Thomas Hoenig on Public Debt Sustainability and the Current State of the US Banking System

Thomas Hoenig is a distinguished senior fellow with the Mercatus Center at George Mason University, where he focuses on the long-term impacts of the politicization of financial services as well as the effects of government-granted privileges and market performance. He was formerly the vice chair of the FDIC from 2012 to 2018 and the 20 years prior to that, he was president of the Kansas City Federal Reserve Bank. Tom is also a returning guest to Macro Musings, and he rejoins to talk about the Treasury market, public debt sustainability issues, and the state of banking in the United States. David and Tom also discuss the history of Tom’s influence on the Jackson Hole Conference, the growing size of the US current account deficit, the Fed’s role as the primary Treasury market backstop, the dangers of risk-weighted capital regulation, and more.

Read the full episode transcript:

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

David Beckworth: Tom, welcome back to the show.

Thomas Hoenig: Thank you for having me. Looking forward to the conversation.

Beckworth: Well, it's always great to get you on. As I noted in the introduction, you're a former Kansas City Fed President, you're a former vice chair of the FDIC, so you bring a wealth of experience. You know people, you have just a lot to draw upon. Recently, you were at the Kansas City Fed Jackson Hole Symposium. You were there, so you got the feel of the conference, what people were thinking about, both the papers as well as the hallway conversations. I want to use that to talk about some developments going on in the economy as I alluded to, Treasury issues, public debt issues, and then the state of banking. I think people want to hear from you on the state of banking given your background there as well. Just for the sake of our listeners, and I know many know this, but you were a bank supervisor at the Kansas City Fed before you were president, is that right?

Hoenig: That is correct, yes. For about 15 to 17 years. I think it's 17 accurately.

Beckworth: You came full circle. You started as a bank regulator, you ended as a bank regulator. In between, you ran the Kansas City Fed as a president and voted on monetary policy decisions. As president though, from 1991 to 2011, you had an important role to play at the Kansas City Fed, and that's in organizing the very conference we're talking about, this Kansas City Economic Symposium Conference held at the illustrious Jackson Hole. It's a beautiful place. I've been to the conference one year and I remember, Tom, just landing at that airport. You're like, "Wow," the backdrop, the Tetons. Then, of course, the resort itself is beautiful. It's hard, almost, to go to the meetings because there's so much natural beauty around you in the outdoors. You were there as president, so you helped plan these. I heard a comment at the recent meetings from Bloomberg's Tom Keene. He said you were the president that really elevated this conference. You were the one who did something, and I want to know what that is, to put it on the map as it is today. Maybe walk us through your recollection of how that happened.

Thomas Hoenig’s Influence on the Jackson Hole Conference

Hoenig: I appreciate Tom Keene's comment. I would start by saying, though, that my predecessor who started the conference really did a great job on getting its reputation up. My role as he told me was to take it to the next level. One of the things we did is it became increasingly international. Globalization was going on, [there were] differences around the world in terms of productivity issues. Central bank issues were becoming more intertwined, and so we broadened the scope. The number of foreign central banks became very important. It was academics, central bankers from around the world, some private sector, although that became less important, and then it was always open to the media. It was an open session. People weren't behind closed doors or any of this. People really enjoyed coming, and enjoyed the papers, and enjoyed the discussions afterwards. We did leave plenty of time for informal conversations at the end of each day. We would usually end around two o'clock in the afternoon, and then the rest of the afternoon was open for informal gatherings, hiking, whatever it was in that environment. People really came to expect it to be not only enjoyable but a learning opportunity. In that sense, we built it, made it better as we went through time.

Beckworth: I went back and looked at the conferences that you produced under your watch from 1991 to 2011. As you look over the titles, the participants, you definitely see that they reflect things that were happening during those times. I also noticed that sometimes you picked topics that became very topical. I was reading one conference speech by Ben Bernanke where he actually commended you for picking, I believe it was around 2007, 2008, you picked this topic ahead of time before markets really did blow up. You had picked that theme. It must have been a challenge or at least took some thought that, “what do we do for next year? How do I plan next year's conference, keep it still timely, topical, and keep it interesting?” Maybe walk us through that process.

Hoenig: The process is, in a sense, very straightforward and involved. We almost start immediately at the conference to talk about next year's conference. We get input from participants, other central bankers around the world, other academics, and we gather those ideas. Then in about October, we begin-- we, at least when I was involved, began talking about next year more formally. What we tried to do was develop at least three possible topics. What we do is we say, here's what we would try and accomplish, here's what the main sessions would be. We'll outline those, all three of them. We will go through them, and if you will, scrub them down and see if there's something that might really be there that would hold up until the time that the conference was actually conducted.

Hoenig: We would then narrow down from three to two, and then we would have other discussions. We would pick one. That one, though, we would send out to people that had been there before, people that would come back. They would be central bankers and they would also be academics. Alan Blinder, for example, would be an individual. Marty Feldstein would be another one. Others would be chosen. We'd ask them, "How does this strike you? Is this a topic that you think is good now? Would it be good at the time of the conference?" They'd give us, I think, wonderful, useful feedback. We would use that and narrow it down and select that or the other topic for the following year, and begin then to outline it in more detail and then begin to think about who would be a presenter and who would be a commenter as we go through that. Then we go select our choices for that and then contact them in, usually, December or January for their interest and whether they think they could put a paper together by the conference time. Most often, they would accept. That includes other central bankers who present, academics who present, and in some cases, the private sector.

Beckworth: It's really neat to go back and look at the list of conferences you organized, look at who the keynote speakers were. Of course, in most cases it was the Fed Chairman, so Alan Greenspan, Ben Bernanke, during your time. You also had notable guests present as well. Going back to '91, which is I believe the first year you were the president and you oversaw the conference, you find Paul Krugman, Marty Feldstein, David Laidler. I was very happy to see a great monetarist there. Jacob Frenkel, the Bank of Israel's governor or deputy governor, Alan Meltzer was there, Larry Summers. As I go down the list, a lot of similar names. It's fascinating to see some of these same people who are involved today. Larry Summers shows up quite a few times, first few years of your time there. Paul Krugman made a few visits. Mark Gertler, Stanley Fischer… he returned several times, so you and Stanley Fisher must be buddies as well. Larry Kudlow, I was really surprised to see his name on that list, he got invited as well. John Taylor, Lars Svensson, Donald Kohn. You had Jean-Claude Trichet, who became the president of the ECB. Bennett McCallum. You had Bennett McCallum there, another great character.

Beckworth:  In fact, as listeners may know from our bumper, we're having a Bennett McCallum conference here pretty soon, and Tom will be on that, so we'll be remembering him, another great economist. You had others. You had the Romers. You had Alan Blinder, Jason Furman, Joe Stiglitz, [inaudible]. You had a number of other central bankers, as you mentioned. I could go on, a lot of big names, James Stock, Mark Watson, Ken Rogoff, Glenn Hubbard, Tom Sargent, Alan Auerbach. I'll stop there, but a lot of great, fun, fascinating names. In fact, I ran into one person who presented there a few years ago, Hanno Lustig. For him, it was like a career highlight to be invited, he said, and to present there. A real honor for these folks to be a part of that. Now, what I want to do before we go on, I want to just briefly go through some of the conferences. I want to highlight a few that I thought were interesting. Maybe I'll ask you first, are there any conferences that you look back with great fondness, or they just really stand out for some reason?

Hoenig: Well, let me first respond to your notice that we had a variety of people there of different views. One of our primary points that we stick to is, opposing views. We're not there to affirm our biases or confirm our biases. We're there to have a very good discussion and sometimes disagreement. Most times, that's received very well. People have their differences. They do it very professionally. That is really one of the top draws to the conference. It is a good setting for different views and discussion, not yelling at one another, but discussion. I think that is extremely important. I say that's number one. Number two, there are many conferences there that I enjoyed, perhaps most of them. One I will mention, though, is when we chose in, I think, 2006, but we made the choice in 2005, I can't remember the date exactly, but the discussion on the housing market. When we were developing that and talking about whether that should be the topic, we did send it out to various contacts, and some of them said, “this is a pretty boring topic for you to be taking on. The market is great. It's going gangbusters. What are you going to do?”

Hoenig: We said, "Well, we're not so confident that it's going to stay that way. It may, and we may lose it,” but we said, "No, we're going to go ahead with it." It turned out to be, of course, right after a lot of the housing market went bust. The conference was very engaging. People had very strong, differing views. Some were quite, shall we say, elevated in their delivery. In that sense, it was a remarkable conference because it was so timely and no one thought it would be. That's one example. The other, you and I talked about a little bit, and that is issues around the government debt. Way back in that period, we thought it was important, not because we necessarily expected a crisis, but because we knew that it would have longer-term consequences on the, shall we say, the ability of the economy to deliver strong growth well into the future. That's also one of my favorites among the conferences we had during my tenure.

Beckworth: That was the 1995 Jackson Hole Conference. I actually have your foreword to the volume. Let me just read this. This is from 1995. Tom Hoenig, 1995, Vintage edition, he says, "Few economic issues have such far-reaching implications as excessive government budget deficits and debt. It is almost universally argued that fiscal imbalances retard economic growth and impose heavy burdens on future generations, and heighten the risk of financial market disruption. It is also agreed, however, that correcting such imbalances is a difficult task. Around the world, countries are attempting to address the problem of excessive deficits in debt. This issue is at the core of many political and economic debates." Then you go on to say, "This is why we're going to discuss it at this session." If only we listened to you, Tom, back in 1995. But as you said, it's a difficult issue

Beckworth: You mentioned the conference on housing. Let me go back to that because that was fascinating, again, looking through these conferences. That one, as you mentioned, was in 2007. I think it was 2007. You planned it in 2006, but in that conference, two papers that I remember well as I went back and looked at this, one by the late Ed Leamer, *Housing is the Business Cycle.* Very fascinating, powerful paper, how it proved true by the time of that conference. Then John Taylor had a really fascinating paper too. In this paper, he does a counterfactual. He goes, "What if the Fed had raised rates sooner? He shows it would have been less of a housing boom, this little counterfactual model. I remember reading about that in The Economist magazine. I hadn't actually read his paper, but I remember The Economist reported that out, and then I went back and read his paper. It's a very fascinating and very impactful conference.

Beckworth: Now let's go to one that was just a few years before that. Let's go back to one that's called, The Greenspan Era: Lessons for the Future. This conference took place in 2005, I believe. This was Alan Greenspan's last time to be there, so we all knew he was going to be stepping down. You had a number of papers. It wasn't just about Alan Greenspan, but there were discussions and a section that was credited to him. I want to read an excerpt from a paper by Alan Blinder and Ricardo Reis. Ricardo Reis, he's a great friend of the show. I'm going to read this with the understanding that we all thought things were looking great back then, except for one person we'll come back to in a minute.

Beckworth: This talk and this paper was titled, *Understanding the Greenspan Standard.* It's about two paragraphs, and they say, "No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although this may come in time as the legend grows. But within the domain of monetary policy, Greenspan has been central to just about everything that has transpired in the practical world since 1987 and to some of the major developments in the academic world as well. This paper seeks to summarize, and more important, to evaluate the significance of Greenspan's impressive reign as Fed chairman, a period that rightly can be called the Greenspan era.” Now, they go on to give a more balanced approach, generally comes down favorable, but they do acknowledge pluses and minuses. But wow, what a paper to give right before everything blows up. His reputation has, of course, been tarnished a bit, I guess we could fairly say. What was the reaction when that paper was delivered at the conference? What is your recollection of that moment?

Recalling the 2005 Jackson Hole Conference and its Impacts

Hoenig: I think people were very polite. No one said, "Oh, yes. That's just hyperbole." There were, I think, some who wondered if it wasn't a little bit too soon to be giving him praise and didn't stand up and say that. That's where you have your informal conversations. There was some of that saying, "Well, that was a little over the top." I think most people did think that Greenspan, for the most part, had done a great job, and therefore recognizing him as such was certainly appropriate. No one really objected to it at that time at all, although there were clearly risks that were rising and people did see it.

Beckworth: Yes, I want to come to a paper by Raghuram Rajan in just a minute that spoke to that same conference. I want to be fair to everyone, to Alan Blinder, Ricardo Reis. I could have easily written a paper myself back then, too. I don't want to look back and say, "How could you write that?" Looking back, it does seem a little premature given what happened afterwards. Let's go to the other part of the conference that was really fascinating, and that was this paper by Raghuram Rajan, who later became the leader of the Reserve Bank of India, the central bank in India, very prominent academic as well as central banker. This conference, I at least get the sense from the articles, is a very “times are great, hoorah, Alan Greenspan.” Everyone's cheerleading the good times.

Beckworth: Then here comes Raghuram Rajan with a little dour, pessimistic, at least “let's be careful” paper. His paper was titled, *Has Financial Development Made the World Riskier?* He goes through all of the things that we now know have happened. Let me read one excerpt from his paper, and it says, "Taken together, these trends suggest that even though there are far more participants today able to absorb risk, the financial risks that are being created by the system are indeed greater. Even though there should be, theoretically, a diversity of opinions and actions by participants and a greater capacity to absorb risk, competition and compensation may induce more correlation in behavior than desirable.”

Beckworth: “While it is hard to be categorical about anything as complex as the modern financial system, it is possible that these developments may create more financial sector-induced procyclicality than in the past. They also may create albeit a still small probability of a catastrophic meltdown." Boom. He called it. Now, again, this is in the context of a conference that's generally upbeat, and everything's going well, and let's praise Alan Greenspan. As you noted during these conferences, they gave a presentation. I believe Donald Kohn gave the comments, and he was reasonable. The comments from the audience were much more fierce and biting, and really strong pushback. I'm going to read the comments from two people in the audience. Here's what Larry Summers says. "I speak as a repentant, brief Tobin tax advocate and someone who has learned a great deal about this subject like Don Kohn from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely misguided." He comes out swinging. Then later Alan Blinder comes and says some nice things. But there was a lot of pushback against this paper. Tell us about that moment.

Hoenig: I remember the moment well. It was in some ways stunning, because it was a very caustic comment on the part of Larry. People were surprised by it. It usually didn't happen at that symposium. Now, Larry was in the administration, I believe. He was not only defending, I guess, Alan at the time, but others in the administration as well. It really was not well-received, I think, by many in the audience. In fact, I think it was the next year or maybe it was even two years later after everything had blown up that one of the participants at this particular conference got up and reminded Larry and others that Raghu Rajan had made these comments and they chastised him for it. It seemed that maybe Raghu was right and some others were wrong. Some of the comments were that Larry is often wrong but never in doubt. I think it came back, as it should have, on Larry, because what Raghu said was thoughtful. It wasn't caustic. It wasn't overly critical. It was merely saying, "I wonder if--," and I would say not unlike a comment that Greenspan made years before in terms of irrational exuberance. It was appropriate to say it and [it was] part of what we wanted in the conference, and that is opposing views. It was a moment of, shall we say, interesting outcomes.

Beckworth: For sure. It will definitely will go down in history as one of the great moments of the Jackson Hole Symposium. One other observation I want to make before we move on, because we do want to talk about this most current conference that you got back from, the 2023 Jackson Hole Symposium, looking over this period again where you were overseeing it, two different times there were papers given on current account deficits, one by Maurice Obstfeld and Kenneth Rogoff in 2000, and one by Sebastian Edwards, also a friend of the show and former guest, in 2005. They all are looking at this growing size of the US current account deficit. The takeaway is, this is not sustainable.

Beckworth: I remember very well, very vividly that during this early 2000 period, really up until the 2007, 2008 period, that the crisis we all were expecting was a dollar crisis or a correction to the current account. It was going to swing around and the dollar would change quickly, and it'd just be one big hot mess, and we just can't continue living beyond our means forever. Here we are many years later. We're more indebted to the world than ever. That calculus has changed, at least the understanding has changed a bit, but it was a concern back then. Again, it's one that I had too. I remember giving a presentation on this very same thing. How can we continue to live beyond our means as a nation, not just the government, but the country as a whole, continue to go into debt to the rest of the world? It's fascinating to look back at that and to see what we were thinking back then. Any thoughts?

The Growing Size of the US Current Account Deficit

Hoenig: I think it's important to remember in economics that we're taught, and we draw lines on a chalkboard, and they change immediately. Whereas in the real world, these things evolve slowly. There's no question that the effects of the current account deficit provided a great opportunity for much of the rest of the world, because it reflected open trade and reflected the US's ability to print money, and it reflected the fact that the Federal Reserve was following policy that promoted, shall we say, global trade and expansion and provided the liquidity in terms of dollars to do that. It was a substitute for gold, but it couldn't continue forever. When we say not continuing forever, we think of it as a crisis. It has to be a crisis. But in fact, it can be a slow bleed. That's my concern. If you look at the last five years and this change in attitude towards globalization, the change in terms of how the US is pictured by the rest of the world in terms of this, it's having its effect. If we continue with these… the printing of the money, the provision of liquidity to the rest of the world at a fast pace… in fact not only our current account but our national deficit, and we will slow growth.

Hoenig: I think those are the things that are now coming to reality. It's not that they missed the point, it's that we think of things instantly where, in fact, in economics it takes a lot of time. We're seeing the effects of that even now, slowly, but we're going to see the effects of that. We shouldn't forget that when we think about policy going forward, because we have many challenges ahead of us. We are going to see our debt grow dramatically over the next 10 years. No matter what we do now, it's going to grow. We can see that the effects on productivity are going to be a slower growth rate. The loss of real wealth over the next decade because of that is going to be substantial. It's not that we fall apart, it's that we bleed. We have a bleeder, and we need to be mindful of that. That's what I remind people. Don't get too comfortable. We are confronting some really major challenges, and we better think about it. The Congress better think about it. The Federal Reserve better start thinking about it because they're supposed to be the independent source of discipline. They are only now beginning to think about that, in my opinion.

Beckworth: In order for the Fed to be independent, we have to avoid fiscal dominance where the debt gets so big, the Fed is forced to support the solvency of the US government by keeping rates low. After World War II that's what the Fed did. It kept rates pegged low, and it did that until inflation began to take off. We had the big Fed-Treasury Accord, and they got their independence. That is the danger, that if inflation takes up off again, and rates stay high, and the debt burden continues to grow, we will be back with fiscal dominance, and then the Fed effectively becomes just an appendage of the US Treasury Department.

Hoenig: You have to have your independence, but you have to exercise your independence as well.

Beckworth: Let go to the most recent Jackson Hole conference that you got back from. The conference title was Structural Shifts in the Global Economy. Since we're talking about debt, let's jump in with a few of the papers, in particular, Barry Eichengreen's paper. It was titled, *Living with High Public Debt.* In it, he talked about how it's likely that we're going to be stuck with high levels of public debt going forward for at least the foreseeable future because it's unlikely that we are going to do what's necessary to bring it down. He said it's unlikely we're going to be running primary surpluses. Politically, it doesn't seem in the cards. R versus G, that calculation is not as favorable as it was past decade or two. Also, he doesn't think we can inflate away the debt. What were your thoughts on that paper, and how was it received at the conference?

Jackson Hole 2023: *Living With High Public Debt*

Hoenig: My thoughts are that it was an outstanding paper. Barry did a great job. He wasn't extreme. He just said, "Here are the facts folks, and here's what it comes to," as you've just described it. I thought he did an outstanding job. I think it was a downer for the audience but also a wake-up call to some. One of the participants-- this is all on the record-- Maya MacGuineas said, "This is exactly what I'm concerned about, and thank you for bringing it up. Now we have to find some solutions," which I hope she is taking back with her and thinking about at her organization, which is concerned about the deficit, moving forward. I think he just did a great job. No one really stood up and said, "No. You're a Luddite." No one said, "You're wrong." Everyone knows he's right. It was a little bit of a downer because there were no obvious solutions. He said, "This is going to grow. It's going to take real discipline.” And the fact is, we don't see it in the Congress that we have today in either house or in the administration. It was a pretty good sobering moment for all of us.

Beckworth: Fascinating to hear. We recently had Brian Riedl from the Manhattan Institute on the show. He's been a tax advisor, budget advisor for Republicans. He's really good with this issue. Something that really he made clear to me is that if you really want to rein in the long-run trajectory of debt, you have to make meaningful changes to Social Security and Medicare. There's just no way to get around that. He goes, "Even if you tax the rich at the most you can, and assuming there's no Laffer curve, it still wouldn't be enough to make up for the shortfall." He fears, or his expectation is, that we won't make these changes. What will happen will be more like we will have huge middle-class taxes, because the middle class is who can ultimately pay the bill. Instead of bringing changes to spending, it's going to be an increased tax on the middle class. As he points out, what that means is it will continue to be a transfer from younger generations to older generations unless there's some meaningful reform on entitlement. It's unlikely to see that change, I suppose, going forward, unless some crisis occurs.

Hoenig: I fear you're correct there. Number one, you're right, you could tax the wealthy 100% and you can't take care of this problem. It goes to the middle class, the next generation. He's absolutely right. No one will put the entitlements programs on the table. In fact, we're trying to expand them, as we talk here today, in some areas. You can't do that and solve this problem. You will weaken the middle class. The thing that bothers me is that the Congressional Budget Office has projected out the effects of this on growth over the next decade and the amount of loss we're going to have in terms of real wealth in this nation… and we ignore it as a nation. What that means is we're going to have greater social unrest as we go into the future. I think then the ability to come together will actually be weakened and more difficult at the time when it has to be stronger and applied systematically. In the context of shared sacrifice, we're not going to have that. That means social unrest, and instability, and crisis.

Beckworth: We're going to going to go from a bleeding victim to one who's in shock and in need of deep emergency care. The other point Brian brings out though, just to echo what you've said, is that that transfer from younger generations to older generations who, on average, are wealthier than the younger generations, that is going to drive that conflict. He said at least Europe has high middle-class taxes, but the middle class also gets benefits back. They proportionally get back what they pay in. I know we can't compare ourselves to Norway or to Sweden, very different systems, but he goes, "At least there, you get back something for what you're paying in. Here, if you're young, middle aged, and you're paying in taxes, and taxes have gone up on you, a lot of it's going to go to an older person,” which is, again, going to drive this tension you've talked about.

Beckworth: Let's go from Barry's paper to the other paper that I really enjoyed, and that's Darrell Duffie's paper. It was titled, *Resilience Redux in the US Treasury Market,* and then Jeremy Stein had some fascinating comments as well coming back to that. This is tied together because what Darrell brings out is that the main intermediaries, the main institutions we rely on to get the Treasury debt sold and out to the marketplace simply can't do their job anymore for two reasons. One we just talked about, the amount of the debt; the debt and the expectations continue to get large. They simply don't have balance sheet capacity to keep up with the amount of debt that's expected to grow. He had a fascinating chart showing the ratio of Treasuries to balance sheet capacities of primary dealers. It's blowing way up. In other words, there's far more debt than they can bear.

Beckworth: The other thing he brings out is just that the regulatory changes since 2008 have also restricted the amount of balance sheet space. They can't just bring on debt without funding with more capital. There's new requirements, Dodd-Frank. We'll come to these in a minute, Basel III, the supplemental leverage ratio, G-SIB scoring, all these things have made their balance sheets less flexible, I guess, is a term you could use. Where he ends up though, Darrell Duffie ends up, is we're going to need the Fed to respond more systematically or more often with these large-scale asset purchases when there are market crises. Because the primary dealers can't step in, we're going to need to rely on the Fed more. It's one of his implications.

Beckworth: Jeremy Stein comes back and says, “it would be nice if we could minimize that option. It would be better if we could tweak the supplemental leverage ratio so that reserves aren't this binding part that make the ratio a binding constraint on banks and also make better use of the standing repo facility.” In other words, expand the standing repo facility to more counterparties. So, Jeremy Stein was trying to find other options other than having the Fed always be the first option when we have market turmoil. What was your assessment of that discussion?

Evaluating the Fed as the Primary Treasury Market Backstop

Hoenig: Mostly, I thought it was wishful thinking. You have a problem and your solution is to eliminate the leverage ratio, which is the only constraint on issuing debt to the primary dealers apparently, and to have a standing repo facility, not just for banks, but for everyone out there. The problem is that we're issuing too much debt, we're spending too much money, we can't afford it, but the solution is to break down all the safeguards in place so that they can do all of this. And in my conversations offline, I guess you would call it, I've said, this is really dangerous. And so I imagine, first of all, the primary dealer in a crisis is not going to provide liquidity. I don't care what their balance sheet says. They run just like everyone else, and that's become clear. Now, not only that, though, because there's so much debt that the primary dealer can't absorb it, so you're going to have all of these others, the money market mutual funds and so forth, are going to hold this stuff. Now we're going to provide liquidity to them, unrestrained liquidity to them. That's the solution. Then, we're going to eliminate the leverage ratio.

Hoenig: What does that say about holding maturities? Treasuries that are underwater and half of Bank of America's capital is in unrealized losses on its balance sheet. That doesn't mean your system gets stronger, it means it gets weaker. Stop fooling around with it and address the problem. The problem is that we're spending too much money in this country and financing it by printing more money or borrowing more money. Right now, it's been printing more money, that's why we have this blowout, and still keep interest rates low. The effects are going to be very detrimental to the US economy in the long run. Why don't we wake up to that rather than… I understand the well-intention of these solutions, but they're not solutions. They're band-aids.

Beckworth: I hear you, Tom. But as the Barry Eichengreen paper that we just discussed said, it's unlikely we're going to get to the primary source of the problem. It seems unlikely we're going to have structural reforms to rein in spending and put debt on a more sustainable trajectory. Given that reality, and again, I don't want to be a defeatist here, but given that reality, I think I'm sympathetic to what Jeremy Stein is saying. Correct me if I'm wrong, but my understanding was, he's not saying completely eliminate the enhanced supplemental leverage ratio, simply tweak it so that reserves aren't a part of it. You can adjust the other pieces of the supplemental leverage ratio so that overall capital is still, in total sense, where it would otherwise be. You haven't reduced the capital cushion, you've just taken one of those assets, reserves, off of it.

Hoenig: You removed any constraint to blowing up the balance sheet of these large banks. That's what you've done. I don't think the Treasuries are risk-free. That's what the other side of it is. It’s not just [inaudible]. That's the other side of it. And in terms of market rate and interest rate risk, they're huge risks. If we weren't playing accounting games right now, these banks would be in huge trouble. The public knows that. That's why they run when it's Silicon Valley. It wasn't just because it had, shall we say, too much Treasuries. It's because they had unrealized losses and no liquidity. And so now, to take care of the problem, what has the Fed done? They have the term facility, which says, we will take your Treasuries that you are underwater on and we'll give you par for it, and we'll bail you out. We continue to grow the debt, we continue to enable the government to engage in bad policy, congratulations independent Fed. It's nonsense.

Beckworth: So, your point is, no matter what solution we take, whether it's Darrell Duffie's and his is, have the Fed intervene more and buy up securities when there's a crisis, more asset purchases, or it's Jeremy Stein's approach, tweak the supplemental leverage ratio, expand counterparties, the standing repo facility. Either way, it's the Fed having to do more, one form or the other, and that in turn is driven by the fact that we're creating more and more Treasury securities. Either the Fed needs to do more in some fashion, or you have got to reign in the amount of securities being created.

Hoenig: Correct, and remember what we mean by the Fed has to do more. Print more money to fund the government's debt. If the Fed stays to its commitment, which I would question, in terms of its quantitative tightening, we're going to see interest rates rise, and that's going to be the trigger that said, alright, we have got to do something about this. We'll see if the Fed sticks to its guns, which will be very difficult. I don't envy them that at all, or whether they start printing more money. Like you say, fiscal dominance is a true realized risk.

Beckworth: We've been dancing around banking and we've been touching on this issue. Let's go straight to it, Tom. Again, it's great to have you on because you were a former bank regulator at the Kansas City Fed for 17 years, I believe you said. Then you also were the Vice Chair of the FDIC from 2012 to 2018, so you have got banking in your blood. You bleed bank safety, bank regulations. Let's talk about it. Let's start with 2023, and the banking turmoil of March through April. We had Silvergate capital, Silicon Valley Bank (SVB), Signature Bank, and then First Republic, that all went under or were acquired. I want to get your assessment of why this happened. I know you've touched on it a bit, let's flesh it out a little bit more. What was the cause, was it the banks themselves? Was it regulatory failure? Was it bad macroeconomic policy by the Fed with their interest rates? How do you dice up the blame and attribute to this development?

The 2023 Banking Crisis and its Implications

Hoenig: All three. I will start with most crises, we all focus on the banking crisis when it occurs, but the seeds for the crisis are planted well in advance of that. I'll walk you through three of the experiences. I was in supervision in the '70s and '80s. I saw the Fed inflate until we had 14%. Then we had to clamp down. Paul Volcker comes in and clamps down, and what happens? We have a banking crisis. The stupid bankers, they say, because they took all of this risk, they caused the problem, so we have more regulations for the bankers. The fact of the matter is, they took the bait. You had inflation, asset values are only going to go up, so you made loans based on asset values. When the interest rates rose and the asset values shrank, the banks took the hit and the loss. We had a banking crisis and we blamed it on the bankers. I'm not sure that that's quite fair when we had bad policy for a decade that brought on the crisis.

Hoenig: Then we go and we have the great financial crisis. We lowered rates from 2001, 2002, all the way down to… it was above 5%, all the way down to 1%, and people were using their homes as ATMs. Greenspan even referred to that. They were refinancing at these lower interest rates, taking the money out, spending it, life was good. They increased their leverage, their debt. Bankers and the public took the bait, low interest rates. Then we got inflation started, went up to 3%, 4%, close to 5% and so the Fed, what did they do? The increased rates from 1% to 5.25% over the two-year period. 2006, they stopped. When did the crisis really blow up? Over two years later, [it was] called Lehman Brothers. And so, they blamed it on the bankers. They took the bait, low interest rates, do it. Get the loans out there. Housing is great. You can finance it forever. Interest rates are going to stay low forever. We had a crisis and we blamed it on the bankers. We get the Dodd-Frank.

Hoenig: Now we’re at today, what do we do? We have a pandemic. I understand we put money in there for the immediate crisis, but then we have the CARES Act. That was an immediate crisis. We had the Reconciliation Act in late 2020. That was another two trillion, so two trillion plus two trillion. Then we had the Recovery Act, another two trillion. Then the Fed, every month from March 2020 through 2020 and into 2021, printed money at the rate of $120 billion in new reserves every month. Interest rates were kept at zero and guess what? The banks took the bait. They were handed this, we have loans out at 3%. We have commercial real estate. We have Treasuries on people's balance sheets because they're risk-free, right? They're risk free, so they load up on that stuff. Suddenly, we have 9% inflation, and the Fed gets [inaudible]. They raise rates from 0% basically to 5.5% today in less than two years. So, in March, we have a banking crisis.

Hoenig: Now, I admit Silicon Valley managers were, I'd say, sub-standard, because they took the bait. Then, the others did as well, so we have a mini crisis. Guess what? Interest rates are still high and inflation, while it's come down, this month it went up to 3.7% and they're talking now about the core inflation coming down as a reason not to raise rates, but rates are still high. Commercial real estate's under real pressure, and it is dying on vine. As that happens, banks are what? What happens? Their capital is under risk. When the industry says that the too-big-to-fail banks are well-capitalized, they have a leverage ratio of 7%. If they lose 3% of that, we're going to have a liquidity crisis. For all of our talk about strong banks, given the amount of stress we're putting in the economy going from zero to 5.5% and maybe higher, we have more problems ahead of us. I remind people that we're a year and a half into the tightening phase. The great financial crisis was two years in the tightening phase, and then two years before the crisis really erupted. We're early in this process, folks. Get ready. We're just getting into it now. Now, I could be wrong. I have been in the past. I could tell you that, but if I am, I will be humbly willing to accept it, but I don't think so.

Beckworth: Wow, very sobering, very ominous. What you're saying is that the other shoe hasn't fallen yet, and that other shoe is going to be commercial real estate, the next big thing to break, probably, and that's going to break the banking system or the financial system. Monetary policy works with lags, and so we're only year and a half into this, so we may not have seen the end of the banking stress yet.

Hoenig: One of the benefits we have right now is not that the pandemic was a benefit, but unemployment is low, I agree. That should not be lost, and I think we have an economy that has remained stronger than people thought it would, but I tell people, of course it's stronger than you thought it would be. We put $8 trillion into the economy over what we were projecting to do in three years. God help us if it wasn’t strong. It doesn't make sense. Are we going to continue to print money and do this, so we have inflation and inflation takes care of the problem? I don't think so. I'm not at all saying that we're going to have a soft landing. I could be wrong, understood. I'm willing to accept that risk.

Beckworth: I appreciate your point about banks always being blamed. The business of banks is to take on interest rate risk. That's their business model, to take advantage of that spread. If they're being told from above, “this is what it's going to be…” In fact, I recall that it was in early 2022, if you looked at the Fed's own Summary of Economic Projections, they still had rates really low two or three years out, and forecasters, everyone did. If you're a banker making these decisions, you look ahead and you think, we've had low rates, they are telling us low rates, by God, it's going to be low rates, full steam ahead. It's on the liability side is where they got hammered, I think, more importantly. The asset side is understandable. It's the liability side where they maybe made bad decisions, who their depositors were. I like Steven Kelly's discussion of this. He talks about, "Look, the Fed's tightening, taking the foam off the top." Kind of, maybe, the worst behaved banks are the first ones you're going to see, so those that were servicing Silicon Valley. Some of these were also servicing the crypto industry. The ones that had the most froth were the ones to first go down.

Hoenig: And remember, if Silicon Valley would have had access to the term loans and lending that the Fed is now doing, it might not have failed. They had treasuries and mortgage-backed securities that were guaranteed, and they had concentrations in deposits perhaps, but they didn't have the credit risk. They didn't have the loan losses coming in by the bucket. They had interest rate risk that the Fed set them up for. They do get blamed for trusting the Fed to do what they said. Not having a good liability management program in place is management's fault. The supervision was actually out of the Fed's Board of Governors. It was faulty. All three went, but don't take away from the fact that bad monetary policy and fiscal policy is having its effects.

Beckworth: Briefly, I want to move on to the state of banking in the US in terms of recent developments from our Vice Chair, Michael Barr, and Basel III Endgame issues. Before we move on to that, Tom, one last point on this response to the turmoil in March and April, and that is the Fed's bank term funding program. You've already mentioned this, but it truly was an innovation or truly was unique in that it took collateral at face value or par value, as opposed to giving it some kind of haircut or discount. Is this a watershed moment? Is this something really big, or is this kind of a blip on the radar screen, we'll look back on and not think much of it?

Hoenig: It’s precedent-setting, because we're going to have crises in the future. What we're learning is, if the Fed just puts some money out there, you might be able to get through it better. What chairman is going to say, “no, I'm not going to do that?” So, I think it's precedent-setting and very important in terms of its longer-run implications and a threat to the Fed's independence in the long term.

Beckworth: Let's move to Vice Chair Michael Barr and his holistic review. He gave a speech on July 10th that brought together a number of threads, the Basel III Endgame. He talked about the enhanced supplemental leverage ratio, which he's not going to touch. He talked about changes to the stress tests, adjustments to the G-SIBs surcharge, the countercyclical buffer, no changes there, but maybe use it more in the future. Then today, even as we're recording this, we are recording on the 14th of September, but today there was a great article in The New York Times. I want to just draw from it. This article is titled, *Meet the Man Making Big Banks Tremble.* This is what it says, "Yelling at Michael Barr, the Federal Reserve's top banking regulator, has never been particularly effective, his friends and coworkers will tell you. That hasn't stopped America's biggest banks, their lobbying groups, and even his own colleagues who have reacted to his proposal to tighten and expand oversight of the nation's large lenders with a mix of incredulity and outrage. ‘There is no justification for significant increases in capital of the largest US banks,’ Kevin Fromer, the President of the Financial Services Forum, said in a statement after regulators released the draft rules spearheaded by Mr. Barr. The proposal would push up the amount of easy access money that banks need to have at the ready, potentially cutting into their profits."

Beckworth: "Even before its release, rumors of what the draft contained triggered a lobbying blitz. Bank of America's lobbyists and those affiliated with banks including BNP Paribas, HSBC and TD Bank, descended on Capitol Hill. Lawmakers sent worried letters to the Fed, and peppered its officials with questions about what the proposal would contain." Let me go ahead and just jump down here to what, actually, the proposal is. It says, "For the eight largest banks, the new proposal could raise capital requirements to about 14% on average, from about 12% now, and for banks with more than $100 billion in assets, it would strengthen oversight in a push that has been galvanized by the implosion of Silicon Valley Bank in March. Lenders of its size faced less oversight because they were not viewed as a huge risk to the banking system if they collapsed. The bank’s implosion required a sweeping government intervention, proving the theory wrong." So, more capital for large banks, more for those medium-sized banks, and a big reaction from the banking industry. Walk us through that, and maybe tie this all into the Basel III Endgame. What is the Basel III Endgame, and how is this tied to that?

The Basel III Endgame and Risk-Weighted Capital Regulation

Hoenig: David, how do I do this? I have absolutely no use for the risk-weighted capital program at all. It is misleading. Let me give you an example. You quoted the G-SIBs, the largest banks, have 12% capital now. They may have to go to 14%, of what? 14% of what? Risk-weighted assets, not total assets. It's much smaller than the 12 to 14 would have you believe. That's number one. On average, what is their basic equity, tangible equity to total assets? Not supplemental leveraging, basic equity to total assets. It's 7%. It's not 14%, it's 7%. They manage their balance sheet. I said yesterday, the Basel capital rules are not rules, they're a game to be played, and the largest banks are master chess players at that. This is what they get, and I've watched some of the hearing today on the issue of the Basel III Endgame. It was all based on risk-weighted.

Hoenig: I criticize the Fed for continuing to promote the risk-weighted system that doesn't work. It didn't stop the first crisis, it didn't stop the second crisis, and it hadn't stopped the third crisis. In fact, it's misled people. Because, what the investor wants to know, and I've talked to many of the investors, they would say, I want to know what its tangible capital is to its assets. I know then how much loss they can handle before we have a problem, a liquidity problem. At 7%, and I lose… not 7%, that means you're insolvent, I lose 3% of that, I have a liquidity problem, then I have a solvency problem. I'm saying to them, abandon that. Michael Barr, I understand you want to raise the capital, but do it in a straightforward manner, say, 7%. Now, here's the other thing. I'm told, based on that 14%, that the largest banks are the best capitalized of any of the groups of banks. Then I go and I calculate, well, how much equity do the regional banks have relative to their assets? Oh, they have 8% to 9%. Actually, over 9% on average. Oh, how about the smaller regionals? Well, they have more than 9%. How about the communites? They have over 10%.

Hoenig: The most systemically important has the lowest equity to their assets than any of the other groups. We say, “oh, they're so well capitalized.” That's what I mean by mislead. I argue, yes, you need more capital, you need quite a bit more capital. Academics show you that, history tells you that, and yet we ignore it. We get into these hearings and these esoteric conversations about Basel III Endgame, which says, we're going to change the weights. We're not going to let you do your internal models, which we think you cheat at. Which, I wouldn't blame them if they did. They're there to increase their leverage. So you say, let's look at that. They're not going to let them use an internal model, and they gave them a standardized model, which I cannot understand. It is a three-system equation, it is impossible. Does a bank board member really understand risk-weighted capital? They're the ones responsible. Do they understand it? Does the CEO really understand?

Beckworth: Probably not.

Hoenig: Why don't we just go to the leverage ratio? Now, I don't mind arguing over what's the right number of leverage. Then you use the stress test to say, well, you're a higher risk. Go, we have the stress on you, you might have to have a higher leverage ratio. That's fine. But, risk-weighted, when your assets are shrunk, what other industry, for reporting purposes, can shrink their balance sheet by half, and get away with it? There is none. My point is, get the measurement right, if that's what you're going to rely on, and then get the supervision right, and the management. I was asking at one of the hearings, have you ever known a bank that's well-managed, well-capitalized, and well-supervised, that’s failed? No, but I know a lot of banks that were poorly managed, poorly supervised, and badly capitalized that have failed. So, why don't we get it right? We're arguing over a concept that no one understands. Maybe a few in Basel, maybe a few at the Fed, but now what have we done? We've created an infrastructure around risk-weighted capital that is huge. Risk-weighted capital costs us hundreds of millions of dollars a year in resources. To do what? To fool the public. What a crime.

Beckworth: I read somewhere that the Basel III regulations are in the thousands of pages. Only a few people probably do know what's in all of those. Now let me just go back briefly to the motivation for risk-weighted regulation. The idea is that some assets are safer than others, therefore we should proportionally assign risk. I think the counterargument, correct me if I'm wrong, is that when you're in a crisis, all assets become risky. There's a correlation… if there's a run, there’s a run, and every asset class becomes risky. There is no safe versus risky asset. Is that the concern?

Hoenig: Yes. I'll give you a little history on it. I was part of the original group on Basel I. Let me tell you, the reason that they went to that is to try and get international agreement because the Japanese banks were so leveraged. They had so little capital that they were required to hold that they were able to outprice US banks in a global situation. They said, “we'll get everyone together, we'll do this risk-weighted analysis.” It took years, actually, to get the agreements in place. It was a simple method, loans are this much, and so forth. Then people said, “wait a minute, this maybe a good idea here from the industry side.”

Hoenig: Then we went to Basel II, and that's when we got increasingly complicated, and we shrunk the balance sheets even more. I'll give you an example, and I won't pick an American bank. I'll pick a foreign bank, Deutsche Bank. Even after the great financial crisis, in public data, they had a risk-weighted capital ratio of around, I'm going to say, 11%, and their leverage ratio was 1.7%. So, you see what's happening? That's my concern with it. That's the history. It was there to try and get banks to raise their capital, and it became something that allowed them to game the system and leverage themselves even more or more freely, I should say. Those are the sorts of things that we tend to forget so often.

Beckworth: This will be something to watch going forward, especially if that other shoe is to fall, as you suggested, and what effect, if any, will Basel III have? I guess Basel III, the Endgame, it’s still… it's just being proposed. It hasn't actually been implemented yet. Is that right?

Hoenig: Look, from my point of view, I understand the industry and I understand… I think the vote of the board was four to two, two against. Powell said that he thought that he had problems with it, but he wanted to have it out for comments, so he could learn. There's not unanimous agreement even there, but Basel Endgame is incredibly complicated. It's 1,000 pages, 500 of it is just basic explanation, and 500 of it is… it’s putting it out there and explaining the complications. It is an unfortunate proposal to put forward. I think part of it was that we had this crisis in March, and I will tell you something about bank supervision, is very pro-cyclical. You had this crisis, they've been talking about capital for about a year. Suddenly, it's become important, and they put it out. And then, the hearing today was, you didn't explain anything here. You didn't really give us any data. You didn't really do any cost-benefit. You didn't do this. Well, that's probably right. That's why it's being challenged with some justification.

Beckworth: Well, with that, our time is up. Our guest today has been Tom Hoenig. Tom, thank you once again for coming on the program.

Hoenig: Happy to be here. Thank you for having me, David. I appreciate it.

Photo by Saul Loeb via Getty Images