Contra Randal Quarles

Donald Trump has nominated Randal Quarles as the Federal Reserve's Vice Chairman for Supervision. This is a position that really matters. As Ryan Tracy wrote in the July 28, 2017 Wall Street Journal article "Meet Randal Quarles, Trump’s Pick to Shake Up the Fed," 

Mr. Quarles, who would be President Donald Trump’s first appointee to the central bank, is expected to be confirmed in coming months for a four-year term as Fed vice chairman for supervision. That would make him the most influential U.S. financial regulator and give him a voice on monetary policy.

I urge the Senate not to confirm him.

If Randal does become the Federal Reserve's Vice Chairman for Supervison, I hope that Randal changes his views (or perhaps has already changed his views since the quotations below). Let me detail where I disagree with Randal to do my bit toward one of those more favorable outcomes. I will mostly follow the order of the article linked above: "Fed Nominee Randal Quarles in His Own Words." Most of the quotations below from Randal can be found in that article; some are in sources that article links to. 

How Should Banks Be Funded? 

Randal the 2016 op-ed "Focusing on Bank Size, Missing the Real Problem" with Lawrence Goodman. They write:  

Focusing on bank size is politically appealing but diverts attention from the major source of systemic risk in the financial sector: a shortage of stable deposits. Banks are but one part of an interconnected financial sector providing over $40 trillion of credit to the economy, but that credit is supported by only about $11 trillion of bank deposits.

The gap must be closed largely with professionally managed, “wholesale” funding, such as short-term repurchase agreements. Wholesale funders are quick to pull their support by not rolling over short-term credit if they perceive those funds are at risk. This leads to periodic runs on financial institutions and the resulting demand for government intervention to prevent the failure of those institutions.

It is fair to say that "too big to fail" has been overhyped, since "too many to fail" can also lead to bailouts. And Randal and Lawrence are right that the way in which banks are funded is the key question for financial stability. But after saying correctly that the way banks are funded now is unsafe, without even trying to offer a better means of funding banks, they dismiss what they concede would be a much safer means of funding banks:

Mr. Kashkari’s alternative proposal, promoted by academics including most vocally Stanford economist Anat Admati, is to ramp up bank capital to such a degree that the possibility of failure would be remote to nonexistent. But the consequence of a dramatic increase in bank capital is an increase in the cost of bank credit, meaning higher interest rates across the board. Those who favor much higher bank capital argue this would not happen, because investors would accept lower returns if the banks they put their money in were safer.

In the real world of capital markets, however, there are not enough natural investors in bank equity seeking utility-like returns. 

Note that Randal and Lawrence do not dispute that increasing bank capital would make banks safer. They concede that point. They object because they believe making banks safer in this way will increase the cost of bank credit so much that it outweighs the benefit of the extra safety. 

Let me argue that the increase in the cost of bank credit would not be so great or so harmful as     Randal and Lawrence believe. First, I think they are wrong when they say

... there are not enough natural investors in bank equity seeking utility-like returns. 

If bank stock really were as safe as utilities, the same kind of people who invest in utilities and who invest in corporate bonds would invest in safe bank stock. The issue is that bank stock has to prove over time that it is, indeed, safe. Theory gives excellent reason to think that, other things equal, bank stock will be much safer when there is more of it for a bank of given size, since the risk will be shared across more stockholders. But one should not expect investors to instantly believe bank stock is safer than it used to be, especially so soon after a painful financial crisis. And so far the increase in the risk spreading by an increase in the total amount of stock has been modest enough that other factors could easily overwhelm the effects of greater equity finance. So the push towards banks being financed by stock instead of by "wholesale funding" needs to be sustained for long enough to make bank stock so much safer that investors can't help but see the added safety. 

Second, of course the cost of bank credit would go up if banks were required to finance themselves more from stock rather than flightier funding ("more bank capital"). But that is as it should be. Because banks would be safer, they would lose the implicit bailout subsidy they now have. Without that government subsidy to lending, it is natural and appropriate for the cost of lending to go up. If we think that the government should be subsidizing lending (say to counteract a distortionary financial friction), let's at least subsidize lending in a way where banks don't have the incentive to design themselves as fragile in order to get the subsidy. 

The bankruptcy of Randal and Lawrence's approach becomes clear in this passage from their op-op-ed:

Given these structural facts, the job of the regulatory system is clear. First, facilitate the reallocation of capital during the inevitable periodic crises through orderly liquidation of failing or failed banks.

That is, "Give up on trying to keep banks from failing. Give up on trying to have the cost of mistakes absorbed by stockholders. Depend on "orderly liquidation" to happen fast enough to keep a financial crisis from getting worse. This is not a plan for avoiding financial crises at all, it is a resignation to the fate of serious financial crises over and over again. If banks make bad bets, the one truly "orderly" way to have the system of losses is to have enough stockholders who have 

  1. signed up to take the hit if things to south,
  2. in that worst case scenario take the hit very quickly, before they have had a chance to build up steam to ask for a bailout, and 
  3. are reminded every day as the stock prices go up and down that they have accepted that risk, so that they have a hard time pretending they didn't know, and should be bailed out. 

The Role of the Government in the Financial System

In a May 2015 Bloomberg television interview, Randal said

“The government should not be a player in the financial sector. It should be a referee. And both the practice and the policy and the legislation that resulted from the financial crisis tended to make the government a player. It put it on the field as opposed to simply reffing the game.”

The government is a player in the financial system as long as banks think they will be bailed out in in a crisis. In order to be less of a player through expected bailouts, the government has outlaw the kind of designed fragility that banks have the incentive to pursue given the bailout subsidy. To me, insisting on very high capital requirements is acting like a referee, since the whole game comes crashing down when bank mistakes cannot be absorbed by stockholders. But this is a type of getting out of the game and being a referee that Randal argued against.

One key way in which high equity requirements allow the government to get out of the game and be a referee is that if liability-side regulation for banks means that stockholders are set to absorb losses, the government doesn't need heavy-handed legislation on the asset side. For example, the Volcker rule that Randal said in the same Bloomberg TV interview he dislikes is only needed because capital requirements are too low. (See my post "The Volcker Rule.") 

Of course, some asset-side regulations are necessary, because extreme-enough derivatives on the asset-side could create a situation equivalent to excessive leverage, even if a very large share of funding came from equity. But with a very high equity requirement on the liability side of banks' balance sheets, the asset-side rules would only need to rule out practices that are quite far from what most banks currently do on the asset side.   

There are other ways of getting out of the game and being a more neutral referee that I think Randal and I might agree on. Let's split up Fannie and Freddie and fully privatize the pieces. Let's equalize the taxation of debt and equity so that incentive towards high leverage isn't added on top of the bailout subsidy. 

On Monetary Rules

Here I can just use duelling quotations. From the May 2015 Bloomberg TV interview:

Randal: I am all for transparency; I think the Fed has that part of it right. What it has wrong is that it continues to believe that it shouldn’t be following a rule. If you are going to be transparent in activity like the Fed’s, you have to be much more rule-based in what you are doing. The transparency has to involve, ‘This is the rule that we will follow.’ So that the markets can say, “OK, we now understand what is the Fed is going to do. We can see what its inputs are.”

From my paper "Next Generation Monetary Policy" (see "The Scientific Approach to Monetary Rules"): 

Because optimal monetary policy is still a work in progress, legislation that tied monetary policy to a specific rule would be a bad idea. But legislation requiring a central bank to choose some rule and to explain actions that deviate from that rule could be useful. To be precise, being required to choose a rule and explain deviations from it would be very helpful if the central bank did not hesitate to depart from the rule. In such an approach, the emphasis is on the central bank explaining its actions. The point is not to directly constrain policy, but to force the central bank to approach monetary policy scientifically by noticing when it is departing from the rule it set itself and why.

Interest Rates and Speculation, Hawks and Doves

In "Focusing on Bank Size, Missing the Real Problem," Randal and his coauthor Lawrence write:

Years of near-zero interest rates have led to a rise in speculative positions across a wide range of asset classes, as all financial institutions find themselves under intense pressure to seek adequate returns.

Let me answer this in a roundabout way. At the Mercatus Center's "Monetary Rules for a Post-Crisis World" Conference" (video) where I first presented "Next Generation Monetary Policy," I made the point that being a monetary "hawk" or dove makes little sense if a "hawk" is someone who, whatever the circumstance, thinks interest rates should be higher and a "dove" is someone who, whatever the circumstance, thinks interest rates should be lower. In my view, as laid out in "Next Generation Monetary Policy," interest rates should be very high for brief periods in some circumstances and very low for brief periods in others, in order to quickly right the economy if it lists towards overheating or recession. The way to tell someone who is a hawk is the tendency to set out a motley grab bag of arguments that have no coherence except that they all favor higher interest rates. Despite his stated views in favor of monetary rules that have interest rates much higher in some circumstances than others, John Taylor is a good source for such a motley grab back of arguments. You can see this motley grab bag in my post "Contra John Taylor." The argument that low interest rates lead to excessive speculation is a particular favorite of hawks. Here is what John said together with my reply:

[John Taylor:] The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

[Miles:] I can’t make sense of this statement without interpreting it as a behavioral economics statement about some combination of investor ignorance and irrationality and fraudulent schemes that prey on that ignorance and irrationality. The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality. (That is, I don’t see how the claim could hold in a model with rational agents and no fraud.) Whatever combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance an irrationality a successful model uses are likely to have much more powerful implications for financial regulation than for monetary policy. It is cherry-picking to point to implications of a not-fully-specified model for monetary policy and ignore the implications of that not-fully-specified model for financial regulation.

To what I said back in January 2013, I should add two thoughts, in response to both John and Randal's concerns about what is often called "reaching for yield." 

First, it is possible to have an "irrational firm" due to incentive structures within the firm, or an "irrational contract" due to incentive structures within the contract, even if given the structure of the firm or contract the individuals act rationally. This is sometimes called an "institutional" explanation of a phenomenon. 

Second, remember that "risk-taking" has a positive side to it. Often, a recession persists because of too little risk-taking. When people aren't taking the risks the economy needs them to take to keep functioning well, it is important to make the alternative of playing it safe less attractive. That is exactly what low interest rates do.

The key to making risk-taking a good thing rather than a bad thing is to align the benefits and costs of the risk to the one making the risk-taking decision with the benefits and cost of the risk to society. Having high enough levels of equity—or equivalently, low enough leverage—so that there won't be bailouts helps a lot with that alignment. Otherwise it is "heads I win, tails the taxpayer loses."

In "Monetary Policy and Financial Stability" I argue:

  1. It is almost impossible for monetary policy to stimulate the economy except by (a) raising asset prices, (b) causing loans to be made to borrowers who were previously seen as too risky, or (c ) stealing aggregate demand from other countries by causing changes in the exchange rate.
  2. Quantitative easing is likely to have unprecedented effects on financial markets—effects that will look unfamiliar to those used to what the standard monetary policy tool of cutting short-term interest rates does.
  3. It is not risk-taking we should be worried about, but efforts to impose risks on others—including taxpayers—without fully paying for that privilege.

... nonstandard monetary policy in the form of purchases of long-term Treasury bonds and mortgage-backed securities and “forward guidance” on future short-term interest rates take the economy into uncharted territory. But uncharted territory brings not only the possibility of new monsters but also the near certainty of previously unseen creatures that might look like monsters, but are harmless.

Letting people get high interest rates from a central bank is OK when they would otherwise invest too much and overheat the economy. But when the economy desperately needs more risk-taking investment, tempting people away from that risk-taking investment by letting people get high interest rates from a central bank is folly.   

To the extent that banks turn to forms of risk-taking other than loans when the interest rate they can earn from the government goes down, I think it has a lot to do with the faulty approach of cutting interest rates a modest amount for a long time (or making large-scale purchases of long-term bonds), instead of cutting short-term interest rates sharply for a briefer period of time. Here, it is important to remember that there is no lower bound on the interest rates that can be earned from the government—except as a result of policy. 


In the November 2015 Bloomberg TV interview, Randal said:

In some ways Dodd-Frank was not ambitious enough, and in other ways it was overly ambitious and I think there are lots of ways to refine Dodd-Frank and other forms of regulatory policy in ways that would be beneficial to the economy.

I have no doubt that there are many flaws in Dodd-Frank. But given where financial industry lobbyists and many in Congress and the Administration may want to go, I view Dodd-Frank now as an important bulwark against weakened capital requirements. I also see the Consumer Financial Protection Bureau it established as important. In "On the Consumer Financial Protection Bureau" I argue there are

... three principles that can justify consumer financial protection beyond simple contract enforcement: 

Duping people is fraud even if they wouldn’t have been duped had they had infinite time and infinite intelligence. ...

Facilitating gain for oneself and harm to others by taking advantage of preexisting confusion is predation of those who are especially vulnerable. ...

It is legitimate to protect time-slices of people from serious injury by other time-slices of people.

I don't have any problem with tinkering with Dodd-Frank to improve it—on two conditions: that Anat Admati and the Consumer Financial Protection Bureau's former Chief Economist Chris Carroll both endorse the modification to Dodd-Frank. 

Tying the Government's Hands in a Situation Calling for a Bailout

In 2011, at the Atlantic Council think tank, Randal said

I have come to believe that there is a fundamental problem with resolution mechanisms that allow substantial discretion for governments to act in particular cases, which Dodd-Frank…does. The consequence of that is that it multiplies uncertainty in a time of crisis because you’re not going to act until you know what the government is going to do…as opposed to the admittedly more difficult, and perhaps unattainable, but I think ultimately the only really workable solution, which is to sort of have something that is like a bankruptcy regime—a rules-based approach as opposed to something that says, ‘and then ‘Mr. Wizard will decide what to do.’

I worry that what Randal calls "a rules-based approach" would, in fact, be an approach that tried to tie the government's hands so it could not do a bailout. But some situations call for bailouts. And it is hard for people writing the rules to fully put themselves in the shoes of those in the dire situation that calls for bailouts. Moreover, I think banning bailouts that would have much different effects in practice than in theory, because banning bailouts is not really banning bailouts—it simply puts legal obstacles in the way of bailouts that would still probably happen, but with even more uncertainty because of those legal obstacles.

As I said in my talk "Restoring American Growth,"

The moment you let banks [have] high leverage, that is the moment you've decided to do a bailout.

Trying to tie the government's hands so that, ex post, it can't do a bailout is unlikely to actually succeed in stopping a bailout, but is likely to make the bailout more costly. The better course is to prevent a bailout from being necessary in the first place by requiring that banks fund themselves much more by stockholder equity and much less by debt. 


Let me emphasize that my criticisms of Randal Quarles' views above are not criticisms directed at Randal personally. From what little I know of him, I think he is more likely to modify his views in response to cogent arguments than most prominent people are. In "Meet Randal Quarles, Trump's Pick to Shake Up the Fed," Ryan Tracy writes:

Friends and former colleagues said that if Mr. Quarles does try to change direction at the Fed, they expect him to move slowly and methodically, and to seek consensus. ...

Ravi Menon, a Singaporean official who engaged in last-minute talks with Mr. Quarles on a U.S.-Singapore trade deal, wrote in 2004, “Right from the start, we took a problem-solving approach aimed at finding middle ground rather than trying to convert each other on ideological arguments.”

In other words, Randal is not as dogmatic as many of those who are in positions of power, and is open to persuasion. Nevertheless, unless he reconsiders his views, I worry that a vote for Randal Quarles is a vote for another financial crisis, simply because as things stand, he is not committed to doing whatever is possible to continue to raise capital requirements on banks.


Further Reading: "Martin Wolf: Why Bankers are Intellectually Naked"