Financial Reform Destined To Fail, Top Federal Reserve Official Says

WASHINGTON -- Reforms instituted after the financial crisis to prevent future taxpayer-funded bailouts are bound to fail and will likely be weakened within the next few years, the Federal Reserve's longest-serving policy maker predicted Monday.

The stark warning, offered by Federal Reserve Bank of Kansas City President Thomas Hoenig, who's been warning about the rise of too-big-to-fail banks for more than a decade, comes as international regulators finalize plans to increase supervision of and toughen requirements on the world's largest banking organizations as a reaction to the global financial crisis. Rather than break up big banks, politicians decided to simply subject them to more oversight.

Yet debate rages as to whether the requirements are too tough, or not tough at all, and whether regulators will have the backbone to follow through on their commitments. Republicans in the U.S. House of Representatives are trying to dismantle the domestic financial reform law passed last year; banks are screaming that lending will dry up, inhibiting the anemic U.S. recovery; and on the global level, regulators from some countries where large banks dominate the national economy (and thus enjoy overt taxpayer backing) are trying to weaken international accords.

For Hoenig though, the choice is clear when it comes to what to do with the financial institutions that caused the most punishing downturn since the Great Depression: break them up into pieces that regulators can understand and provide a backstop to entities engaged in the so-called real economy -- but allow those dabbling in more risk-laden activities to fail.

The Obama administration and Congress chose the alternate route in passing the Dodd-Frank financial regulation law. To Hoenig, they made a mistake.

"Following this financial crisis, Congress and the administration turned to the work of repair and reform," he said during a Monday speech in Washington. "Once again, the American public got the standard remedies -- more and increasingly complex regulation and supervision."

"The Dodd-Frank reforms have all been introduced before, but financial markets skirted them," he continued. "Supervisory authority existed, but it was used lightly because of political pressure and the misperceptions that free markets, with generous public support, could self-regulate."

Regulators will lack the will to wind down failing companies deemed systemically important financial institutions, or SIFIs, Hoenig said. The power to force large firms into liquidation was the centerpiece of the Obama administration's plan to reform the financial system in the wake of the crisis and Great Recession.

"I just can't imagine it working," Hoenig said. Speaking of the difficulty of forcing a large, complex firm like Citigroup or Goldman Sachs into bankruptcy-like proceedings, the Midwesterner admitted that if he were the one ultimately making the decision, "I would be inclined to bail them out."

"One of the difficulties in terms of supervision of these SIFIs is they are so horribly complex their directors don't understand it, their management don't understand it, and the supervisors certainly can't deal with all the issues," Hoenig said.

The second part of the administration's plan -- forcing large financial firms to hold more capital as a buffer against the kind of debilitating losses that led policy makers to bail them out -- also will inevitably come up short, as bankers will likely game the system once the economy rebounds.

An international consortium of bank regulators hammered out an agreement over the weekend that requires the world's biggest banks to hold extra capital beyond the requirements faced by their smaller international competitors. SIFIs would be required to hold up to 2.5 percentage points of extra capital as a proportion of their risk-weighted assets, for a total buffer of 9.5 percent.

"I don't have any faith in it at all," Hoenig said in response to a question at an event hosted by the Pew Financial Reform Project and New York University Stern School of Business. "It will be co-opted within three years of the recovery."

"The resistance ... is ferocious," Hoenig said of the banking industry's objections. "Once the economy turns around and these institutions are thought to be sound again, we will start to erode these capital requirements, just as we have in every instance in the past."

Bankers argue that increased capital requirements will impede lending, though academic research tends to refute that assertion. "It's almost propaganda," Hoenig said of bankers' reasons for objecting to tougher standards.

Proponents of the measure say bankers are simply objecting because the more capital firms are forced to hold, the lower their earnings will be in relation to their equity. U.S. bankers say they'll be at a disadvantage relative to their foreign counterparts. Hoenig called that assertion "nonsense."

Others argue that bankers are simply concerned about their bonuses, as shareholders will likely call for lower pay packages as a result of lower earnings.

SIFIs must be broken up and simplified, Hoenig said, not just to avoid the inevitable weakening of standards and reemergence of timid regulators, but also because they're un-American.

"I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism," Hoenig said. "They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril."

Hoenig, who became president of the Kansas City Fed in 1991, will step down this October due to the Fed's mandatory retirement policy.

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Shahien Nasiripour is a senior business reporter for The Huffington Post. You can send him an email; bookmark his page; subscribe to his RSS feed; follow him on Twitter; friend him on Facebook; become a fan; and/or get e-mail alerts when he reports the latest news. He can be reached at 1+917-267-2335.