the value-at-risk models that banks overly depended upon. And in the tests, the model wasn't robust to a big, big crisis. And so maybe the same thing could happen. But couldn't that be a problem even if they didn't know ... I mean, once they start passing ... If they hadn't revealed the model and the Fed is doing a stress test and they started figuring out how they could pass it, I mean, you could become complacent, "Oh, I've passed the stress test." Could that be a concern no matter even if they hadn't revealed it?

Gelzinis: Yeah, no, that's definitely a concern and that's why I think people in the progressive policy community and academics have been pressing the Fed to continue to evolve their stress testing-

Beckworth: So a dynamic-

Gelzinis: ...to have a more dynamic stress test, a stress test that better captures the actual dynamics of a financial crisis. So there are certain elements of a crisis. We've talked about them, whether they're runs, fire sales, that aren't quite captured by the current Fed stress test which are really macroeconomic shocks directly to the balance sheet, not those second order effects of a financial crisis that can compound losses.                               

And so yeah, pushing the Fed to continue to be more dynamic, continue to come up with more robust, unique stressors, I think is something that they should do regardless, absolutely-

Beckworth: All right, so evolve the model over the time so there's not a sense of complacency. Also, try to avoid the danger of everyone building their balance sheets around the test.

Gelzinis: And we had a perfect example of that before the crisis, Fannie and Freddie stress tests. Those were noticed for public and comment. They were out there for everyone, including Fannie and Freddie, to look at, and they were absolutely useless. They said Fannie and Freddie were well-capitalized before the crisis. That turned out not to be the case.

Beckworth: Okay. All right.

Gelzinis: So we have an example of completely transparent stress tests, and it didn't work out.

Beckworth: All right. So your point is big room for improvement there on stress tests. Okay, let's talk about the Volcker Rule. Tell us about it and why are you so concerned about it, because I know you've written a lot about that lately.

Gelzinis: Yeah, so the Volcker Rule was, again, one of the pillars of the post-crisis response in Dodd-Frank, and it really targeted speculative trading investments and hedge funds and private equity funds at bank holding companies that owned insured depositories that have access to the federal safety net, whether that be FDIC insurance or access to the Fed's balance sheet that we don't want firms with this unique taxpayer support to engage in type hedge-fund-style behavior where they're making swing-for-the-fence bets in financial markets or their trading activities or doing the equivalent of that by investing significantly in hedge funds or private equity funds and then letting those firms engage in that high-risk trading because we don't want to subsidize that activity as a taxpayer and we also ... That's really risky activity that we don't want to blow up the firm and then taxpayers foot the bill later for that risk-taking, the privatize your gains and socialize your losses after that high-risk trading.                                

So the Volcker Rule banned proprietary trading, as it's called, trading for your own account.

Beckworth: So Goldman Sachs trading for itself-

Gelzinis: Exactly, not for your customers.

Beckworth: ...even while it has clients who ... So Goldman Sachs could be trading on a bet that might be betting against its very own customers.

Gelzinis: Yeah, and it did, and it certainly did that in the past because you have this interesting ... If you're a market maker, you have that interesting almost inherent conflict of interest where if you're going to trade on your own account, you also have all this information about how your clients are trading and you can trade against them.

Beckworth: Okay. So the Volcker Rule outlawed this, outlawed this proprietary trading. Now the critique I often hear, and it seems reasonable to me, and you can correct my thinking, is it's really hard sometimes to know the difference between legitimate market-making activities and proprietary trading. I mean, is it a gray area? I mean, is it hard to draw the right boundaries there?

Gelzinis: So there can certainly be a gray area between market making and proprietary trading, but if you look at the final Volcker Rule implemented by regulators in 2013, I think they made a pretty reasonable attempt at discerning what is market making and what isn't. So if you look at that rule, basically said under the market making provisions that, "Look, you can trade under the reasonably expected near-term demand, RENTD," another acronym to add to the glossary, "of your clients." So if I expect to trade X amount or my clients demand X amount of this type of corporate bond, then I can have that in inventory and not flunk the tests on the Volcker Rule.                                    

And so that real expected near-term demand of your clients, that measure, which is in statute and then implemented by regulators, was tied to historical customer demand. I think that's probably the best data we have on what your future client demand is and what your past client demand is. And it gave banks a little bit of flexibility there to say, "Well, this was my past demand for this financial instrument. I think it's going to be a little bit different going forward for X, Y, and Z reason." But they had to show regulators their work and make sure it's anchored in historical demand.                                

One of the big changes that was recently finalized is that on this market making provision it basically lets banks set their own internal risk limits, and then as long as they stay within those limits, you're fine. But it can take into account any number of variables to come up with those risk limits. It's not necessarily tied to your historical customer demand. And so it basically gives them free rein to come up with whatever real expected near-term demand they think, and they don't necessarily have to rigorously justify that and show their work to regulators. So I think that's a huge hole and a way to exploit that permitted activity.                                    

But even larger than that, on the front end of the Volcker Rule ... So the Volcker Rule, like we said, it applies to the trading account of the firm. So it basically says, "You can't act as principal for the firm's trading account." So that means the definition of trading account is really important because if a financial instrument falls outside of the definition of trading account, it's not looked at under the Volcker Rule. So what the most recent proposal did was narrow the definition of trading account and actually exclude about $600 billion worth of financial instruments that were previously captured under the old definition of the rule and captured under the proposed definition of the rule in 2018 but certain provisions were stripped in the final rule that narrowed that definition of trading account.                                    

So about $600 billion of financial instruments will no longer receive any scrutiny under the Volcker Rule, period, because remember, the Volcker Rule is, "Okay, we're going to look at this universe of financial instruments and transactions. Then you, the bank, show us how you're meeting one of these permitted activities, like market making or underwriting or hedging." There's going to be no second glance at these instruments that now fall outside the scope of the Volcker Rule.

Beckworth: Okay. Well, this is a complicated issue and discussion. And again, in my mind, it takes me back to the simplicity. Let's just have share capital funding. It would solve a lot of problems if we could get to that high market you suggested earlier, but we're not there. So in the real world, we deal with the Volcker Rule, stress testing, FSOC, all these issues. And the fight continues. You continue-

Gelzinis: The fight continues. That is exactly right.

Beckworth: Yes. Okay. Well, we are out of time. Our guest today has been Gregg Gelzinis. Gregg, thank you so much for coming on the show.

Gelzinis: Thanks for having me. I've enjoyed the conversation.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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