Banking Crises, Stablecoin Regulation, And Fed Policy With Randal Quarles

Episode Transcript
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[MUSIC]

>> Jon Hartley (00:09):
This is the Capitalism and Freedom in the 21st Century podcast,
an official podcast of the HooverInstitution Economic Policy Working Group,
where we talk about economics,markets, and public policy.
I'm Jon Hartley your host.
Today my guest is Randy Quarles,who is an attorney and investor.
He served as vice chair ofthe Federal Reserve for Supervision,
is chair of the Financial Stability Board.

(00:30):
Undersecretary of the treasury forDomestic Finance in the George W.Bush
administration, andis currently the chairman and
co founder of the Cynosure Group,a Utah based investment firm.
Welcome, Randy.

>> Randal Quarles (00:41):
Thanks for having me.

Well, Randy,
I'm super excited to talk toyou about all things finrag or
financial regulation wise, but I want tostart with talking about your early life.
You were born in San Francisco, butraised in Utah and state at Columbia.
For your undergrad you did yourlaw degree at Yale Law School.
Never heard of that place.
You worked at Davis Polk, you worked forNick Brady in the George H.W.

(01:07):
bush administration,you later worked at Carlisle.
I'm just curious.
You know, interestingly,
many of those plays are some of the sameplaces that Jay Powell worked as well.
I'm curious, at what point did you getinterested in financial regulation?
Was this something very early on foryou or
was it something that you sortof grew to enjoy over time?

(01:28):
I also know as another funfact I think you were at,
when you were at Yale Law School, you werepart of one of the, I think you were part
of the founding chapter the FederalistSociety at Yale Law School there.
I'm just curious, like at what point didyou really get into financial regulation?

Well, it wasn't in law school.
I had a law school classmate whofrom the day he walked into school,
very, very friend who very much, you know,
was focused on financial regulation,international banks.
He knew exactly what he wanted to do.
And, andI did not probably wanted to be more of

(02:08):
a constitutional lawyer anda legal academic.
Became a little disillusioned withthe academy during my time at
Yale Law School andmuch more interested in the sort of
practical application of law andpolicy went to Davis Polk.
Davis Polk is one of the main, I guessyou'd say the two main financial law firms

(02:32):
in the country,along with Sullivan and Cromwell.
And so that then became myexposure to the technical aspects
of financial regulation,both bank regulation and
regulation of the financialsystem more generally.
And I found it very interesting andit was my job.

(02:56):
And after several years there,the, you know, the, the treasury,
this is now at the very outset ofthe George H.W. bush administration.
The treasury had taken on,in the aftermath of the savings and
loan crisis, a study of financialregulation, the Glass Steagall Act.

(03:20):
They asked sort of the usual suspect lawfirms in New York, there were four or
five of them to nominatea candidate to come down and
join the team that wouldbe working on that project.
Along with Bob Glauber,who was an academic from Harvard.
Jay Powell,who by that point had left Davis Polk and
was a investment banker at Dylan Reed,which had been Nick Brady's firm.

(03:44):
John Dugan, who was a lawyer,who'd been the general counsel of the,
of the Senate Banking Committee.
And they wanted someone about the.
A six year associate seniority, which iswhere I was at the time, to come down and
kind of be the junior person on that teamto bring the sort of technical expertise.

(04:06):
Davis Polk nominated me.
I went down and joined that team.
And you know, so it,it was serendipitous as opposed
to a result of a long standing strategy.
But you know, with hindsight kind ofinevitable given the places that I went
and the people that I worked with.

Fascinating.
I know Bob Glauber, he was one of my ownprofessors at the Harvard Kennedy School
and I knew him before he passed.
Amazing.You work with Nick Brady and
all these other amazingfigures I think formed many,
many people like Jay Powell andothers later on.
Later on I guess.

(04:46):
So I'm just curious.
I want to talk about the financial crisis,
I think the financial crisis was adefining moment for financial regulation.
I mean, what went wrong inthe Global Financial Crisis 2008?
As you see it,in terms of sort of underlying causes,
what went wrong with banks?
Would lack of bank capitalbe at the top of your list?
I know other folks like totalk about contagion a lot.

(05:08):
I'm curious, how do you diagnosethe global financial crisis and
what was wrong with banks?

Capital was obviously relevant, but
I wouldn't put it at the top ofthe list as the cause of the crisis.
I think.
I mean this sounds quite mundane, but
I think the financial crisiswas almost an inevitable,
certainly an expectableconsequence of the combination

(05:38):
of human nature and the great moderation.
So you know,when I started out as a very young lawyer
back in the Coolidge administration,you know,
the practices of banks making loans were,you know, extremely tight.

(06:01):
They were very buttoned up.
And the express job of the young lawyerswas to keep the young bankers in line.
The, you know, the bankers werethe clients, they knew the deal.
But you were to ensure that allof the due diligence was done.
That all the things that might go wronghad been thought of, that the appropriate
measures had been taken to protectagainst what might go wrong.

(06:22):
And at the very top of the systems,at both the banks and the law firms, the,
you know, there were very clearinstructions to the troops down below that
this is how it was supposed to go andpeople were very careful.
And over the ensuing 30 years from,you know,
from when I began, the,the people became laxer and

(06:46):
laxer because nothing very bad happened.
Those practices had developedbecause some bad things had happened
in the 60s and 70s with respectto the extension of credit.
And you had the sovereigndebt crisis of the 80s,

(07:06):
but you didn't have systemicresults as a consequence of that.
You had the 1987 market crash and whichseemed to happen and be extraordinarily
dramatic, as I recall at the time andyet nothing really bad happened.
And I think you can, yeah.

In the real economy at least, nothing I guess.

Exactly.
In the real economy.

All these Latin American financial crises going on in the 80s too,
and their inflations and so forth.

Exactly.
But, but with respect to the, with respectto the advanced financial economies and
the, you know, andsort of credit, you know,
widespread credit problems asa result of what was the, you know,
of some of these quite significant events,it led to, again,
just this is, I think,almost inevitably human nature.

(07:59):
It led to a.
Well, we don't have to bequite as strict as we have
been in the past with respect to the.
Just the practical measures that wetake in connection with the extension
of credit.
We can get more creativewith the vehicles and
mechanisms through which we extend credit.

(08:20):
We can increase the amount of leverage.
And if we don't, somebody else will.
And so within organizations,
the inevitable pressure again from thefolks who are doing the work to the folks
at the top who used to say, you know,let's, let's keep this all together.
You know, kind of like raising teenagers,after a while you just say,

(08:43):
this is exhausting tolisten to you complain.
Yeah, go ahead and do it.
And which ultimately led toa situation where you had,
you know, a lot of poorly structured,
poorly underwritten credit inwhat extended in ways that
were not always obvious thatit had even been extended,

(09:07):
and certainly what the amounts were.
And I don't think that that wasa result of bad bank regulation or
bad bank supervision or, you know,
I'm not even sure that you would callit bad management of the institutions.
And certainly people were neither crooksnor idiots involved with that process.

(09:33):
You know, they were human beings who hadlived through an extraordinary stretch of
quite good times.
And that's what's going to happen now.
You know, when the, you know, whenthe crisis happened, it became clear that,
we should have tried to ensure,since we can't, since we are human and
can't really feel that that's happeningover the course of decades, can't

(09:57):
see where, you know, where a big financialstability shock may be coming from.
We should have a system that'smore resilient to shocks.
We should have more capital.
But it wasn't really the regulation or
the capital levels that were inany way a cause of what happened.

Sure, well, I guess, yeah, had the capital been different,
I guess, would it have beena different result, I guess.
There's all sorts of,
I guess, people who, I guess there'sdifferent sort of schools of thought.
There's some, I guess,who would say that one.
I mean, there was obviously a bigbuildup in housing and, you know,

(10:35):
to what degree that was even preventable,I think, is another question.
Whether this lacks lendingstandards is it something that was
a cultural issue versus,I guess, a regulatory issue.
Then some people point tothe Community Reinvestment act as
incentivizing housing in some way,sort of passed in the 90s.

(10:58):
And I guess then there's other peoplewho sort of blame mass securitization,
CDO squared, as creating toomuch sort of complexity and
financial markets andthat sort of complexity.

I really think that all of those are various manifestations.
Really almost all of those are variousmanifestations of the larger
kind of the larger theme that,you know, the caution that was drilled
into people involved in the extensionof credit in its various forms,
you know, in the late 70s andearly 80s, as I was starting,

(11:37):
my career eroded and it eroded because wewere living through a pretty good time.
And I'm not sure.
And, and that will happen again in partbecause measures that were taken in
response to that have again allowed usto live through some pretty good times,
some at least with respect tothe stability of the financial system.

(11:58):
And over the course of a long periodof time, humans will be humans.
You're not going to change that.
And they will get complacent.

Well, I guess so.
I guess moving away from some ofthe causes, you know, crises are,
are a fact of, of life andthey aren't, you know, recessions,
I don't think are ultimately preventable.
I mean, there are these disastersthat just happen often,
almost always for unforeseeable reasons.

(12:28):
But I guess so fast forward,2008, Bear Stern,
there's all these problems that emergewith Bear Stearns and later Lehman.
Then you sort of, you have September 2008,you have these sort of panic moments
where, you know, first Fannie andFreddie are put into conservatorship.

(12:51):
So you have that, then you have Lehman,you know, Lehman, you know,
declaring bankruptcy.
I think Hank Paulson was looking fora buyer for one many of these,
you know, JP Morgan came in andbought Bear Stearns, you know,
Merrill lynch was boughtby bank of America.
You had these big commercialbanks kind of bringing stability

(13:13):
in buying up thesedistressed investment banks.
In some cases there was help from,from the, the federal government,
from the Federal Reserve to,to make those acquisitions.
And then there was sort of this Lehmanmoment where there was a question of,
you know, what to do with Lehman.
And my understanding from, fromHank Paulson, then Treasury Secretary,
was that he was trying to find a buyer forLehman with Barclays.

(13:36):
And they were halted by,I think, the UK government.
There's something that, I think,
Paulson is sort of blamed at leastin terms of the Lehman bankruptcy.
But I guess, you know, in your mind,would things have been very different had
Lehman actually been sort of outrightsaved in, in some way that the government,

(13:58):
I guess, tried to completely backstopin some way rather than letting it go?
I mean, in your mind, could things havebeen played out very differently had
Lehman not sort of gonebankrupt the way it did?

No, I actually don't think things would have been that
different if they hadsomehow bailed out Lehman.
I may be one of the five people who stillbelieved that was the correct decision.
And if you go back and you look athow the financial crisis evolved on
kind of a day to day basis during thattime, you had the Lehman failure.

(14:35):
And if Lehman is going to be the ofa crisis of confidence in the system,
you can't really see that inthe performance of the financial
system in the immediateaftermath of the Lehman crisis,
in the performance of credit,in the performance of various markets.

(14:58):
The actual crisis began almosta couple of weeks later,
maybe not quite a couple of weeks later.
In my view,the trigger was the failure of WaMu and
most specifically the manner in whichthe failure of WAMU was handled.
And I'm not.
And because again, markets were, you know,obviously they were under strain

(15:22):
because of everything that had beenhappening over the course of the summer.
But in the aftermath of the Lehman crisis,they were not particularly more
dramatically affected untilthe failure of WAMU at Carlyle.
We were in the process, for example,of considering kind of a anchor,
confidence inspiringinvestment in Wachovia.

(15:48):
Bob Steel, who had succeeded me asUndersecretary of the treasury,
was the CEO of Wachovia at the time.
And the thought was Carlyle,a private equity firm,
even the size of Carlyleis not going to be able to.
Put in enough capital to sort offundamentally recapitalize Wachovia,
but that if we would make a significantinvestment, having done a lot of due

(16:11):
diligence on the state of the bank,that that would anchor confidence and
would, you know, and would shore upothers in being willing to provide
various sorts of financing to the bank andsettle its situation.
And we were prepared to do thatup until the failure of WaMu.
And, and the FDIC was worried that therecould be a number of bank failures

(16:35):
that it was facing going forward,given the stress that the situation saw.
And so they wanted to preserve the fund.
And therefore there were categories of,of obligations of WaMu that were,
had traditionally been protectedby the FDIC in a bank resolution,
although they weren't legally requiredto be that in this case, the FDIC said,

(17:00):
well, since we, since we think we needto really work to preserve our fund,
we're not going to preserve them.
But there was little advance warningof that with the failure of WaMu and
Little andconfused communication around it.
And that is when you saw kindof the system of financing for

(17:22):
banks completely freeze up.
Everyone said, well, wait a minute.
We now don't know what the rules are.
We don't know what's going to happen inthe event of a bank failure if we extend
credit.
And that's,in many ways it's not surprising.
It's almost economic one.
That uncertainty andunclarity is, you know,

(17:43):
perhaps the worst villain insapping confidence in a system.
It's like,if I don't know what's going to happen.
And so we immediately stepped back fromproviding the equity investment in
Wachovia.
We said,we don't know what the rules are anymore.
And Wachovia failed relativelypromptly after that because.

(18:04):
Because it was now part ofthe system being swamped by a lot of
providers of financing to the banks andto the financial system generally saying,
we don't know what the rules are.
And in my view,it's an eccentric view, I allow, but
in my view, that was the triggerof the financial crisis.

(18:24):
It was not Lehman.
And I think, you know, going forward,letting Lehman fail was the right thing.
It's the moral hazard questionthat people were concerned about.
The moral hazard reason thatthey did not save Lehman.
The view that going forward, you wantpeople to say they don't save everybody.

(18:47):
As we're making decisions about whatsorts of risk we ought to be taking,
we can't count on being bailed out.
And I continue to think thatthat was the right decision.
And that it was nota trigger of the crisis.

Got it, but
you don't think I guess in my mind oneseminal moment was this fact that,
in my mind there's a clearlya run on money market funds.
Particular prime funds,and the reserve fund,
the oldest money market fundin the US broke the buck.

(19:20):
And I think a big part of thatrun on money market funds,
again it's an untraditionalsort of bank run.
It's not a traditional people lining upto get their deposits out of a commercial
bank, but essentially money marketinvestors trying to get their money
out of money market funds was that therewas this Lehman paper that exists,
a commercial paper, and people werefreaking out about that and that.

(19:41):
But that wasn't in your mind thatthe money market run that kind
of existed was not sort ofthe trigger in your mind?

No, I don't think so.
Not as important, not the proximate cause.
All of this added up to create anenvironment in which the financial crisis
could happen.
If that environment hadn't been building,you could have had a failure even
of an institution as large asWaMu without a financial crisis.
We just had Silicon Valley bankfail a few a few years ago,

(20:14):
which was not quite as big as WaMu,but along the same size.
And it didn't trigger anything like that.
So part of that was the extra amountof capital in the system, but
part of it was just, you know,you didn't have these other elements but,
but I don't think they were nearly asimportant or really the triggering cause

(20:35):
and certainly not the failure of Lehmanrelative to the failure of Walmart.

So another thing that I think comes up in these sorts of global
financial crisis diagnoses is inthis question, the big banks and
Senator Warren I think often,and others often said, well,
all the Grand Leach Bliley big bankconsolidation in the 90s that was
allowed to happen was part of thiscause and which break up the big banks.

(21:04):
And, and I mean to me that seems likenot a great sort of story either or
explanation either.
In fact, like in my mind, I think ifthe big banks have been broken up,
maybe the financial systemwould have been less stable.
I mean, there's largely investmentbanks that were stressed during
the global financial crisis.

(21:26):
The larger, more diversifiedcommercial banks, the JP Morgan Cities,
Bank of America, the larger financialinstitutions were generally safe.
And this is an argument thatI've heard from Ben Bernanke,
sort of against breaking up the bigbanks is that in diversification, having
both commercial banks and Investment banksunder sort of one umbrella allows for

(21:47):
better weathering ofthese sorts of shocks.
Do you sort of buy that line of reasoning?

Absolutely.
I mean a large part of the work that Idid both as a private sector lawyer and
then in policy work duringthe course of the 90s, during the,
during my time in the Bush41 administration was,
was precisely to allow to increasethe financial resilience of the system and

(22:16):
particularly the banking system by first,you know, we,
we put forward a proposal forthe revision of the Glass Steagall Act.
It's actually incorrect to say that theGlass Steagall act was repealed because
the central provisions ofGlass Steagall were never repealed.
There ancillary provisionsthat were repealed.
But the revision of the Glass Steagallact to allow the creation of

(22:39):
kind of merchant banks to allowinvestment banks to merge, but
the first order of business was simply toallow banks to merge across state lines,
which was not possible in the earlypart of my career, which I guess is
a long time ago now, but it's stillwithin the mind of living memory.

(23:02):
And, and that was very usefulwhen you had, you know,
over the course of thatperiod you had some intense
financial problems in Texas atthe beginning of that period and
then you had finance some intensefinancial problems in the Southeast.
And because we had changed themone of the results of the Bush

(23:26):
41 administration was to easethe restrictions on interstate banking.
You now had banks, you know, NorthCarolina national bank, which eventually
became bank of America, you know, had for,had required, had acquired a Texas bank.
And as a result it had the resources toprevent that Texas bank from failing when

(23:47):
there was pressure in Texas and the systemand that system had the resources to
prevent the bank from failing whenthere was pressure in the Southeast.
And you know, sothose mergers were very much.
Kind of financial stability supportive,first by allowing geographic
diversification and then by allowingbusiness line diversification.

(24:11):
And exactly as you said, if we had notmodified the Glass Steagall act to allow
Morgan Stanley and Goldman Sachsto become bank holding companies,
which, you know, before, you know,under Glass Steagall, they could not,
in the great financial crisis,those firms would have failed.
In the great financial crisis,the first thing they did was we need to

(24:32):
let the world know that we are supportedby the Federal Reserve and
the Federal Reserve's backstop.
And so they immediately became bankholding companies, which they were able to
do because of these changes that hadallowed banks to become larger and
more diversified.
I mean, it's not.
There certainly are issues as anyorganization becomes extremely large.

(24:54):
The largest banks now have hundredsof thousands of employees.
There are management concerns,totally appropriate official sector
issues in ensuring that, you know,that the management of those banks
is up to the challenge of managingorganizations that are that complex.
But from a pure financialstability point of view,

(25:16):
all of that has been a positive andnot a negative.

Great, so I guess sort of just moving forward in time here we had
the global financial crisis.
We had all the interventions, TARP Tau,
the Fed was buying up toxicassets off bank balance sheets.
The first Quantitative Easing or QE1.

(25:41):
And then we had this thing in 2010which was the Dodd Frank act.
And it did a lot of things.
But, but as far as bank regulation goes,
some of the bigger things that happenedwas, you know, imposed capital standards.
So there's both a risk weightedcapital ratio and a risk neutral one.

(26:04):
The whole idea is just, you know, limitingthe amount of leverage that can be taken.
So for our listeners that aren't asfamiliar yet, there's sort of beyond just
the US there's this idea of Basel 3capital standards which sort of comes out
of the bank for International Settlements,the BIA assets in Basel, Switzerland.

(26:25):
And they sort of put forth thesecapital standard ideas that have
been implemented across various countries.
And Dodd Frank was the USmanifestation of that.
And so there'd be risk weightedcapital ratios or CT1.
And the idea is that the amount ofequity is a share of risk weight,

(26:48):
assets is above a certain threshold.
And similarly your SLR oryour leverage ratio,
your supplementary leverage ratio,is at a certain level.
And so all this is about the liabilityside of the balance sheet
in the sense that we're settinga limit on a minimum limit for

(27:09):
how much equity there is, which is anotherway of saying kind of A maximum for
how much leverage there is as a fractionof the total capital or total assets.
And so, there's a risk-weighted way oflooking at this, anonymous-weighted way or
a risk-neutral way of looking at this.
Now, sort of fast forward many yearslater, something like SLR might be binding

(27:33):
for this is the sort of riskneutral you might be buying for
a bank like Goldman Sachs doesa lot of treasury market making
the risk weighted capitalratio might be buying for
a bank like Capital One that does a lotof sort of risky credit card lending.
Credit cards sort of get thishigh risk weight of 1 one.
So I guess my question for you is,is the financial system today, you know,

(27:55):
safer after Basel III's gold financialsystem safer in, in your mind, or
are the banks too regulated or,or not regulated enough?

Well, I think it's unquestionable that the system is safer.
The increased capital levels,the Basel capital price process,
beginning all the way backto Basel I in the 80s,
has been run atthe significant insistence or

(28:28):
impotence impetus fromthe United States to try
to ensure that the competitiveenvironment for
international banking was such that our
banks could competewithout being pushed to

(28:49):
lower their capital to dangerous levels.
So in the 80s, the Japanese banksoperated with very little capital,
certainly relative to ours andrelative even to the Europeans.
And Basel 1 was an effort to getinternational agreement that that capital
needed to be increased.
And then, you know, over the courseof the 90s, it became clear that

(29:12):
the European capital levels were lowerthan those in the United States.
Our internationally activebanks were being disadvantaged.
And so, you know, Basel 2,which is, you know,
was really kind of an incrediblycomplicated, very analytically, you know,

(29:32):
analytically granular, intelligent,ultimately I think misguided, but
approach to try to create a frameworkin which we in the United States
could be comfortable andconfident in allowing our bank's capital
levels to lower themselves to thoseof the Europeans by creating,

(29:53):
you know, sort of a, an agreed andcareful risk assessment framework.
It was very complex,probably excessively complex, but
no sooner had that been completed thanwe had the great financial crisis and
we realized that thatwas the wrong direction.
We shouldn't be lowering our capitallevels to match the Europeans.
We should be raising the Europeans capitallevels as well as our capital levels to
higher standards.

(30:13):
And that was the point of Basel iii.
I think that, you know,conceptually it was successful.
You know, it has been successful.
I think we've seen the increasedresilience of the banking system
to some shocks like those thathappened in the spring of 2023 and
you know, sounquestionably the system is safer.

(30:37):
Are banks too regulated?
Well, just to take the capital system,the capital framework as an example,
it is excessively complicated.
We have now a very complicated set of,through the cycle capital rules in
the aftermath of Dodd Frank andthrough Basel iii, we've layered
on top of that a stress testingregime which I think is very useful.

(30:59):
It's very, it's well done by the Fed,
really competent peoplewho run the process.
But it is incredibly complicated ontop of what is already a fairly,
you know, a much more complicated kind of,
of standard capital frameworkthan it used to be.
We, you know, are now regulatingliquidity, which we should be,

(31:24):
but, you know, in, in a much moredirect way than we did before.
Much more complicated way that maybe getting more complicated in
the aftermath of sdb.
The supervisory examination ofbanks is much more burdensome and
again, particular andcovering a broader range of

(31:48):
activities with much more directinstruction than it used to be.
So all of that is, again,that's an inevitable human response.
Response to something likethe great financial crisis.
And I think that directionallyit has made things better.
You can't question that.

(32:08):
But it's also improvable.
That can be streamlined, that can berationalized, that can be, okay, well,
now we're doing the same thingin three different ways.
Maybe we can do it in one and a halfdifferent ways and that will be enough.
And thinking all of that through is,
I think should be inevitablythe task of the bank regulators and
thinking through the practicesof bank supervision,

(32:31):
the task of the bank supervisors.
You know, once the, you know, theimmediate reaction through Dodd Frank and
Basel 3 to the great financial crisis isin place, then you say, all right, now,
now, with the benefit of experience,with the benefit of a little calmness,
how do we improve that?

Got it.
I've worked at Goldman Sachs and after,
in the aftermath of the financial crisis,or in the years after in the 2010s.
And yeah, I worked in risk management andkinda had a sense of how some
of these worked in portfolio structure,risk management in GSM.

(33:10):
But I had risk management friends thatwere sorta dealing with the CCAR and
stress test sorta side of things.
So I guess like one question and complaintthat I've heard is that, you know,
from people broadly, you know,in general in the policy space,
not just any particular bank, is that, youknow, the stress tests aren't transparent.

(33:32):
You know, there's a bunch of scenariosthat are given and it's not clear
ahead of time what they are and theysort of change from year to year could,
you know, and some people say, you know,trans, a lack of transparency is kind of
a virtue in the sense that banks shouldbe prepared for all sorts of scenarios.

(33:53):
But I guess, is there some way inwhich that could maybe be done better?
I mean, also, at the same rate,you're hearing from folks.
I think this is a Jamie Dimon question,he asked him and all,
how many bank regulators we actuallyhave physically in our building any day?
And it's, you know,it's hundreds of people.
And I hadn't realized myself when I wasworking at Goldman Sachs that there were
actually, you know,Federal Reserve employees or

(34:16):
regulator employees thatwere actually in the bank.
Is that too many?
So I guess I'm just curious what yourthoughts are on just stress testing and
how that process maybe could be improved,if at all, in your mind.

Yeah.
So first I should say, and there are twoaspects to the answer that I'll give.
One is one sort of Legal, constitutional,but that aspect of policy,
not legal in the sense of, you know,kind of granular regulation, but.
And then the other is, you know,

(34:51):
a different set of policyconsiderations around the, you know,
how the stress tests need to beconstructed in order to be effective.
Stress testing is,is an obvious, an obvious good.
It's something that banksupervisors should be doing and

(35:13):
in, in some ways not nearly as expansive,you know, and, and
as rigorous as has happened in theaftermath of the great financial crisis,
but in some ways have, you know,been doing for a very long time.
And, andwe saw a particularly important example of

(35:34):
that during the COVID eventwhere the rest of the world,
almost all of the rest of the world,immediately upon the sort
of global administrativeshutdown of the economy, said,
well, if businesses can't operate,they can't pay their loans,

(35:56):
and this could be a huge problem forthe banking system.
And bank regulators around the world shutdown the ability of their banks to pay
dividends.
They simply forbade them frommaking any distributions at all.
And we, we closed off the ability ofbanks to repurchase their shares,
which in the US System is a significant,you know,

(36:19):
is actually the majority of the way thatthat capital is returned to shareholders.
But dividends are still important, and
the dividends is the onlything that's promised.
Right?The share repurchases are easier to,
to close off because there's nopromise that that's going to happen.

(36:40):
And because we had just complete,we were just in the process of
completing the stress test forthat year, we had confidence in the,
we could add in there some additionalvariations to the scenarios to say,
well, what if this happens?
What if that happens as a result ofCOVID what happens to the system?
And then over the course ofthe succeeding 12 months,

(37:03):
we ran seven different stress tests.
It was, it was a, I mean, the,it was a great national service on
the part of the stress testingstaff at the Federal Reserve and
just an almost impossible amount ofwork for a team that we weren't able to
increase in size just given the speedwith which all of this was happening.

(37:24):
And, and as a result of doing that,
we maintained confidence inthe resilience of our system.
That allowed us to say, no, you cankeep paying dividends until we see some
evidence that the system is undera level of stress that it can't support,
you may keep paying dividends.
The information that we have fromthe stress test shows that and our,

(37:46):
the cost of capital for our banks was, youknow, is now, is now much more favorable.
There are many reasons for that.
But this is an important reason forit than for European banks,
because you're providing equity capital.
European banks, andyou say when they get spooked,
they could just say you can't pay.
Whereas in the US they do everything theycan to preserve those payments if it's

(38:11):
going to be safe.
And we had the mechanism to say itwas safe through the stress testing.
So all of that is great.
Now, on the question ofthe transparency of the stress tests,
there's the legal question of theseare quite consequential government
actions because particularlyparticularly in the aftermath of
a measure that I took which I thoughtwas necessary and appropriate,

(38:35):
again as a, just as a good governmentmeasure, that there would be
predictable consequences of a certainresult of the stress tests.
If your stress test shows that you needmore capital, then you will be required to
have a buffer added to your particularbank's capital requirements that will
increase your capital by that amountaccording to the stress test.

(38:59):
Before that,
the results of the stress test didnot have any determinate consequence.
It was all a result of whatthe Federal Reserve Board had for
breakfast on the morning that theywere presented with the results.
And that's just nota way to run a railroad.
But because of that change,there is a fairly direct and

(39:20):
important economic andfinancial consequence for
individual institutions as a resultof running the stress test.
And our system of law, the AdministrativeProcedure act, constitutional
principles would say that can't bethe result of a star chamber process.
You must be transparent.

(39:41):
People need to know if that,if something like that can happen,
what they can do toprevent it from happening.
And you know, the example that Iwould often use would be to say,
yeah, if you took all the speedlimit signs off the roads and said,
but there's still a speed limit.
And it varies from day to day.

(40:03):
And we're not going to tell you whatit is or how it's determined, but
if you exceed it,you will have a very serious fine.
Well, people would drive slower,they certainly would.
But you can't do that in America.
I don't think you can do it in Russia.
So there's the legal side of it,that transparency,

(40:26):
a significant amount oftransparency is important.
And there are lawyers who say thatthe whole process, all of the models,
all of the scenarios need to be totallypublic and subject to comment on,
making sure that the stresstests are fit for purpose.
However, I was persuadedin my time at the Fed and

(40:46):
remain persuaded of the socalled monomodel argument that's going
to be very familiar to many ofthe folks who listen to your podcast,
that if the Fed is totallytransparent about its framework for
assessing the resilience of anyparticular bank's, you know,

(41:07):
portfolio of assets, then whatevermistakes and eccentricities and
idiosyncrasies that there are in thatframework, and those are inevitable,
then all of the system will congregatearound those and those now become
the fault lines of the system where therewill certainly be breaks going forward.

(41:31):
And to the extent that you are not whollytransparent, you at least ameliorate,
you can't eliminate, butyou ameliorate the mono model problem.
I think that's real.
I think that's, and to ensure thatthe stress tests are actually fit for
purpose, I think it hasto be taken into account.

(41:52):
I tried while I was at the Fed,you know, for
a balance that maybe was notthe most ineluctably principled, but
I thought practical of wecan be more transparent,
we can be much more transparent aboutwhat it is, what the models show
without completely opening the kimonotowards the monomodel problem.

(42:15):
And the staff was making, I think,
material progress in being moretransparent around the models.
I think that stopped prettyquickly after I left and
I think it should be picked back up again.
So that's, that's probably a lot morelogaria around your simple question of,

(42:35):
you know, should the stresstest be more transparent?
I think the answer is they can and shouldbe, probably are required to be under law,
but we shouldn't completely openthe kimono in the way that some would ask,
because then the stress testwould not only not be as useful,

(42:55):
they could even be counterproductive.

Got it, and I guess, yeah, one criticism,
I guess it could be gamed in some way.
If it was totally.

I think you could say, yeah,
I was Always less worriedabout the gaming argument.
People would say, if you,if you give them the models,
you're, you're showing themthe answers to the test,
it's like, no,you're giving them the textbook,

(43:25):
you know, and, andit would not be right to give a test.
You know, it's not right to give a testthat you've given the answers away to, but
it's also not right to give a test thatyou haven't given anybody a textbook for.

Absolutely.
That's a great way of putting it.
I just want to fast forwarda little bit here just in
time to your time at the Federal Reserve.
You were nominated during the firstTrump administration to be
the first vice chair ofthe Federal Reserve for supervision.

(44:01):
And then you are also the chair of thefinancial disability board from 2018 to
2021.
I'm just curious in your mind andjust, I guess for some context, too,
around that time, in terms of whatwas going on in Finrake, there was
the Jim Hensling bill that changedthe SIFI threshold and increased that.
So there was kind of that goingon in the backdrop as well and

(44:23):
the SIFI threshold is basically a certainthreshold above which you're treated
very differently in terms of regulation,having to do these sorts of,
this regulatory scrutiny fromthe perspective of regulators.
And I think when it was increased,it affected banks like SunTrust and

(44:45):
BB&T at the time.
They've actually since merged.
That's a whole other story.
But I'm curious, what, in your mind,were your greatest accomplishments
during your time at the Fed board andas chair of the Financial Stability Board?

So at the Fed, you know, I think you,
I think I would say it was the,
it was the whole complex of refining andrevisiting and
streamlining the post financialcrisis regulatory framework.

(45:20):
The principal element of thatwas the mellifluously named
Igurkapa legislationthat we then implemented.
We worked, you know,we worked very closely with the Senate and
the Congress in, in developingthat regulation and then, and
then through the implementation process.
But there were, you know,

(45:42):
I think there were over 20separate measures that we took.
And I was, you know, I, I, I came insaying there were lots of folks, you know,
who kind of wear my political jersey, lotsof people who think about the industry
who said, you know,Dodd Frank was an unmitigated disaster,
you need to strap a napalm tank onto yourback and just burn it all to the ground.

(46:08):
And my tack was to say, look, no,what we're going to do is we're going to
identify some material thingsthat will make a difference.
You know, the overall benefit ofthe increase in capital from Dodd Frank
is that that is a good thing.
But we can increasethe efficiency of the system,
which is a public good that is probablyequal to the safety of the system.

(46:34):
We can increase the efficiency ofthe system in ways that do not harm its
safety.
And we can do that in a way thatwe're very methodical about,
that we make a very good case for, and
that we get enough bipartisanpolitical support for that.
When we're done, the next folks willcome in and the pendulum won't swing

(46:58):
back because the case will have beenmade and we will have been meticulous
enough about what it is that we that wedid and why we did it and how we did it.
And I do think, you know, at first,you know, when, when my successor came in,
who is a smart and good guy, buthave very different views than mine,
and some of the initial proposals,people said, we told you so,

(47:21):
you know, that was a bad strategy.
It's a one way ratchet.
You came in andyou said instead of burning it all down,
if we burn it all down,they'll just put it back in worse.
And now they're puttingit back in worse anyway.
But at the end of the day,that didn't work.
That didn't happen.
And I think one of the reasons it didn'twas the way that we constructed our
approach.

(47:42):
So I think that was at the Fed,the most consequential,
and at the fsb,I think the work that we began on non bank
financial intermediation,which had really stalled in the FSB for
a long time fora whole variety of reasons.

(48:03):
You know,
the FSB had done really good work on bankregulation along with the Basel Committee.
Nbfi, you know, had really languished.
And, and, and it, it requires a muchdifferent approach than bank regulation.
And so there are reasons thatthat's a difficult thing to do.

(48:27):
But we began a process by creatinga separate committee where there was much
more representation of the non bankregulators relative to the central banks.
It was a little more equalthan in the FSB as a whole.
And that allowed progressto be made there.
That again, I think was quite useful.

Great, I guess, sort of shifting just for
a second away from finrag andfinancial regulation.
You were also, you know, by virtue ofbeing on the Federal Reserve Board,
you were also a voting FOMC member.
And you know,during this time we had everything from,

(49:02):
during the time we were in office,
everything from COVID to the beginningof the early 2020s inflation.
I'm curious, in your mind,did the Fed respond,
I guess appropriately both to Covid anddid it respond
quickly enough to inflationin terms of raising rates?

(49:26):
I know you've spoken, I think anotherpodcast before maybe saying that the Fed
should have raised rates earlier.
Just thinking that it became clearthat it wasn't just a transitory story
by say October of 2021, in that this wasaround the time that you were leaving,
but by that point when inflationfirst ticked up in April 2021,

(49:48):
but by October it was clear thatit wasn't just used cars anymore,
and it was not just used car prices, but
housing rental prices were going up,owner occupied rents were going up.
It was clearly broad basedat that point in time.
You kind of had left just at that, I thinkpoint in time when that became apparent.

(50:09):
But in your mind was the Fed andyour colleagues,
were maybe they a littletoo slow to raise rates and
maybe inflation wouldn't have been as highif they had done something differently.
I'm curious about what your sort ofretrospective take is on the Fed's short
performance during, during that period.

Yeah, I don't, I don't think that there, I don't think the, that
the Fed is guilty of any serious sin withrespect to the timing of its response.
I think with the benefit of hindsight,and there were a few of us, you know,
even during, at the, who were thereat the time who would have said yes,
the time to start raising rates was in thefall of 2021, you know, over the summer.

(50:52):
You know, as you said, I think the datathat we were seeing really supported
the Case that this was a supplyconstraint driven inflation,
which is not something that a centralbank can effectively respond to, and
that it was a temporary supply constraint.
You know, we can't unload, we can'tunload containers on the ports and

(51:13):
we can't make vaccines oranything like that.
So, butthat this would in fact be transitory.
The data really supported thatover the course of the summer.
But by the fall it was clear that, no,this is really a much more traditional
fiscal stimulus driven inflation,which is something that we can respond to.

(51:34):
Some people, Larry Summers, for example,have blamed the framework that the Fed,
the monetary policy frameworkthat the Fed put into place
in August of 2020 as kind ofthe culprit in the Fed not
responding as soon as it becameclear that this was the sort

(51:55):
of inflation that its toolswere designed to address.
That I don't think is correct.
Really.
There probably was a majority onthe FOMC in favor of saying, okay,
well now we need to respond to thisin September, October of 2021.

(52:16):
And, and some were more vocal about it.
Chris Waller, certainly I was supporting,there were others.
But we were still purchasing$120 billion of, you know,
treasury andagency securities a month at that time.
And some general principles that the Fedoperated under that I think with hindsight

(52:39):
ought to be more flexible where,well, you can't push on the gas and
the brake pedal at the same time.
So we can't be continuing to purchasethis amount of securities and
providing accommodation in that wayas we're raising interest rates.
You know, that results in a,in a mismatch.
So we have to stopthe securities purchases.
But the taper tantrum of 2013 headshad taught everyone that, well,

(53:03):
you can't stop security purchases on adime because the markets lose their minds.
And so first you have to talk abouttalking about it and then you have to talk
about it and then you have to havea serious discussion about it at
the fomc and then you have to announcethat you're going to do it in a while.
So that plan was worked outin the fall that we would

(53:25):
go through this whole taperingprocess of purchases and
then start raising interest ratesin response to the inflation.
And it just quickly became clear that,we need to accelerate the,
you know, the tapering fasterthan was originally envisioned.
I mean, the original plan was that itmight have taken as much as a year.

(53:48):
And I think with the benefit of hindsight,the Fed will have learned the lesson
that there are circumstances in whichit is perfectly okay to start Raising
interest rates even as you're beinggradual in tapering asset purchases.
And this was one of them.

Fascinating, shifting back to banks and pinch regulation.
I just really want to, in my lastquestion for you is really just on
deposit insurance because I thinkthe most recent banking crisis that
we've seen was really the Silicon Valleybanking crisis in regional or

(54:27):
regional banking crisis of 2023.
And we had these banks inparticular Silicon Valley bank,
large bank, a lot of insured deposit,
uninsured deposits that really forgothow to manage interest rate risk.
And that concern aroundtaking losses triggered this

(54:49):
massive bank run essentiallythrough people's cell phones.
We've never really seen a bankrun quite like this before.
Typically we're used to thinking ofpeople lining up in a wonderful life or
these other famous photosof people lined up
outside of banks when they gettheir money, to get their deposits.

(55:10):
But here, you know, now peoplewith a click, you know, can take,
pull their money out of a bank andcause a bank run overnight.
The FDIC came in though andresolved these banks and
you know, took them into,took them over and
functions the FDIC should, but.

(55:33):
And there's not just Silicon Valley Bank,there are a few others.
It's also sort of led to Credit Suissealso eventually being very distressed and
got bought out by ebs.
But I think there's sort of thisunresolved question of what is going on
with deposit insurance in that previouslythe rule still is on the books.

(55:56):
Everyone has $250,000 ofdeposit insurance at each bank.
And you could go Go to each bank andget another for every account,
get $250,000 of deposit insurance, and youcould go to hundreds of banks in theory.
But I'm curious, you know, at some level,
we kind of had this de facto sort ofunlimited amount of deposit insurance.
I'm curious where you think, sort of,as a policymaker, where we're at and

(56:17):
how we should be thinking aboutthe regional banking crisis of 2023 and
what we should be doing about depositinsurance from a policy perspective.

So, so, so I do buy in, you know,
at maybe an 85% level to the viewthat the liquidity need for
the current banking system,and particularly for
sort of banks of,of Silicon Valley bank size,

(56:47):
regional banks and, and smaller,
is durably different thanit was 15 years ago as
a result of advances incommunications technology and
in bank technology exactlyas you described it.

(57:07):
So that the ability of Iran to form and
to be severe is much greater than it was.
I mean, just referring back tothe WAMU example, you know,
WaMu failed because it waslosing $1.6 billion a day,
I think, and it did that for10 days in a row.

(57:29):
And that was viewed as an unsustainable,you know,
a completely unsustainabledeposit outflow.
It was slightly largerthan Silicon Valley Bank.
Silicon Valley bank lost $40billion in an afternoon, and
$100 billion was lined up tobe going out the next morning.
This is a, and WaMu was the largest and
most severe bank failure inAmerican history up to that point.

(57:54):
Something was different, and I don'tthink that it was purely idiosyncratic
to Silicon Valley bank, although weall know what its idiosyncrasies were,
that made that a particularly severe case.
So I do think that the liquidity needof the system is greater than it was.
There are two ways, two principalways to address that systemically
as opposed to through draconiansupervisory measures.

(58:18):
One is to increase deposit insurance andtherefore to increase
the amount of comfort that I don'thave to go for a run on the bank
because my deposit is protected andto cover a much higher percentage,
if not all of the sorts of businessdeposits that were, you know, that.

(58:40):
That were the lifebloodof Silicon Valley Bank.
The other, which I think is the preferableapproach because there are significant,
obvious moral hazard concernswith excessive deposit
insurance, is forthe Federal Reserve to return to its

(59:00):
role as the liquidity providerto the system in the.
One of the mistakes, I believe, thatwas made in the aftermath of the great
financial crisis the focus onthe liquidity position of banks, you know,
the, the increased focus onthe liquidity position of banks was, and
the Fed has been the mostextreme about this, is for

(59:23):
the banks to self insuretheir own liquidity.
Basically to say you musthave enough liquidity in your
institution to withstanda very severe run.
And, and
we're going to measure that in a varietyof ways with liquidity stress tests.
And a large part of this hasto be intraday liquidity.

(59:48):
And that was an issue even whenwe were talking about a liquidity
need that was of the sort thatwe still thought we were talking
about at the time ofthe Dodd Frank act and Basel III.
If we're talking about a liquidityneed where a $220 billion able to

(01:00:09):
support the outflow of $140 billionover the course of 24 hours,
that is, that's unsustainable that, thatyou can't, you can't remain a bank and
have that many liquid assets inside ofyour system and self insure yourself.
And the Fed has beenquite insistent on that.
For example, when,

(01:00:30):
when the Fed goes in to do a supervisoryassessment of the bank's liquidity, it
doesn't allow it to take into account thatit has the right to borrow from the Fed.
And as a consequence, many banks do notprepare themselves to borrow from the Fed.
We all know the famous story that well,Silicon Valley bank didn't
have any collateral at the Fed inorder to borrow because why should it?
The Fed had said,you have to have, you know,

(01:00:51):
we're only counting the liquiditythat you keep on your books.
So it borrowed from the Federal Home Loanbank of San Francisco in order to fund
putting liquid assets on its booksthat it could show the Fed that I have
enough hqla.
So.
I think the Federal Reserve should go backto the fundamental reason that it was

(01:01:12):
created.
It's the reason we don't call itthe central bank of the United States,
but call it the Federal Reserve,
which is that it exists to poolthe reserves of the banking system and
direct them to where they are most neededat any point in the event of a run.
And you know, Silicon Valley banks,the structure of its portfolio was such
that if it could have held those assetsto maturity, it was perfectly solvent.

(01:01:36):
It could not hold on tomaturity during Iran but
the Fed could hold thoseassets to maturity.
The Fed could have very safely simplylent the money to Silicon Valley
bank to pay off those deposits.
And eventually what wouldhappen with every run is,
I'm going to get myMoney I don't have to run.
But you would do that through the Fed'sprovision of liquidity as opposed to

(01:01:56):
kind of non discriminant depositinsurance which allows for
kind of much more intelligent decisions tobe made about the ultimate viability of
an institution that the liquidity is beingprovided to and therefore an amelioration
of the moral hazard problem of anysort of government intervention.
So, so, so that's again that's my logaricanswer to the deposit insurance question,

(01:02:21):
which is I don't think we should beincreasing deposit insurance, but the Fed
really needs to kind of go back to basicsin thinking about its role as the lender
of last resort and reinvigorate it towhat it was originally intended to be.

>> Jon Hartley (01:02:38):
That's great.
One last question.
Any last.
Any thoughts at all onstablecoin regulation?
There's some legislation that'sgoing through Congress right now.
There's been I thinka lengthy debate about this.
You know, how much should stable coinsbe treated like banks and so forth and
what should the sort of guide rails be?
And we've had sort of circle whichruns USDC led by Heath harbor mutual

(01:03:03):
friend of ours that this much I think beenhistorically wanting to be regulated.
Tether on the other side that's been a bitmore controversial, doesn't kind of quite
want to be regulated, hasn't been quite astransparent as some people would like in
terms of where it's keeping its proceeds,that that's backing the stablecoin.
At the end of the day, they're bothinvesting in treasury bills and

(01:03:27):
taking the, investing the float andtaking this and the interest and
maintaining a stable asset.
But I'm curious froma regulatory perspective,
how do you think about stablecoins?

>> Randal Quarles (01:03:38):
Yeah, I think that, you know, I think that stablecoins distinguish
them from sort of crypto 1.0,Bitcoin, Ethereum,
that sort of thing which I have no problemwith, but I don't think is ever going
fundamentally be transformative of thepayment system or the financial system.

(01:03:58):
But stablecoins could be quite.
Important in the financial system and
particularly with respect to internationalpayments and across border payments.
And, andthe official sector has some legitimate
issues with regard to howthe pool of assets by which
the stablecoins value ismeasured is constructed and run.

(01:04:24):
I think those issues are pretty obvious.
They're well addressed in the stablecoinlegislation that's passing.
They've been well addressed sincethe President's working group
with Janet Yellen as chairof the treasury, as chair,
as Secretary of the treasuryput out at the end of 2021.

(01:04:47):
You know, the, the issues are clear,the way to address them is clear.
The stablecoin industry is actually quitehappy in having them addressed in the way
that has been, you know, know,kind of well understood for a while.
We just went through a period where thatwhole process was being stymied by well
intentioned but aggressive regulatorwho wanted to be the crypto cop and

(01:05:08):
didn't want a, you know, a frameworkthat kind of put clear responsibility,
you know, clearer responsibilityon the bank regulators as opposed
to securities regulators for the,for the stable coins themselves.
I think, you know,once we put that framework in place,
which is not politically orintellectually difficult to do and

(01:05:33):
so I think it will be done overthe course of this year probably we
have a great framework forstablecoins to grow.
I think that's not only good for thefinancial system, I think it's good for
the US dollar and
I think it then prevents some ofthe concerns that I have about tether.
The people will live in that framework.

(01:05:54):
It is a livable framework.
It is good for the public,it's good for the industry,
it's good for the financial system.
And the tethers of the world willkind of be relegated I believe
once we get that done.

>> Jon Hartley (01:06:10):
Yeah, it's fascinating.
And there's now word that the consortiumbanks may be starting their own
stablecoin.
It's gonna be very interesting to seewhere the stablecoin industry goes as it
sort of becomes more regulated.
Randy, I really want to thank you forcoming on.
It's been an amazing conversation.

>> Randal Quarles (01:06:26):
Thank you very much for having me.
That was a great pleasure.

>> Jon Hartley (01:06:29):
This is the Capitalism I'm Free from the 21st Century podcast,
an official podcast of the Hoover EconomicPolicy Working Group where we talk about
economics, markets and public policy.
I'm Joan Hartley, your host.
Thanks so much for joining us.

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Banking Crises, Stablecoin Regulation, And Fed Policy With Randal Quarles

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