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TAKE 5 government and I don't know how we'll get it if we have these highly politicized hangings. M // You recently wrote about the need for "greater market discipline and more effective regulators" today. How would you describe either of these as preventative measures for the next banking crisis? Bill Isaac on Basel, Bank Failures, and Regulation Today he heads a global consultancy for financial services, but William Isaac once helped prevent a banking crisis as FDIC chairman during the 1980s. MReport captures the legendary bank regulator's thoughts for our March profile. M // You were nominated by President Jimmy Carter to serve on the FDIC board and confirmed by Congress in 1978. What was the confirmation process like for you? BILL ISAAC // I was initially concerned about my confirmation process because I didn't know how the senators were going to react my young age—I was only 34 years old at that time. But my actual hearing was a piece of cake. The senator who chaired the banking committee asked me, "Why in the world would a young man with a success- ful career in front of him want to come to work in the public sector?" And that was the most difficult question in my hearing. The process has become quite intimidating today and it's very hard to get good people to go through it. You have to have an FBI background check; they talked to all my neighbors at any place I lived. They talked to all my colleagues. I had to fill out voluminous forms which have only gotten longer and more intrusive over the years. We really should make this a less intimi- dating process. We need higher-quality people in 16 | THE M REPORT BILL ISAAC // The problem we've had is that, for a long time, we've never imposed any losses on any insured creditors of banking institutions. We need to do this in a way that is not overly disruptive to the financial system or economy. What happens needs to be predictable. The latest financial crisis became very politicized because Treasury took over in place of the Fed and FDIC, which had previ- ously been in charge of managing financial crises. So having Treasury intervene—and will again in the future due to the Dodd-Frank Act—gives us crisis management from a political agency rather than independent agencies such as the Fed and FDIC. That is a recipe for disaster as we saw in 2008 and 2009. M // This year marks seven bank failures so far. Last year 192 banks underwent failure. Do you think these were orderly? BILL ISAAC // The small bank failures in the past couple of years have been handled by the FDIC in an orderly way. But during the crisis in 2008, there was no coherence to handling the failures of major institutions. During the 1980s, the FDIC handled nearly 10 times more failures than we have experienced in the past four years. And they were substantial—most of the large S&Ls and many of the large regional banks failed in the 1980s. Yet we did not create panic because there was a coherent strategy in place. We were determined to resolve failures as quickly as we could and merge these into stronger institutions with FDIC assistance whenever possible. That was the strategy in the 1980s and it worked—we maintained order. So it's very important to have a strategy. Treasury handled each failure in the latest crisis in an ad hoc fashion, bailing out one large firm and letting the next one fail and back and forth until the markets panicked. M // Some say that the FDIC's rules and examiners helped accelerate the crisis in certain parts of the country. Is there any merit to this view? BILL ISAAC // My concern is that we have highly pro-cyclical regulatory and accounting regimes. I was opposed to the Basel II capital rules because they were highly pro-cyclical, using highly complex, backward-looking models to determine the need for capital and reserves. When you look backward during an extended period of a good economy, what will the model tell you? It will tell you that you need very little capital. The capital rules need to be forward-looking, not backward-looking. The regulatory system ought to be cautioning banks to tighten their credit standards and increasing capital and reserves when times are good. And when trouble hits, regulators should deal with failures as quickly as possible but work with those institutions that can be salvaged with good management and proper recovery plans. I don't think any of the regulators—including those with the FDIC—have gotten this right over the past couple of decades, and that made the recent crisis more severe than it should have been. M // Regulators conceived of the Basel Accords as a way to avoid the next financial meltdown, in part by conducting stress tests for Global Systemically Important Financial Institutions. What are your thoughts about the Basel Accords? BILL ISAAC // Basel II was a very bad regulation. Basel III is better, but still not right. I am a firm be- liever in stress tests; I think they're important mana- gerial tools. And I think they're important tools for regulators. I believe they ought to be run on a regular basis by significant financial institutions. Stress tests are important in part because many institutions fail to properly diversify their risks. Diversification is absolutely essential in the financial industry. I strongly disagree with politicizing stress testing by playing it out in the public arena as was done in 2009. That proved to be a very serious mis- take that caused enormous harm to the recovery of our financial system. [Fed Chairman Ben] Bernanke was finally forced to announce that none of the 19 large stress test banks would be allowed to fail no matter what results the stress tests produced. M // Over half of the rules under the Dodd- Frank Act still need writing, but you suggest in a recent article that it's the people writing the rules to worry about, not the rules. What could the federal government do to innovate with rulemaking? BILL ISAAC // I don't think you can tinker with it; I think Dodd-Frank is a terrible law. It didn't address any of the things that led to the crisis. I would tell the next president, let's come up with a good financial reform bill. The last paragraph of the new bill should read—"Dodd-Frank is hereby repealed." I would address the issues that led to the recent crisis: a fragmented and politicized regula- tory system, Fannie Mae and Freddie Mac, highly pro-cyclical accounting and regulatory rules, and rating agencies not doing their job properly. Most importantly we need to adopt sound fiscal and monetary policies and come up with simplified and much more effective regulation. M // What should the federal government do to wean Fannie Mae and Freddie Mac off conservatorship? BILL ISAAC // I believe the government needs to wind down Fannie and Freddie over time and take itself out of the mortgage market except for possibly subsidizing housing for veterans and low- income families. The private sector will be able to take care of loans not handled by the GSEs. The United States is the only industrialized country in the world with a Fannie-and-Freddie system. I agree with trying to create homeownership, but homeownership rates in the United States aren't much different from those in other countries that don't have a Fannie and Freddie. The recent crisis would not have occurred had Fannie and Freddie not engaged in reckless growth with grossly inad- equate credit standards.