Former FDIC Chair on How to Build a Better Financial System

Sheila Bair had a front-row seat to the financial crisis as the chairwoman of the FDIC from 2006 to 2011. She gave a talk at the CFA Annual Conference in Seattle on Monday. Following are my notes, lightly edited for clarity. 

On Canada's financial system: They have never had a banking crisis. It's a truly phenomenal record. And I think there are a couple of things that Canadians do better than we do. One is their political system. As I understand it, they have a $1,000 cap on anybody making a political contribution. Whether we want to admit it or not, a lot of the lax regulation, and lapse in regulation, that we saw leading up to the crisis came from political pressure to stupid laws, like the Commodities Futures Modernization Act, which basically told everybody at the federal level that you can't regulate derivatives. So, in Canada there's less influence in the regulatory process. I think there's also a healthier attitude toward regulation. There's more of a sense among regulated institutions in Canada to try to work with regulators. Here, there's this adversarial relationship, which I think is quite harmful.  

On FDIC insurance creating moral hazard: There are a couple of heartbreaking stories from the financial crisis. I remember at IndyMac Bank, there was a policewoman who had just sold her house, and had the proceeds of her house sale in the bank, thinking it was only going to be there for a few days. [Then IndyMac failed], and she took about a $50,000 loss, which is a lot of money for a policewoman. For that to happen while we were bailing out the bondholders [of other banks] I think was really quite troubling. 

People like that, you're not going to get a lot of market discipline. She's not going to come home from work and download the bank's annual report and figure out how risky that bank is. They don't have the time or the background to do that. You get market discipline with bondholders, because they do have the background and the resources to analyze banks [and] figure out how risky they are. 

On how to become a better bank investor: Don't just look at assets. Look at liabilities. This was a big problem for regulators, too. Our bank examiners were in there looking at the asset quality of banks, but they weren't looking at the liability structure. [Some of the biggest banks] had far too much reliance on wholesale short-term funding and little understanding of how that was going to perform when the markets turned. There were a lot of things banks were counting as capital that were really debt instruments, like trust preferred securities. In my experience, the only thing [that] matters is tangible common equity during a crisis. 

Also, compare capital to non-risk-weighted assets. Regulators rely far too my on risk-weighted assets to determine how well capitalized a bank is. There's a lot of gamesmanship, and frankly some political calculus, that goes into how regulators determine what is risky and what isn't. So look at tangible common equity in relation to to total non-risk-weighted assets. 

Can analyst really analyze something as complicated as a big bank?: I think there were some obvious risks [before the financial crisis] and obvious warning signs. But I sympathize. I think both our accounting rules and our regulatory rules for defining capital are far too complex. And complexity leads to people making mistakes. The accounting rules are frankly kind of dumb. You know, your credit quality deteriorates, and because theoretically you can buy your debt back at cheaper rates, banks get to book a gain. The counterintuity, but also the hyper-complexity, of the capital rules makes it very difficult. 

Don't invest in JPMorgan Chase , or Citigroup , or whoever, if you can't understand their derivatives book, or if you can't identify what their exposure is. Just don't invest, or invest only at a very, very steep premium. Because that, I think, can be more immediate at creating market discipline. That is what market discipline is all about. Find other investments with an understandable business model and product. When the information is so complex, and you can't understand the risk, don't invest. 

On huge banks: Analysts have done some really interesting studies of shareholder returns prior to the crisis. Well-managed regional banks that pretty much stuck to the commercial banking model of taking on deposits and making loans, even in the go-go years, performed better than the megainstitutions. I think that's because whatever perceived benefits of economies of scale for the large banks are not proven. You get inefficiencies and management challenges, because being a commercial bank is very different from being a derivatives market-maker, and being a market-maker is very different from being a traditional investment bank, or insurance -- they are all completely different businesses. So trying to manage all those different business lines from the top of the house is too challenging even for the best management. Returns become depressed because management just can't stay on top of all that, the way they can if they have more specialized entities. 

When we were dealing with Citigroup, we had authority over the banking division of the company. But the legal structure of the company was so complicated we joked that we couldn't find the bank. 

Shareholders of Citigroup and JPMorgan have been agitating for the boards to do a break-up analysis. Just try to figure it out: Are you worth more in pieces than you are in one big blob? I think it would be good for boards to respond to that. It would educate us all. 

I'll have more from the CFA Conference this week. 


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Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Motley Fool recommends Bank of America and owns shares of Bank of America and Citigroup. The Motley Fool has a disclosure policy.

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