Leadership Matters

During the late 1990s and the early 2000s, interest rates were low, the economy was strong, and the banking industry was earning record profits. Most people acted like the good times would never end. Federal Reserve Chairman Alan Greenspan talked about how productivity gains were creating strong economic growth without inflation.

Amid this climate of confidence, the FDIC was slowly but steadily rebuilding. The downsizing that had consumed the agency for many years was mostly complete. A number of new initiatives were launched to improve management within the agency, and a new chairman, Don Powell, pressed the agency to become more assertive, recognizing that its inward focus had been a handicap in debates over financial regulation.

With this mandate, the FDIC reengaged with external constituencies. We also placed renewed emphasis on identifying and analyzing issues that posed a potential threat to the stability of the financial sector. As a result, the agency identified and spoke publicly about the shortcomings inherent in the Basel II capital standards, began preparing for how to handle the failure of a large bank (which was viewed as unlikely at that time), and pinpointed the risks in the housing market as subprime mortgages proliferated. While the FDIC's warnings mostly fell on deaf ears, our work nonetheless signaled that the agency was prepared to once again be a leader in financial stability and financial regulation.

In January 2001, Bill Clinton ended his eight years as president and George W. Bush succeeded him. This shift from a Democratic to a Republican administration marked another shift in the composition of the FDIC's board of directors. John Reich, a Republican who had been a community banker in Illinois and Florida and who had served as Senator Connie Mack's (R-FL) chief of staff, was appointed as vice chairman that same month. He replaced Skip Hove, who retired after 10 years as an FDIC board member and three stints as acting chairman. It was an emotional farewell. Skip was highly regarded by the FDIC staff throughout the country for his steady demeanor and strong commitment to the agency and its staff.

In August 2001, Don Powell was confirmed by the Senate to become FDIC chairman, replacing Donna Tanoue, who had resigned a few weeks earlier. Powell, like President Bush, was a Republican and a Texan, and had worked in banking for many years, most recently as the president and CEO of the First National Bank of Amarillo. He also was a former chairman of the Board of Regents of the Texas A&M University system.

Two years earlier, in November 1999, I was selected by Donna Tanoue to serve as deputy to the chairman and chief operating officer, returning to the position that I had held while Bill Seidman and Bill Taylor served as chairman. This time, I gained the broader responsibilities associated with the role of chief operating officer. Once again, I was working for a new chairman and wondering how it would work out.

The early signs were encouraging. Powell showed a clear desire to work effectively with the FDIC staff. Having recognized that the FDIC was historically composed almost entirely of career staff, Powell decided to bring only two people with him to the agency. John Brennan, a long-time and highly successful banker from St. Louis, Missouri, was brought in as a deputy to the chairman. Jodey Arrington, who had worked at the White House for President Bush, became Powell's chief of staff, replacing Mark Jacobsen, who had recently left the FDIC after capably taking the lead on several key policy initiatives.

From the start, Powell was in charge. He was perfectly willing to make the decisions he felt were appropriate for a chairman to make and delegate other decision-making responsibilities. He wanted everyone to be responsible and accountable for his or her own actions. When one manager who had become accustomed to running relatively minor decisions up the flagpole asked what to do about a certain matter, Powell told him that was his area of expertise so he should be telling the rest of us what to do.

I knew what my responsibilities were and appreciated the authority that Powell was allowing me to exercise. Powell made it clear that he would hold me accountable for my actions but that it was up to me to determine how to get my job done. Powell's management style allowed me to place a lot more authority and trust in the hands of the people working directly for me. They could then place more authority and trust with the people who worked for them. When I made mistakes, Don would let me know, but he always publicly defended my decisions.

Powell wanted the entire management team at the FDIC to understand his philosophy and become better managers. He began a series of regular leadership conferences for the agency's senior managers and invited outside speakers. These didn't start out well. Many managers were mistrustful of Powell and what he wanted to accomplish. Greater accountability meant greater personal risk. Since the downsizing wasn't completely over, some managers were fearful that their new chairman might be looking to push them out the door. While that wasn't the case, Vice Chairman John Reich, who strongly supported Powell, made it clear to the managers assembled at the first leadership conference that no one needed to stay at the FDIC if they weren't satisfied with their jobs.

Powell wanted to bring accomplished leaders to our management conferences. The first person he invited was Jack Welch. Welch refused. We were told that Welch believed there was no hope for any government agency so he didn't want to bother. For those of us who actually believed we could make a difference, this was disappointing.

However, Herb Kelleher, the CEO of Southwest Airlines, did agree to speak. Erica and I met Kelleher when he arrived at the conference center. We had been told in advance to bring a bottle of 150-proof Wild Turkey. Kelleher chain-smoked his way through his speech and had more than a few shots during the evening but was a knowledgeable and entertaining speaker.

Under Powell's leadership, we began a series of management initiatives to improve the FDIC's internal operations. Training programs that extended to all of the FDIC's employees were of particular importance. Bank examiners, who had very structured training programs during their first few years of employment, had relatively few training opportunities after that point. Given the growing complexity of the financial system, creating more advanced training programs in specialized areas of expertise was becoming increasingly important. In 2003, under the FDIC's newly created Corporate University, we began developing such programs.

We also needed to enhance our generalist training programs. We created a Corporate Employee Program. It allowed new employees to develop their skills in more than one area of expertise before they settled on a career path. The program created greater awareness among the staff of the FDIC's broader activities, and gave the agency greater flexibility to move staff into jobs where they were most needed, which would be particularly important during a financial crisis. I believe the program led to better decision making and performance across the agency.

Other steps were taken to improve decision making within the FDIC. A Human Resources Committee was formed, composed of senior representatives of all the internal functions, to provide recommendations on major personnel issues such as compensation levels, training initiatives, and promotion policies. Glen Bjorklund, the senior deputy in the Division of Administration, chaired weekly no-holds-barred meetings of this group.

At the time, Powell did not get much credit for such initiatives in part because employees were fearful of additional downsizing initiatives, but also in part due to active opposition from the FDIC's union. Powell was aware that on major personnel issues, such as pay-and-benefit negotiations, the union had often reached an agreement with management on a course of action, then immediately denounced the agreement in public forums. Such actions undermined cooperation between management and the union and added fuel to employee unrest (which also helped add dues-paying members to the union). In an attempt to avoid such a result, one of Powell's first meetings was with Colleen Kelly, the head of the National Treasury Employees Union, which represented FDIC employees. Powell asked if he could count on her to publicly support any agreement they reached together. She refused, and the tone for their relationship was set.

While considerable effort was devoted to having strong management, another of Powell's top priorities was for the FDIC to end its inward focus and reassert its role as an important part of the financial regulatory community. He told us that we “kept talking to ourselves” and that we needed to interact more with the outside world.

He was right. Years of downsizing had taken its toll. We had invested so much time and energy navigating through those difficult times that we were not communicating effectively with our external constituencies. Powell encouraged us to engage more broadly with relevant groups to develop our positions on the key policy issues. We began conducting symposia to gather input from interested parties, as we developed our policy positions and then began to publicly promote those views.

Powell cared deeply about ensuring that the banking industry maintained strong capital levels. This meant ensuring that sufficient amounts of the owners' money were at stake to cover any losses that might arise in the event banks ran into financial difficulties. Powell ran a bank in Amarillo during the 1980s and early 1990s. Hundreds of banks in Texas failed during those years, but his bank survived. He made sure his bank had built up enough capital during the good times to survive through the bad times. In his mind, “capital was king.”

The focus on strong capital standards contrasted with the efforts of the other bank regulatory agencies, which were directed toward reducing bank capital standards. International efforts to reform bank capital standards under the “Basel II” capital framework (named after the city in Switzerland where bank regulators meet to determine international bank supervisory standards) were being pushed by the Federal Reserve and by other international bank regulators. The Basel II approach allowed the world's largest banks to use their own internal models to determine how much capital they should hold. The standards also permitted much lower capital requirements for certain categories of “less risky” assets, such as residential mortgages and government debt.

While in theory it makes sense to have lower capital requirements for less risky types of assets, in practice it's quite difficult to determine what qualifies as “less risky.” The flaw in Basel II became painfully obvious a few years later, as the plunge in U.S. housing prices and Europe's sovereign debt crisis showed that residential mortgages and government debt carried considerable risk.

Even more problematic under the Basel II standards, “off-balance-sheet assets” had no minimum capital requirements. The 2008 financial crisis showed that banks sometimes still have responsibility for (and potential losses associated with) assets that presumably are off of their books. All of this argues strongly that banks be required to hold large amounts of capital regardless of the composition of their assets—a position the FDIC has always strongly supported.

The U.S. bank regulatory agencies required that the largest banks conduct “quantitative impact studies” with their internal models to see how much capital they would have throughout the business cycle under the Basel II capital standards. By now, the regulators were on their third test, or QIS-3, as it was called in the bank regulatory world. The reports back from the banking industry were that aggregate capital requirements would not decline much under Basel II, even though individual banks might be positively or negatively impacted.

George French was the senior FDIC person working with staff from the other bank regulatory agencies on assessing these results and determining the likely impact of the proposed Basel II capital standards. Most people who know George believe he is a rather reserved person. I know better. George enjoyed taking me apart over a chessboard. Others had similar experiences, which gave rise to the (friendly) nickname “Mean George.”

His analysis of the results from a change to Basel II capital differed from the conclusions reached by the banks. Using more realistic scenarios than what the banks had provided, he projected that implementation of Basel II would result in a significant decline of the required capital levels at the largest banks—averaging about 40 percent.

The Federal Reserve and the largest banks didn't particularly like hearing what George had to say. They were pretty far down the road on the Basel II framework and didn't want the FDIC throwing it off track. Representatives from the largest banks, who had never paid much attention to the FDIC before, started to come by to visit to explain their case, but the agency did not back down.

Powell gave George permission to release his results, over the objections of the Federal Reserve, and they were published in December 2003. The main conclusion was highlighted up front: “Contrary to descriptions of Basel II not significantly changing overall capital requirements, we expect large percentage reductions in risk-based capital requirements.” Nevertheless, the FDIC's voice was ignored as much of the rest of Europe's and the United States' bank regulatory agencies remained firmly behind the Basel II standards.

To his credit, Powell made the case for strong bank capital levels throughout his term as FDIC chairman. Later, Acting Chairman Marty Gruenberg and Chairman Sheila Bair would continue as vocal advocates for strong capital requirements. If the banking industry had listened to them, it would have been better prepared for the 2008 financial crisis.

Powell also helped the FDIC staff win back an important authority it had lost a decade earlier. This authority was known as “backup supervisory and enforcement authority,” and Powell's action freed the FDIC staff of the requirement to seek board approval before examining problem banks that were outside the agency's direct supervisory authority (most large financial institutions are supervised not by the FDIC, but by the Federal Reserve and the Office of the Comptroller of the Currency [OCC]). While it sounds like an administrative matter, few issues resonated deeper with the FDIC's staff.

The FDIC's board voted in 1993 to impose the requirement to obtain board approval for all backup supervisory actions. In the years that followed, the FDIC generally had a vacancy on its five-member board. With two of the remaining four board positions filled by representatives from other bank regulatory agencies, it became difficult for the staff to obtain approval for any backup supervisory actions. Generally, the view of the “outside” board members, and the view of many bankers, was that there were enough regulatory agencies examining these banks without creating the extra burden and cost associated with adding the FDIC into the mix. As a result, the staff rarely sought to use its authority, despite the agency's desire to intervene early in troubled institutions, and a strong practical interest in how all insured institutions are managed and supervised.

Powell knew the staff felt handicapped without being able to effectively exercise the agency's backup authority and was determined to take corrective action. When the board was reconstituted with a full five members (three of whom had no affiliation with the other bank regulatory agencies), he seized the opportunity to consider the issue, and secured a majority vote to restore the authority. In the aftermath of the 2008 financial crisis, Congress included provisions in the 2010 Dodd-Frank Act that further enhanced the FDIC's backup authority.

In the aftermath of the banking and S&L crisis in the 1980s and early 1990s, it was clear that the FDIC had not done enough to examine the broader, more systemic risks facing the banking industry. Chairman Helfer addressed that concern in 1995 when she created a Division of Insurance, which was staffed with economists, financial analysts, and bank examiners, who were tasked with examining system-wide risks.

In January 2003, Powell created a National Risk Committee composed of the agency's senior-most officials and began to look at pending risks from a variety of perspectives. Art Murton, Maureen Sweeney, Rich Brown, and the staff in the Division of Insurance and Research were responsible for providing regular assessments of conditions in the overall economy and its various sectors. Mike Zamorski, John Lane, and the staff in the Division of Supervision and Consumer Protection were responsible for providing analyses of how banks were faring overall, and how they were faring in particular types of activities at the national, regional, and individual bank levels. The committee meetings started to provide us with coordinated insight that guided us in developing policy responses, supervisory priorities, and organizational resource requirements.

Of all the work carried out by the National Risk Committee, the most significant was its findings about the U.S. housing market. At a time when analysts throughout the private and public sectors were celebrating the rise in housing prices, the committee identified a number of reasons to be cautious about the rising prices.

Cynthia Angell and Norm Williams analyzed each of the country's metropolitan areas and found that there were 33 markets in 2003 where housing prices had risen so dramatically they could be characterized as boom markets, the highest number witnessed during the 25 years covered by their data. The analysis also showed that while housing booms sometimes turned into busts, more often the result is a prolonged period of price stagnation. What made these price rises different from others was an erosion in mortgage-lending standards. Subprime mortgages had increased nearly 10-fold in the prior nine years, and such mortgages were associated with much higher rates of default. Home buyers were also increasingly availing themselves of higher leverage mortgage products and second mortgages (also known as “piggyback” loans). The report concluded, “An increased incidence of default and foreclosure could, in turn, contribute to downward pressure on home prices as distressed properties are liquidated by lenders.”

In warning about the rise in housing prices, and the potential for a crash of the housing market, the FDIC was a lone voice in the wilderness. No other government agencies were issuing similar warnings, and the chairman of the Federal Reserve, Alan Greenspan, was categorically rejecting the idea of a bubble in the housing market.

Trying to draw the right balance between getting important information out to the public and not creating panic by having a federal agency say the sky was falling, we decided to publish the study to raise public awareness and let others draw their own conclusions. In February 2005, the FDIC issued the report, which was titled: “U.S. Home Prices: Does Bust Always Follow Boom?” We expected that it would receive a lot of attention; instead, it received very little.

Shortly thereafter, Angell and Williams updated their analysis to incorporate data from 2004 and found that the number of markets with housing booms had increased to 55, twice the peak of the late 1980s' housing boom. This analysis was published a few months later, under the same title. An Associated Press article about the report was headlined “Red-Hot Housing Markets Stir Fears of Busts: Bank Regulator Warns of End to Housing Boom.” The article noted that the FDIC repeated its warning that “credit market conditions may make current housing market booms different than past ones, which have tended to taper off rather than bust.”

While the FDIC began taking more aggressive action against individual institutions with weak mortgage-lending standards and high exposure to markets with housing booms, there was little market reaction to the report. It may simply have been that people were making so much money from the housing boom that they didn't want to stop speculating on housing prices any sooner than necessary. But, in retrospect, we should have been more aggressive with our warnings.

The FDIC also identified the risks posed by an erosion of lending standards, as well as higher concentrations of risk building in commercial real estate markets well before they began to manifest themselves in actual losses. We addressed those concerns by issuing a regulation requiring that banks increase their capital levels as both the level and the riskiness of their commercial real estate exposure exceeded certain levels.

In March 2004, I created a Large Bank Resolution Policy Committee. My purpose was to better prepare the FDIC for a large-bank failure. While I viewed the likelihood of such an event anytime soon as small, the implications for the FDIC and the financial system were severe. It was way past time for us to address the issue. Ever since the failure of Continental Illinois in 1984, there had been an awareness of the problem of too big to fail.

Between 2004 and 2007, the FDIC started to address large-bank resolution policy issues. A number of steps were taken to better prepare for the financial market calamity that ultimately awaited us. At one point, Powell encouraged us look at whether it made sense for the FDIC to seek failure resolution authority for Fannie Mae and Freddie Mac, the two large government-sponsored housing agencies that later had to be taken over by the federal government. We ultimately decided not to pursue such authority.

Between 2006 and the first half of 2008, we engaged in a series of bank failure–related training exercises and large-bank failure simulations. These exercises proved to be helpful in preparing us for the financial crisis. Our last failure simulation exercise had much in common with what later happened at Wachovia.

While the FDIC could take pride in its work highlighting the shortcomings of Basel II and vulnerabilities in the housing market, as well as our work preparing for how to respond to major bank failures, the agency had a mixed record in identifying emerging risks to the banking system prior to the 2008 financial crisis. For example, our efforts focused exclusively on insured depository institutions (the banks we were responsible for as deposit insurer) and the universe of institutions that created the banking crisis of the 1980s and early 1990s. We did not try to identify the risks that were building up in institutions outside the banking system, as we saw that as beyond our scope, and we accepted the conventional wisdom that these institutions were adequately diversified. While data were scarce, our mistake was in not trying to identify the nature of this diversification, and failing to see that relatively new and complex instruments, like collateralized debt obligations, could actually be magnifying risks—not mitigating them—and threatening to overwhelm the entire financial system.

The FDIC also missed some of the problems developing within the country's largest banks. These banks had moved many of their risky mortgage-backed securities off their balance sheets into special investment vehicles (SIVs). The large banks didn't own these SIVs—that privilege was reserved for some of their best customers. But when these SIVs could no longer obtain market funding, their sponsor banks felt obligated to absorb the losses. We may have missed the SIVs because the FDIC still wasn't really involved in monitoring risks in the country's largest banks. In our defense, the OCC and the Federal Reserve, the large banks' primary regulators, also missed the threat posed by SIVs, as did the banks that created them.

Even these shortcomings could not obscure that the FDIC, having worked through its many internal issues, was coming out of its self-imposed shell and reengaging in important public policy debates. Don Powell, who left the FDIC in November 2005 when President Bush asked him to take charge of the Hurricane Katrina relief efforts, deserves much of the credit for helping the agency to reassert itself. With a major financial crisis on the horizon, the new thinking that permeated the agency came not a moment too soon.