Evan Soltas
Jul 8, 2012

The Specter of State Management

Federal Reserve Bank of New York Building
A few weeks ago, I attended a talk and Q-and-A which featured Sarah Dahlgren, an executive vice president of the New York Federal Reserve, where she heads the Financial Institution Supervision Group. Also on the panel of three were Steven Manzari, a senior vice president there who runs the Complex Financial Institutions Function division of Dahlgren's Group, and Jonathan Polk, another senior vice president.

I've waited some time to share my notes on the blog because I was expecting, ultimately in vain, to hear back from the event organizers as to whether I had clearance to share their comments publicly. I didn't see any other media representatives at the talk, and I didn't see any subsequent coverage, so I feel a some sense of obligation to put this on the record. Be advised that all three people made it clear that they were not speaking as formal or official representatives of the New York Fed, but as private individuals.

Dahlgren, Manzari, and Polk led the New York Fed's response to the near-bankruptcy of AIG, and the session focused on this topic and the resulting Dodd-Frank redesign of the financial regulatory structure.

The crisis and its lessons

In response to a comment that AIG should have been forced into bankruptcy, Dahlgren and Manzari, answering together, said that bankruptcy -- and especially the orderly, quick, confidence-inducing sort that some wanted -- would have been effectively impossible for AIG. This is because AIG didn't know fully AIG's own legal structure. A Standard Oil-esque octopus conglomerate, AIG was so complex and multilayered that taking it apart to sell off components took weeks, if not months, of legal work. There was at one point an org-chart of AIG which went from wall to wall in the office of the AIG crisis response team of the New York Fed. In other words, they saw the problem as not "too big to fail," exactly, but "too complex to fail." The lesson learned for the Fed was to force all systemically important financial institutions to have "living wills."

Manzari also faulted regulators for looking at the risk management plans and controls of firms under their scrutiny to the exclusion of basically everything else. For years before the crisis, the regulators' job was seen as examining these policies; if the firm's risk management policies looked sound, then the regulators' job was done. The consequence of this approach was that regulators had little knowledge, not only of the firms' legal structures, but of their revenue models. They had looked only at the risk controls, without having any understanding of the financial products or businesses which were producing the risks. As a result, they were not in a position, prior to the crisis, to detect or prevent the risk-management problems which came from the expansion of the derivatives market or any other sides of the financial sector. What looked sound using standard procedures of risk management would have been revealed, without the need of a crisis, to be dangerously insufficient had they understood the origin of the risks. And when the crisis happened, their lack of knowledge of the business models of the firms they were regulating hurt the regulators badly, because they were at a loss as to how to resolve the failed firms and spent a great deal of time playing catch-up amid the crisis to understand their business models.

Dahlgren also said that she did not see it as the job of the regulator to prevent financial crises -- that it wasn't a reasonable goal -- but rather it was their job to construct a system of financial regulation in which future crises would be local and contained, rather than systemic and epidemic, and furthermore that the financial system would be able to withstand and quickly recover from any crisis, rather than scarred or disabled for long periods of time. One way to achieve this, Dahlgren said, is to substantially increase capital and liquidity requirements for the systemically important financial institutions, with the power of regulators to increase the requirements in level and in type to forestall crisis -- here was a reference to financial problems in Europe transmitting themselves to the United States.

Another important line of Dahlgren's commentary related to the new resolution processes and tools regulators have for failed financial firms. The goal is unambiguously not to "rescue" the firm, but rather to render it systemically unimportant by selling off businesses, slowly cutting down the firm's operations, and shriveling it down like a raisin in the sun until it can be ultimately shut down. Under such procedures, clearly, it is the public/systemic/state interests which come first; private interests and shareholders get wiped out in such a scenario.

The new regulatory structure

As they began to discuss the new regulatory program, it became very clear to me that the New York Fed had asserted and gained effective state control of systemically important financial institutions.

With regulators now empowered to examine sources of revenue and business models of such firms, in addition to their risk control structures as Manzari discussed above, regulators gain the ability to design the business models of such firms according to what they see as generating systemic risk. If the New York Fed thinks that a credit-derivatives trading branch of some systemically important financial institution is a source of systemic risk, then the Fed has the power to tell the financial institution that said branch has to go.

The conclusion that complexity, not size, is the problem has led the NY Fed to orce restructuring so the American financial system consists of simple, streamlined firms rather than multipurpose, diversified, and highly complex financial institutions. Regulators, of course, are also empowered to use their discretion to decide which firms qualify as "systemically important," and Manzari made it clear that the Fed would use this definition as necessary to control systemic risk. A member of the audience asked a question (not me, I didn't ask any questions) if a hedge fund, boutique investment bank, or other firm which was small in size could be considered as falling under this scope if need be, and Manzari basically said yes.

Increased capital and liquidity requirements will also further the public/systemic/state interests at the expense of profit and the private interests; the ability to increase or alter the requirements on an as-desired basis gives regulators an additional mechanism of state control.

The regulators are also much more closely involved than they used to be. First, Dahlgren said that regulators attend the firms' board meetings, work with and counsel extensively the firms' board members. Second, Polk said that senior members of the regulatory staff have been designated contacts for particular senior executives at the firms they are regulating, and Dahlgren said that these relationships have communication almost every day with 24/7 access. The executives are giving, and are required to give, live updates, information, and answers to the regulators' questions; the regulators are giving instructions, information, and answers to the executives' questions. Third, the Fed has moved the teams which are doing the actual regulatory monitoring into the buildings of the firms they are regulating, giving them much more extensive access, involvement, and authority to take action.

I am far from an expert on financial regulation, nor do I have the firsthand experience of Dahlgren, Manzari, or Polk in crisis management. (See my other comments on this topic here and here.) But I hope I am not the only one who is made profoundly uncomfortable with the policies drawn up in response to the crisis and the specter of state management they stir in the name of crisis prevention.