As part of his farewell tour, Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, has candidly addressed the effect of prudential standards and regulatory initiatives on big bank bailouts.

Hoenig, after six years with the FDIC, will be stepping down from the post. But he is not going quietly. In a March 28 speech delivered to the Peterson Institute for International Economics in Washington, D.C., he discussed the idea of “Finding the Right Balance” when it comes to the push-pull of regulation and de-regulation versus prudential standard-setting.

He began by offering a history lesson, one that goes back to what might possibly be the start of the “Too Big to Fail” regulatory conundrum.

Over Fourth of July weekend in 1982, he was the officer in charge of lending at the Federal Reserve Bank of Kansas City. The week began with a phone call from a panicked banker with a serious liquidity problem.

The bank’s funding sources, mostly deposits and upstream purchasers of its energy loans, had lost confidence. Lines formed outside the bank as depositors demanded their money back, having heard rumors that the institution was in trouble. The Federal Reserve bank provided some replacement funding, an effort to buy time, determine whether the bank was solvent and, if so, whether it had sufficient collateral to lend against.

“Ultimately, the bank, Penn Square National Bank, met neither test,” Hoenig said. “It had too little capital and its assets were too distressed to offer any hope of survival. The bank was closed that holiday weekend.”

The story didn’t end there. Penn Square’s failure, because of its relationships and obligations to other institutions, contributed to the largest bank failure in U.S. history at the time with the collapse of Continental Illinois National Bank. At the time, it was the fifth-largest U.S. bank.

“Because numerous creditors would have taken significant losses if it had failed, regulators chose to bail it out,” Hoenig said. Thus began “Too Big to Fail” as a policy option in the United States.

The story, he said, “illustrates just how little has changed over the past almost 40 years.”

Events since then have included the S&L crisis, the Mexican Peso crisis, the Asian financial crisis, the Russian financial crisis, the Great Recession, and the Greek sovereign debt crisis. “Each crisis has its own personality, but what is often ignored is that the fundamental elements almost never change,” Hoenig said. They include “a significant change in monetary policy—a crucial but inherently blunt instrument with far-reaching effects; a significant ramping up of leveraged assets; and management that displays a degree of confidence that repeatedly proves unjustified.”

“On the other side, they too often include supervisors who lack the confidence or are so convinced of management’s talents that they fail to challenge questionable executive behavior,” he added.

Another common element, he said, is the aftermath, in which new laws and regulations are enacted with the intent to prevent new crises. “But memories are short and with an improving economy, these laws and regulations—which early in the recovery are viewed as essential—are eventually recast as burdensome constraints that need to be eased or ended.”

“And here we are again,” Hoenig lamented. “After years of slow recovery, the U.S. economy is booming and the call for regulatory relief is loud. This is the case despite changing monetary policy, increasingly volatile markets, increasing economic leverage, and changing risk profiles of some of our largest institutions.”

As he steps away from his role at the FDIC, Hoenig took the opportunity “to outline an approach for providing meaningful regulatory relief without undermining the goal of assuring sound banking.”

The goal, he said, is to ensure that financial markets face “proven prudential standards that are enforced rigorously and complied with consistently.”

These standards, in his estimation, include strong capital and “wise constraints” on a bank’s reliance on the government’s safety net. “With such a foundation in place, a number of costly administrative rules that create burden with little benefit can be removed or minimized.”

“As bank profits have grown, so has their appetite for risk and their dislike for regulations that constrain that appetite, Hoenig added. “They also are frustrated with rules that impose thousands of pages of administrative processes and unproductive costs onto their operations. The challenge is to eliminate those rules that impose a real administrative burden from those that set performance standards that allow properly gauged and priced risks onto the balance sheet.”

In his assessment, the former rules create needless barriers to bank competition and fall disproportionately on the different segments of the industry, while long-proven prudential standards promote responsible performance and are key to meaningful deregulation.

 “In circumstances like that lenders must pull back, liquidity dissipates at an accelerating pace, and fear gathers momentum. The magnitude of the shock spills over into the broader economy where it can severely affect Main Street,” he said. “It is not credible to base public policy on the assumption that unrestrained leverage accelerates economic growth without serious consequences for which ownership, not the public, should be accountable.”

Hoenig cautioned against “eroding the post-crisis capital standards that have contributed to the strength of U.S. banks” and their long-awaited recovery. Weakening these standards will undermine the long-term resilience of not only the banking system, but the broader economy as well.

For example, reducing the capital requirements of the most systemically important banks by excluding central bank reserves from the supplemental leverage ratio “is a serious policy mistake” he said. Measures on the table to do so would excuse primarily the custody bank business model from holding as much capital per assets as all other banks, he warned, adding that custody banks are integral to the financial system, highly interconnected to the capital markets, and relied upon as safe havens in times of stress.

Another concern: the U.S. regulatory agencies have joined the recent Basel Committee agreement that, according to some estimates, could remove as much as $145 billion of capital from the eight largest banking firms. “This is counterproductive,” Hoenig said. “Should the U.S. banking agencies embrace the Basel standard, the reduction in private capital would necessarily be underwritten by the FDIC, the Federal Reserve, and then the taxpayer.”

As an example, one bank that received more than $100 billion dollars of capital and liquidity support in the last financial crisis would be free to reduce its capital by 30 percent under the new Basel accord. “The United States should not engage in this race to the bottom,” he said.

No review of post-Crisis banking regulations would be complete without a look at the Volcker rule, a Dodd-Frank Act ban on proprietary trading by federally insured deposit institutions.

Limiting the use of deposit insurance to fund speculative trading and related activities, the goal of the rule, should not be compromised for any group of banks. “With that said, the application of the Volcker Rule can be greatly simplified,” Hoenig said.

Commercial banks should be free to enter into swaps and other derivatives to accommodate loan customers or hedge their own risks, he suggested. They should be free to buy and sell government securities and manage their day-to-day liquidity needs.

“I suggest such activities be entitled to a presumption of compliance with zero additional reporting requirements, unless compelling evidence to the contrary is identified during the normal supervisory process,” he said. “With meaningful reporting relief in effect the burden would be eased, so rather than carve out exceptions, the Volcker rule should continue to apply to all banks that benefit from deposit insurance.”

For the largest banks that engage in market making and trading, there should be the additional requirement that their CEOs attest in their confidence that procedures are in place and tested to assure compliance, he said.

The living will process developed for endangered banks by legislators and regulators “is cumbersome, political, and misleading,” Hoenig said, moving onto another crucial topic. Annual preparation is costly to both banks and regulators, he said, “but provides little new information as it is submitted and resubmitted each year.”

Most of what is learned is available through the examination process and the annual stress test. Eliminating or extending the reporting cycle would reduce bank and regulatory costs with access to information no less available, he proposed.

The living will process may also have the unintended result of institutionalizing Too Big to Fail, Hoenig warned.

With encouragement from regulators, the largest banking firms have adopted single point of entry as a resolution strategy. This assumes that operating companies remain open through a crisis. Should it be necessary, these companies will have creditors, in the form of Total Loss-Absorbing Capacity, to recapitalize the banks and, if needed, they will have access to liquidity from the Treasury.

“However, this approach also has the effect of signaling that creditors of operating units will be able to get out of their position, which effectively is a bailout,” he said. “The largest banking firms should be subject to bankruptcy, but the evidence suggests that the living will is unlikely to achieve that goal.”

“The point is that the imposition of administrative rules and regulations that substitute for long-tested and more reliable prudential standards is a poor tradeoff,” he added. “We can do with far fewer rules if we have a clear expectation that private ownership and substantial private capital, not taxpayer funding, will minimize the likelihood of crisis and its effects should it occur.”

Hoenig’s conclusion: “Prudential standards strengthen performance, while administrative procedural rules raise new barriers, increase costs, and discriminate against banks that are less able to absorb those costs.”

“I suspect we will always have a Federal Reserve Bank loan officer getting that dreaded phone call, where the banker on the other end is desperate for help in addressing a liquidity crisis,” he added. “But I would prefer it be less often than in recent years and from an institution that really only needs help with liquidity, not with solvency and a bailout.”

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