In a long speech William Dudley, President of the New York Federal Reserve, addressed his economic outlook and the lessons learned for last year’s financial crisis. I present key excerpts from the speech about the lessons learned below as well as my assessment of them. However, the speech is worth reading in its entirety and can be found here.

This is part 2 of my notes on this speech. Click here for my commentary on the first part.

“We are also exploring the potential for contingent capital. The goal is to bolster the amount of common equity available to absorb losses in adverse economic environments. This might be done by allowing the issuance of debt instruments that would automatically convert into common equity in stress environments, under certain pre-specified conditions.

“Such instruments might have proven very helpful had they been in place before and during this crisis. Investors would have anticipated that common equity would be replenished automatically if a firm came under stress, and this knowledge might in turn have tempered anxieties about counterparty risk. At a minimum, contingent capital instruments might have enabled common equity buffers at the weaker firms to be replenished earlier and automatically, thereby reducing uncertainty and the risk of failure.”

Seems like a reasonable compromise allowing for equity upside during the good times, but with the threat of dilution automatically if things start to go sour. Think of them as convertible bonds with automatic triggers tied to the balance sheet. It would be easier to raise such capital before a crisis than during one.

“There are many details that still need to be worked out to determine the potential for contingent capital instruments to enhance financial stability. For example, what are the circumstances under which conversion is triggered? How much common equity do debt holders receive upon conversion?

“However, our early work on this issue suggests that contingent capital may be a promising mechanism for injecting common equity into the banking system in times of stress without unduly raising intermediation costs or pushing financial activity out of the banking sector into the unregulated sector.”

That is a significant problem — the unregulated sector. I would contend that perhaps it would be a good idea to have fewer unregulated parts of the financial system. International coordination would have to be key in that regard.

The other issues sound like they would be issue and issuer specific and the sorts of things that are addressed it the prospectus of any security. It is supposedly what the investment bankers earn the big bucks figuring out. Perhaps each institution could have several layers of such contingent capital, so in a relatively minor crisis, only the first or second layers are triggered, but more layers get triggered in more severe crises.

“On the liquidity front, there are a host of initiatives underway. For starters, the Federal Reserve is now supervising most of the holding companies of the systemically important financial institutions. That was not true at the start of the crisis. So, for example, the holding companies of Goldman Sachs (GS), Morgan Stanley (MS) and Merrill Lynch, which is now a subsidiary of Bank of America (BAC), are now under our direct supervision. We are making sure that they have appropriate liquidity buffers and capital.

“Second, the Federal Reserve is working with a broad range of private sector participants, including dealers, clearing banks and tri-party repo investors to dramatically reduce the structural instability of the financial system utilities, such as the tri-party repo system.

“Third, the Basel Committee is working on establishing international standards for liquidity requirements. There are two parts to this. The first is a requirement for a short-term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. The second is a liquidity standard that limits the degree of permissible maturity transformation — that is, the amount of short-term borrowing allowed to be used in the funding of long-term illiquid assets. Under these standards, a firm’s holdings of illiquid long-term assets would need to be funded mainly by equity or long-term debt.”

Mismatches between long-term assets and short-term liabilities can always create problems, but it is also a big part of the economic function of banks. Banks make most of their money (at least traditionally) by borrowing at low interest rates for short-term money (checking deposits for example) and lending at high rates long-term (a 30-year mortgage, for example).

“There is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk-taking. This issue of compensation is obviously a hugely potent one, as there is a fundamental unfairness in what has happened over the past few years.

“The actions taken by the Federal Reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. Many of those financial institutions are now prospering, and many of their employees will be highly compensated. This situation is unfair on its face. But it is even more galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet.

“Despite the fundamental unfairness of the situation, I don’t think it is feasible or practical for the Federal Reserve, or any other supervisory entity, to attempt to determine the level of compensation at individual firms on an ongoing basis. A better approach is for supervisors to ensure that a firm’s compensation regime is consistent with an institution’s safety and soundness and with broader financial stability.

“That can and should have important implications for the level of individual compensation. For example, a trader should not be paid solely on the basis of this year’s accounting profits if those profits are based on the valuation of illiquid assets held on the bank’s books that could easily go down considerably in value before they are liquidated.”

I agree that that level of micro-management is not appropriate. However, the Fed and other regulators should be able to make sure that there are not perverse incentives for bankers to take on too much risk by setting up “heads I win, tails I break even and someone else loses” compensation structures. As far as the overall level of pay is concerned, a progressive income tax is probably the best tool in that regard.

“The Fed is in the process of implementing a framework that will embed compensation practices more deeply into the supervisory process. We have made it clear to the major banks and dealers that 2009 compensation should be consistent with the recently developed Financial Stability Board principles on compensation, which emphasize the importance of appropriate incentives.

“Finally, there is considerable work underway on the ‘too big to fail’ problem. On this front, there are two main strands of work. First, we must improve the resolution mechanisms for large complex bank holding companies and nonbank financial firms that become troubled, and to complement that initiative with efforts to strengthen the financial market infrastructure. If regulators had at their disposal an effective resolution mechanism for large financial firms and the financial system was made more resilient to shocks, then the number of firms that were indeed ‘too big to fail’ would be significantly reduced.

“Second, after building such a resolution mechanism, we must still act to ensure that no special advantage persists from being perceived by creditors, counterparties and investors as ‘too big to fail.’ After all, it will be hard to build a resolution mechanism that credibly ensures that any firm will be allowed to fail under any circumstance. If there is a chance that a firm may be too big to fail, then there should be an explicit quid pro quo for that status in the form of higher capital and liquidity requirements. For example, contingent capital could be made a part of any additional regulatory capital requirements for ‘too-big-to-fail’ firms.”

The real solution to “too big to fail” is that if a firm becomes that big it really is too big to exist. Tax-free spin-offs to shareholders would be the fairest way of going about this. I would in particular like to see a return to something more like the Glass-Steagall Act, which separated commercial banks from investment banks.

However, the crisis moved us 180 degrees in the other direction as J.P. Morgan (JPM) ended up owning Bear Stearns and Bank of America ended up with Merrill Lynch. Unscrambling that egg will be tough to do. Having a resolution mechanism for such institutions is critical, so there is some path between paying everyone off at 110 cents on the dollar (for example, what happened with the AIG [AIG] counter-parties) and letting the institution collapse.

“As I have discussed, we are moving forcefully to make the system more robust and resilient. While at times the criticism of the Federal Reserve and other regulators has been on target, at other times I believe it has been off the mark. For example, the Federal Reserve has been singled out for criticism about the failures of supervision even though it did not have any regulatory responsibility for many of the largest U.S. financial firms that collapsed during the crisis.

“Turning now to another difficult issue, it is deeply offensive to Americans, including me, and runs counter to basic notions of justice and fairness, that some of the very same individuals and financial firms that precipitated this crisis have also benefited directly from the response to the crisis. This has occurred at the same time that many Americans have lost their jobs and hard-earned savings.

“The public outrage this situation has produced is understandable. In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefitted from our intervention.

“In a perfect world, we would be able to prevent those individuals and institutions from benefitting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.”

The bailout had to happen — the consequences of not doing so would have been too painful to contemplate. However, just as the central bank can be the lender of last resort, on sound collateral at a penalty rate if the Treasury must be an investor of last resort, it should be so on very onerous financial terms. That did not happen at all.

The Treasury should have gotten terms that were at least as good as private investors at the time were getting. Berkshire Hathaway (BRK.A, BRK.B) got twice the interest rate, and much more valuable warrants than did the Treasury Department when both invested in Goldman Sachs at roughly the same time.

It is good that we are going to lose less than we thought we would on the TARP program. But I wanted the taxpayers to make a bundle on the deal. After all, we took a lot of risk.

“The Great Depression represents an important example of the consequences of inaction. Recall that during the Great Depression the unemployment rate rose to 24 percent. It is generally accepted that the authorities at that time, by not responding sooner and more forcefully, contributed greatly to the severity and duration of the Great Depression.

“In contrast, during this crisis, the Fed and other agencies acted much more aggressively to ward off a total collapse of our financial system — liquidity was restored to markets and the banking system was recapitalized much more quickly. These aggressive actions helped to prevent the type of deep and protracted crisis that occurred during the 1930s.

“Going forward, the Federal Reserve and other regulators need to move aggressively to change the system so we don’t ever find ourselves in this position again. We need to improve our ability to identify catalysts for potential crises, whether those catalysts manifest themselves in the form of asset price bubbles or reside elsewhere. Perhaps most critical among the challenges facing policymakers and lawmakers is how to ensure that we have a more effective regulatory structure going forward.

“This is a complex subject that I do not have time to do justice here tonight. However, I believe it is important to explain why the Federal Reserve’s monetary policy, lender of last resort and supervisory functions should remain in place. These functions are interrelated so that the execution of one of these responsibilities helps the Federal Reserve in its conduct of the others.

“For example, consider the Fed’s ‘lender of last resort’ function. For the Fed to perform this role effectively, it is important that it have first-hand knowledge about banks, the capital markets, and payment and settlement systems. To perform this role safely, it must know its borrowers, which is why a supervisory role is essential.

“Put simply, if supervisory and other financial oversight responsibilities were taken from the Fed, it would make it more difficult for us to perform our lender of last resort function. To do that well and safely, it is important that we understand banks, the financial system and all its interconnections.

“One instructive example in this context is the Northern Rock experience in the United Kingdom, where banking supervision and the ‘lender of last resort’ functions were separated. Many have concluded that this separation led to coordination problems that delayed intervention and significantly exacerbated the crisis. The experience with Northern Rock is a cautionary lesson about the potential costs of separating banking oversight from the lender of last resort function.

“A similar argument applies to monetary policy. In the conduct of monetary policy, it is important to understand how changes in the federal funds rate or the interest rate on excess reserves affect financial conditions. A detailed understanding of banks, capital markets and payment and settlement systems is essential to properly understand the linkage between monetary policy, the financial system, and the real economy.

“In other words, if you take away the Fed’s oversight of the financial system, the ability of the Fed policymakers to understand how their actions are going to affect financial conditions and the economy will be impaired. The economy will suffer as a consequence.”

Yeah, understanding what you are doing — both in monetary policy and in bank supervision — is a good thing. The Fed probably is the best-positioned institution to deal with issues of systemic risk, and I think having the responsibility in one institution makes more sense than forming a committee to deal with the issue.

There was much more to the speech, and would encourage people to read it in full. Dudley’s ideas on limiting leverage and leverage being a proxy for bubble formation are interesting and should be carefully considered. The details on the contingent capital need to be fleshed out more, but are a worthwhile idea. All in all, an interesting speech.
 
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.
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