Banking Crises, Stablecoin Regulation, and Fed Policy with Randal Quarles

>> Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Institution 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 of the Federal Reserve for Supervision, is chair of the Financial Stability Board.

 

Undersecretary of the Treasury for Domestic Finance in the George W. Bush administration, and is currently the chairman and co-founder of the Cynosure Group, a Utah-based investment firm. Welcome, Randy.

>> Randal Quarles: Thanks for having me.

>> Jon Hartley: Well, Randy, I'm super excited to talk to you about all things finrag or financial regulation-wise, but I want to start with talking about your early life.

 

You were born in San Francisco, but raised in Utah and state at Columbia. For your undergrad, you did your law degree at Yale Law School. Never heard of that place. You worked at Davis Polk, you worked for Nick Brady in the George H.W. Bush administration, you later worked at Carlisle.

 

I'm just curious. You know, interestingly, many of those plays are some of the same places that Jay Powell worked as well. I'm curious, at what point did you get interested in financial regulation? Was this something very early on for you or was it something that you sort of grew to enjoy over time?

 

I also know as another fun fact I think you were at, when you were at Yale Law School, you were part of one of the, I think you were part of the founding chapter the Federalist Society at Yale Law School there. I'm just curious, like at what point did you really get into financial regulation?

 

 

>> Randal Quarles: Well, it wasn't in law school. I had a law school classmate who from 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, and I did not probably wanted to be more of a constitutional lawyer and a legal academic.

 

Became a little disillusioned with the academy during my time at Yale Law School and much more interested in the sort of practical application of law and policy went to Davis Polk. Davis Polk is one of the main, I guess you'd say the two main financial law firms in the country, along with Sullivan and Cromwell.

 

And so that then became my exposure to the technical aspects of financial regulation, both bank regulation and regulation of the financial system more generally. And I found it very interesting and it was my job. And after several years there, the, you know, the, the treasury, this is now at the very outset of the George H.W. Bush administration.

 

The treasury had taken on, in the aftermath of the savings and loan crisis, a study of financial regulation, the Glass-Steagall Act. They asked sort of the usual suspect law firms in New York, there were four or five of them to nominate a candidate to come down and join the team that would be 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. 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 is where I was at the time, to come down and kind of be the junior person on that team to bring the sort of technical expertise. 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 of inevitable given the places that I went and the people that I worked with.

>> Jon Hartley: Fascinating. I know Bob Glauber, he was one of my own professors at the Harvard Kennedy School and I knew him before he passed.

 

Amazing. You work with Nick Brady and all these other amazing figures I think formed many, many people like Jay Powell and others later on. Later on I guess. So I'm just curious. I want to talk about the financial crisis, I think the financial crisis was a defining moment for financial regulation.

 

I mean, what went wrong in the Global Financial Crisis 2008? As you see it, in terms of sort of underlying causes, what went wrong with banks? Would lack of bank capital be at the top of your list? I know other folks like to talk about contagion a lot.

 

I'm curious, how do you diagnose the global financial crisis and what was wrong with banks?

>> Randal Quarles: Capital was obviously relevant, but I wouldn't put it at the top of the list as the cause of the crisis. I think. I mean this sounds quite mundane, but I think the financial crisis was almost an inevitable, certainly an expectable consequence of the combination 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. They were very buttoned up. And the express job of the young lawyers was to keep the young bankers in line.

 

The, you know, the bankers were the clients, they knew the deal. But you were to ensure that all of the due diligence was done. That all the things that might go wrong had been thought of, that the appropriate measures had been taken to protect against what might go wrong.

 

And at the very top of the systems, at both the banks and the law firms, the, you know, there were very clear instructions to the troops down below that this is how it was supposed to go and people were very careful. And over the ensuing 30 years from, you know, from when I began, the, the people became laxer and laxer because nothing very bad happened.

 

Those practices had developed because some bad things had happened in the 60s and 70s with respect to the extension of credit. And you had the sovereign debt crisis of the 80s, but you didn't have systemic results as a consequence of that. You had the 1987 market crash and which seemed to happen and be extraordinarily dramatic, as I recall at the time and yet nothing really bad happened.

 

And I think you can, yeah.

>> Jon Hartley: In the real economy at least, nothing I guess.

>> Randal Quarles: Exactly. In the real economy.

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

>> Randal Quarles: Exactly. But, but with respect to the, with respect to the advanced financial economies and the, you know, and sort of credit, you know, widespread credit problems as a 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.

 

It led to a. Well, we don't have to be quite as strict as we have been in the past with respect to the. Just the practical measures that we take in connection with the extension of credit. We can get more creative with the vehicles and mechanisms through which we extend credit.

 

We can increase the amount of leverage. And if we don't, somebody else will. And so within organizations, the inevitable pressure again from the folks 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, this is exhausting to listen to you complain.

 

Yeah, go ahead and do it. And which ultimately led to a situation where you had, you know, a lot of poorly structured, poorly underwritten credit in what extended in ways that were not always obvious that it had even been extended, and certainly what the amounts were. And I don't think that that was a result of bad bank regulation or bad bank supervision or, you know, I'm not even sure that you would call it bad management of the institutions.

 

And certainly people were neither crooks nor idiots involved with that process. You know, they were human beings who had lived through an extraordinary stretch of quite good times. And that's what's going to happen now. You know, when the, you know, when the 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 happening over the course of decades, can't see where, you know, where a big financial stability shock may be coming from.

 

We should have a system that's more resilient to shocks. We should have more capital. But it wasn't really the regulation or the capital levels that were in any way a cause of what happened.

>> Jon Hartley: Sure, well, I guess, yeah, had the capital been different, I guess, would it have been a different result, I guess.

 

There's all sorts of, I guess, people who, I guess there's different sort of schools of thought. There's some, I guess, who would say that one. I mean, there was obviously a big buildup in housing and, you know, to what degree that was even preventable, I think, is another question.

 

Whether this lacks lending standards is it something that was a cultural issue versus, I guess, a regulatory issue. Then some people point to the Community Reinvestment act as incentivizing housing in some way, sort of passed in the 90s. And I guess then there's other people who sort of blame mass securitization, CDO squared, as creating too much sort of complexity and financial markets and that sort of complexity.

 

 

>> Randal Quarles: I really think that all of those are various manifestations. Really almost all of those are various manifestations of the larger kind of the larger theme that, you know, the caution that was drilled into people involved in the extension of credit in its various forms, you know, in the late 70s and early 80s, as I was starting, my career eroded and it eroded because we were living through a pretty good time.

 

And I'm not sure. And, and that will happen again in part because measures that were taken in response to that have again allowed us to live through some pretty good times, some at least with respect to the stability of the financial system. And over the course of a long period of time, humans will be humans.

 

You're not going to change that. And they will get complacent.

>> Jon Hartley: Well, I guess so. I guess moving away from some of the causes, you know, crises are, are a fact of, of life and they aren't, you know, recessions, I don't think are ultimately preventable. I mean, there are these disasters that just happen often, almost always for unforeseeable reasons.

 

But I guess so fast forward, 2008, Bear Stern, there's all these problems that emerge with 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 and Freddie are put into conservatorship. So you have that, then you have Lehman, you know, Lehman, you know, declaring bankruptcy.

 

I think Hank Paulson was looking for a buyer for one many of these, you know, JP Morgan came in and bought Bear Stearns, you know, Merrill lynch was bought by bank of America. You had these big commercial banks kind of bringing stability in buying up these distressed 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 Lehman moment where there was a question of, you know, what to do with Lehman. And my understanding from, from Hank Paulson, then Treasury Secretary, was that he was trying to find a buyer for Lehman with Barclays.

 

And they were halted by, I think, the UK government. There's something that, I think, Paulson is sort of blamed at least in 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 outright saved in, in some way that the government, I guess, tried to completely backstop in some way rather than letting it go?

 

I mean, in your mind, could things have been played out very differently had Lehman not sort of gone bankrupt the way it did?

>> Randal Quarles: No, I actually don't think things would have been that different if they had somehow bailed out Lehman. I may be one of the five people who still believed that was the correct decision.

 

And if you go back and you look at how the financial crisis evolved on kind of a day to day basis during that time, you had the Lehman failure. And if Lehman is going to be the of a crisis of confidence in the system, you can't really see that in the performance of the financial system in the immediate aftermath of the Lehman crisis, in the performance of credit, in the performance of various markets.

 

The actual crisis began almost a 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 which the failure of WAMU was handled. And I'm not. And because again, markets were, you know, obviously they were under strain because of everything that had been happening over the course of the summer.

 

But in the aftermath of the Lehman crisis, they were not particularly more dramatically affected until the failure of WAMU at Carlyle. We were in the process, for example, of considering kind of a anchor, confidence inspiring investment in Wachovia. Bob Steel, who had succeeded me as Undersecretary of the treasury, was the CEO of Wachovia at the time.

 

And the thought was Carlyle, a private equity firm, even the size of Carlyle is not going to be able to. Put in enough capital to sort of fundamentally recapitalize Wachovia, but that if we would make a significant investment, having done a lot of due diligence on the state of the bank, that that would anchor confidence and would, you know, and would shore up others in being willing to provide various sorts of financing to the bank and settle its situation.

 

And we were prepared to do that up until the failure of WaMu. And, and the FDIC was worried that there could be a number of bank failures 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 protected by the FDIC in a bank resolution, although they weren't legally required to be that in this case, the FDIC said, well, since we, since we think we need to really work to preserve our fund, we're not going to preserve them.

 

But there was little advance warning of that with the failure of WaMu and Little and confused communication around it. And that is when you saw kind of the system of financing for 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 in the 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 and unclarity is, you know, perhaps the worst villain in sapping confidence in a system. It's like, if I don't know what's going to happen.

 

And so we immediately stepped back from providing the equity investment in Wachovia. We said, we don't know what the rules are anymore. And Wachovia failed relatively promptly after that because. Because it was now part of the system being swamped by a lot of providers of financing to the banks and to 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 trigger of the financial crisis. It was not Lehman. And I think, you know, going forward, letting Lehman fail was the right thing. It's the moral hazard question that people were concerned about.

 

The moral hazard reason that they did not save Lehman. The view that going forward, you want people to say they don't save everybody. As we're making decisions about what sorts of risk we ought to be taking, we can't count on being bailed out. And I continue to think that that was the right decision.

 

And that it was not a trigger of the crisis.

>> Jon Hartley: Got it, but you don't think I guess in my mind one seminal moment was this fact that, in my mind there's a clearly a run on money market funds. Particular prime funds, and the reserve fund, the oldest money market fund in the US broke the buck.

 

And I think a big part of that run on money market funds, again it's an untraditional sort of bank run. It's not a traditional people lining up to get their deposits out of a commercial bank, but essentially money market investors trying to get their money out of money market funds was that there was this Lehman paper that exists, a commercial paper, and people were freaking out about that and that.

 

But that wasn't in your mind that the money market run that kind of existed was not sort of the trigger in your mind?

>> Randal Quarles: No, I don't think so. Not as important, not the proximate cause. All of this added up to create an environment 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 as WaMu without a financial crisis. We just had Silicon Valley bank fail a few a few years ago, 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 amount of 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 as important or really the triggering cause and certainly not the failure of Lehman relative to the failure of Walmart.

 

 

>> Jon Hartley: So another thing that I think comes up in these sorts of global financial crisis diagnoses is in this question, the big banks and Senator Warren I think often, and others often said, well, all the Grand Leach Bliley big bank consolidation in the 90s that was allowed to happen was part of this cause and which break up the big banks.

 

And, and I mean to me that seems like not a great sort of story either or explanation either. In fact, like in my mind, I think if the big banks have been broken up, maybe the financial system would have been less stable. I mean, there's largely investment banks that were stressed during the global financial crisis.

 

The larger, more diversified commercial banks, the JP Morgan Cities, Bank of America, the larger financial institutions were generally safe. And this is an argument that I've heard from Ben Bernanke, sort of against breaking up the big banks is that in diversification, having both commercial banks and Investment banks under sort of one umbrella allows for better weathering of these sorts of shocks.

 

Do you sort of buy that line of reasoning?

>> Randal Quarles: Absolutely. I mean a large part of the work that I did both as a private sector lawyer and then in policy work during the course of the 90s, during the, during my time in the Bush 41 administration was, was precisely to allow to increase the financial resilience of the system and particularly the banking system by first, you know, we, we put forward a proposal for the revision of the Glass Steagall Act.

 

It's actually incorrect to say that the Glass Steagall act was repealed because the central provisions of Glass Steagall were never repealed. There ancillary provisions that were repealed. But the revision of the Glass Steagall act to allow the creation of kind of merchant banks to allow investment banks to merge, but the first order of business was simply to allow banks to merge across state lines, which was not possible in the early part of my career, which I guess is a long time ago now, but it's still within the mind of living memory.

 

And, and that was very useful when you had, you know, over the course of that period you had some intense financial problems in Texas at the beginning of that period and then you had finance some intense financial problems in the Southeast. And because we had changed them one of the results of the Bush 41 administration was to ease the restrictions on interstate banking.

 

You now had banks, you know, North Carolina 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 to prevent that Texas bank from failing when there was pressure in Texas and the system and that system had the resources to prevent the bank from failing when there was pressure in the Southeast.

 

And you know, so those mergers were very much. Kind of financial stability supportive, first by allowing geographic diversification and then by allowing business line diversification. And exactly as you said, if we had not modified the Glass Steagall act to allow Morgan Stanley and Goldman Sachs to 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 let the world know that we are supported by the Federal Reserve and the Federal Reserve's backstop. And so they immediately became bank holding companies, which they were able to do because of these changes that had allowed banks to become larger and more diversified.

 

I mean, it's not. There certainly are issues as any organization becomes extremely large. The largest banks now have hundreds of 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 managing organizations that are that complex.

 

But from a pure financial stability point of view, all of that has been a positive and not a negative.

>> Jon Hartley: 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 toxic assets off bank balance sheets.

 

The first Quantitative Easing or QE1. And then we had this thing in 2010 which 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 happened was, you know, imposed capital standards. So there's both a risk weighted capital ratio and a risk neutral one.

 

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

 

And they sort of put forth these capital standard ideas that have been implemented across various countries. And Dodd Frank was the US manifestation of that. And so there'd be risk weighted capital ratios or CT1. And the idea is that the amount of equity is a share of risk weight, assets is above a certain threshold.

 

And similarly your SLR or your leverage ratio, your supplementary leverage ratio, is at a certain level. And so all this is about the liability side of the balance sheet in the sense that we're setting a limit on a minimum limit for how much equity there is, which is another way of saying kind of A maximum for how much leverage there is as a fraction of the total capital or total assets.

 

And so, there's a risk-weighted way of looking at this, anonymous-weighted way or a risk-neutral way of looking at this. Now, sort of fast forward many years later, something like SLR might be binding for this is the sort of risk neutral you might be buying for a bank like Goldman Sachs does a lot of treasury market making the risk weighted capital ratio might be buying for a bank like Capital One that does a lot of sort of risky credit card lending.

 

Credit cards sort of get this high risk weight of 1 one. So I guess my question for you is, is the financial system today, you know, safer after Basel III's gold financial system safer in, in your mind, or are the banks too regulated or, or not regulated enough?

 

 

>> Randal Quarles: Well, I think it's unquestionable that the system is safer. The increased capital levels, the Basel capital price process, beginning all the way back to Basel I in the 80s, has been run at the significant insistence or impotence impetus from the United States to try to ensure that the competitive environment for international banking was such that our banks could compete without being pushed to lower their capital to dangerous levels.

 

So in the 80s, the Japanese banks operated with very little capital, certainly relative to ours and relative even to the Europeans. And Basel 1 was an effort to get international agreement that that capital needed to be increased. And then, you know, over the course of the 90s, it became clear that the European capital levels were lower than those in the United States.

 

Our internationally active banks were being disadvantaged. And so, you know, Basel 2, which is, you know, was really kind of an incredibly complicated, very analytically, you know, analytically granular, intelligent, ultimately I think misguided, but approach to try to create a framework in which we in the United States could be comfortable and confident in allowing our bank's capital levels to lower themselves to those of the Europeans by creating, you know, sort of a, an agreed and careful risk assessment framework.

 

It was very complex, probably excessively complex, but no sooner had that been completed than we had the great financial crisis and we realized that that was the wrong direction. We shouldn't be lowering our capital levels to match the Europeans. We should be raising the Europeans capital levels as well as our capital levels to higher standards.

 

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 increased resilience of the banking system to some shocks like those that happened in the spring of 2023 and you know, so unquestionably the system is safer.

 

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 and through Basel iii, we've layered on top of that a stress testing regime which I think is very useful.

 

It's very, it's well done by the Fed, really competent people who run the process. But it is incredibly complicated on top of what is already a fairly, you know, a much more complicated kind of, of standard capital framework than it used to be. We, you know, are now regulating liquidity, which we should be, but, you know, in, in a much more direct way than we did before.

 

Much more complicated way that may be getting more complicated in the aftermath of sdb. The supervisory examination of banks is much more burdensome and again, particular and covering a broader range of activities with much more direct instruction than it used to be. So all of that is, again, that's an inevitable human response.

 

Response to something like the great financial crisis. And I think that directionally it has made things better. You can't question that. But it's also improvable. That can be streamlined, that can be rationalized, that can be, okay, well, now we're doing the same thing in three different ways. Maybe we can do it in one and a half different ways and that will be enough.

 

And thinking all of that through is, I think should be inevitably the task of the bank regulators and thinking through the practices of bank supervision, the task of the bank supervisors. You know, once the, you know, the immediate reaction through Dodd Frank and Basel 3 to the great financial crisis is in 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?

 

 

>> Jon Hartley: 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 and kinda had a sense of how some of these worked in portfolio structure, risk management in GSM.

 

But I had risk management friends that were sorta dealing with the CCAR and stress test sorta side of things. So I guess like one question and complaint that 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, you know, the stress tests aren't transparent.

 

You know, there's a bunch of scenarios that are given and it's not clear ahead of time what they are and they sort 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 should be prepared for all sorts of scenarios.

 

But I guess, is there some way in which 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 actually have physically in our building any day?

 

And it's, you know, it's hundreds of people. And I hadn't realized myself when I was working at Goldman Sachs that there were actually, you know, Federal Reserve employees or regulator employees that were actually in the bank. Is that too many? So I guess I'm just curious what your thoughts are on just stress testing and how that process maybe could be improved, if at all, in your mind.

 

 

>> Randal Quarles: Yeah. So first I should say, and there are two aspects 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, a different set of policy considerations around the, you know, how the stress tests need to be constructed in order to be effective.

 

Stress testing is, is an obvious, an obvious good. It's something that bank supervisors should be doing and in, in some ways not nearly as expansive, you know, and, and as rigorous as has happened in the aftermath of the great financial crisis, but in some ways have, you know, been doing for a very long time.

 

And, and we saw a particularly important example of that during the COVID event where the rest of the world, almost all of the rest of the world, immediately upon the sort of global administrative shutdown of the economy, said, well, if businesses can't operate, they can't pay their loans, and this could be a huge problem for the banking system.

 

And bank regulators around the world shut down the ability of their banks to pay dividends. They simply forbade them from making any distributions at all. And we, we closed off the ability of banks to repurchase their shares, which in the US System is a significant, you know, is actually the majority of the way that that capital is returned to shareholders.

 

But dividends are still important, and the dividends is the only thing that's promised. Right? The share repurchases are easier to, to close off because there's no promise that that's going to happen. And because we had just complete, we were just in the process of completing the stress test for that year, we had confidence in the, we could add in there some additional variations to the scenarios to say, well, what if this happens?

 

What if that happens as a result of COVID what happens to the system? And then over the course of the succeeding 12 months, 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 testing staff at the Federal Reserve and just an almost impossible amount of work for a team that we weren't able to increase in size just given the speed with which all of this was happening.

 

And, and as a result of doing that, we maintained confidence in the resilience of our system. That allowed us to say, no, you can keep paying dividends until we see some evidence that the system is under a level of stress that it can't support, you may keep paying dividends.

 

The information that we have from the stress test shows that and our, the cost of capital for our banks was, you know, is now, is now much more favorable. There are many reasons for that. But this is an important reason for it than for European banks, because you're providing equity capital.

 

European banks, and you say when they get spooked, they could just say you can't pay. Whereas in the US they do everything they can to preserve those payments if it's going to be safe. And we had the mechanism to say it was safe through the stress testing. So all of that is great.

 

Now, on the question of the transparency of the stress tests, there's the legal question of these are quite consequential government actions because particularly particularly in the aftermath of a measure that I took which I thought was necessary and appropriate, again as a, just as a good government measure, that there would be predictable consequences of a certain result of the stress tests.

 

If your stress test shows that you need more capital, then you will be required to have a buffer added to your particular bank's capital requirements that will increase your capital by that amount according to the stress test. Before that, the results of the stress test did not have any determinate consequence.

 

It was all a result of what the Federal Reserve Board had for breakfast on the morning that they were presented with the results. And that's just not a way to run a railroad. But because of that change, there is a fairly direct and important economic and financial consequence for individual institutions as a result of running the stress test.

 

And our system of law, the Administrative Procedure act, constitutional principles would say that can't be the result of a star chamber process. You must be transparent. People need to know if that, if something like that can happen, what they can do to prevent it from happening. And you know, the example that I would often use would be to say, yeah, if you took all the speed limit signs off the roads and said, but there's still a speed limit.

 

And it varies from day to day. And we're not going to tell you what it 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, a significant amount of transparency is important. And there are lawyers who say that the whole process, all of the models, all of the scenarios need to be totally public and subject to comment on, making sure that the stress tests are fit for purpose.

 

However, I was persuaded in my time at the Fed and remain persuaded of the so called monomodel argument that's going to be very familiar to many of the folks who listen to your podcast, that if the Fed is totally transparent about its framework for assessing the resilience of any particular bank's, you know, portfolio of assets, then whatever mistakes and eccentricities and idiosyncrasies that there are in that framework, and those are inevitable, then all of the system will congregate around those and those now become the fault lines of the system where there will certainly be breaks going forward.

 

And to the extent that you are not wholly transparent, you at least ameliorate, you can't eliminate, but you ameliorate the mono model problem. I think that's real. I think that's, and to ensure that the stress tests are actually fit for purpose, I think it has to be taken into account.

 

I tried while I was at the Fed, you know, for a balance that maybe was not the most ineluctably principled, but I thought practical of we can be more transparent, we can be much more transparent about what it is, what the models show without completely opening the kimono towards the monomodel problem.

 

And the staff was making, I think, material progress in being more transparent around the models. I think that stopped pretty quickly after I left and I think it should be picked back up again. So that's, that's probably a lot more logaria around your simple question of, you know, should the stress test be more transparent?

 

I think the answer is they can and should be, probably are required to be under law, but we shouldn't completely open the kimono in the way that some would ask, because then the stress test would not only not be as useful, they could even be counterproductive.

>> Jon Hartley: Got it, and I guess, yeah, one criticism, I guess it could be gamed in some way.

 

If it was totally.

>> Randal Quarles: I think you could say, yeah, I was Always less worried about the gaming argument. People would say, if you, if you give them the models, you're, you're showing them the answers to the test, it's like, no, you're giving them the textbook, you know, and, and it would not be right to give a test.

 

You know, it's not right to give a test that you've given the answers away to, but it's also not right to give a test that you haven't given anybody a textbook for.

>> Jon Hartley: Absolutely. That's a great way of putting it. I just want to fast forward a little bit here just in time to your time at the Federal Reserve.

 

You were nominated during the first Trump administration to be the first vice chair of the Federal Reserve for supervision. And then you are also the chair of the financial disability board from 2018 to 2021. I'm just curious in your mind and just, I guess for some context, too, around that time, in terms of what was going on in Finrake, there was the Jim Hensling bill that changed the SIFI threshold and increased that.

 

So there was kind of that going on in the backdrop as well and the SIFI threshold is basically a certain threshold above which you're treated very differently in terms of regulation, having to do these sorts of, this regulatory scrutiny from the perspective of regulators. And I think when it was increased, it affected banks like SunTrust and 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 and as chair of the Financial Stability Board?

>> Randal Quarles: So at the Fed, you know, I think you, I think I would say it was the, it was the whole complex of refining and revisiting and streamlining the post financial crisis regulatory framework.

 

The principal element of that was the mellifluously named Igurkapa legislation that we then implemented. We worked, you know, we worked very closely with the Senate and the Congress in, in developing that regulation and then, and then through the implementation process. But there were, you know, I think there were over 20 separate measures that we took.

 

And I was, you know, I, I, I came in saying there were lots of folks, you know, who kind of wear my political jersey, lots of people who think about the industry who said, you know, Dodd Frank was an unmitigated disaster, you need to strap a napalm tank onto your back and just burn it all to the ground.

 

And my tack was to say, look, no, what we're going to do is we're going to identify some material things that will make a difference. You know, the overall benefit of the increase in capital from Dodd Frank is that that is a good thing. But we can increase the efficiency of the system, which is a public good that is probably equal to the safety of the system.

 

We can increase the efficiency of the system in ways that do not harm its safety. And we can do that in a way that we're very methodical about, that we make a very good case for, and that we get enough bipartisan political support for that. When we're done, the next folks will come in and the pendulum won't swing back because the case will have been made and we will have been meticulous enough about what it is that we that we did 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, but have very different views than mine, and some of the initial proposals, people said, we told you so, you know, that was a bad strategy. It's a one way ratchet.

 

You came in and you 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 putting it 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't was the way that we constructed our approach.

 

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 for a whole variety of reasons. You know, the FSB had done really good work on bank regulation along with the Basel Committee.

 

Nbfi, you know, had really languished. And, and, and it, it requires a much different approach than bank regulation. And so there are reasons that that's a difficult thing to do. But we began a process by creating a separate committee where there was much more representation of the non bank regulators relative to the central banks.

 

It was a little more equal than in the FSB as a whole. And that allowed progress to be made there. That again, I think was quite useful.

>> Jon Hartley: Great, I guess, sort of shifting just for a second away from finrag and financial regulation. You were also, you know, by virtue of being on the Federal Reserve Board, you were also a voting FOMC member.

 

And you know, during this time we had everything from, during the time we were in office, everything from COVID to the beginning of the early 2020s inflation. I'm curious, in your mind, did the Fed respond, I guess appropriately both to Covid and did it respond quickly enough to inflation in terms of raising rates?

 

I know you've spoken, I think another podcast before maybe saying that the Fed should have raised rates earlier. Just thinking that it became clear that it wasn't just a transitory story by say October of 2021, in that this was around the time that you were leaving, but by that point when inflation first ticked up in April 2021, but by October it was clear that it 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 based at that point in time. You kind of had left just at that, I think point in time when that became apparent. But in your mind was the Fed and your colleagues, were maybe they a little too slow to raise rates and maybe inflation wouldn't have been as high if they had done something differently.

 

I'm curious about what your sort of retrospective take is on the Fed's short performance during, during that period.

>> Randal Quarles: Yeah, I don't, I don't think that there, I don't think the, that the Fed is guilty of any serious sin with respect 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 there at the time who would have said yes, the time to start raising rates was in the fall of 2021, you know, over the summer.

 

You know, as you said, I think the data that we were seeing really supported the Case that this was a supply constraint driven inflation, which is not something that a central bank can effectively respond to, and that it was a temporary supply constraint. You know, we can't unload, we can't unload containers on the ports and we can't make vaccines or anything like that.

 

So, but that this would in fact be transitory. The data really supported that over 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. Some people, Larry Summers, for example, have blamed the framework that the Fed, the monetary policy framework that the Fed put into place in August of 2020 as kind of the culprit in the Fed not responding as soon as it became clear that this was the sort of inflation that its tools were designed to address.

 

That I don't think is correct. Really. There probably was a majority on the FOMC in favor of saying, okay, well now we need to respond to this in September, October of 2021. 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 and agency securities a month at that time. And some general principles that the Fed operated under that I think with hindsight 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 purchase this amount of securities and providing accommodation in that way as we're raising interest rates. You know, that results in a, in a mismatch. So we have to stop the securities purchases. But the taper tantrum of 2013 heads had taught everyone that, well, you can't stop security purchases on a dime because the markets lose their minds.

 

And so first you have to talk about talking about it and then you have to talk about it and then you have to have a serious discussion about it at the fomc and then you have to announce that you're going to do it in a while. So that plan was worked out in the fall that we would go through this whole tapering process of purchases and then start raising interest rates in response to the inflation.

 

And it just quickly became clear that, we need to accelerate the, you know, the tapering faster than was originally envisioned. I mean, the original plan was that it might have taken as much as a year. And I think with the benefit of hindsight, the Fed will have learned the lesson that there are circumstances in which it is perfectly okay to start Raising interest rates even as you're being gradual in tapering asset purchases.

 

And this was one of them.

>> Jon Hartley: Fascinating, shifting back to banks and pinch regulation. I just really want to, in my last question for you is really just on deposit insurance because I think the most recent banking crisis that we've seen was really the Silicon Valley banking crisis in regional or regional banking crisis of 2023.

 

And we had these banks in particular Silicon Valley bank, large bank, a lot of insured deposit, uninsured deposits that really forgot how to manage interest rate risk. And that concern around taking losses triggered this massive bank run essentially through people's cell phones. We've never really seen a bank run quite like this before.

 

Typically we're used to thinking of people lining up in a wonderful life or these other famous photos of people lined up outside of banks when they get their money, to get their deposits. But here, you know, now people with a click, you know, can take, pull their money out of a bank and cause a bank run overnight.

 

The FDIC came in though and resolved these banks and you know, took them into, took them over and functions the FDIC should, but. And there's not just Silicon Valley Bank, there are a few others. It's also sort of led to Credit Suisse also eventually being very distressed and got bought out by ebs.

 

But I think there's sort of this unresolved question of what is going on with deposit insurance in that previously the rule still is on the books. Everyone has $250,000 of deposit insurance at each bank. And you could go Go to each bank and get another for every account, get $250,000 of deposit insurance, and you could go to hundreds of banks in theory.

 

But I'm curious, you know, at some level, we kind of had this de facto sort of unlimited amount of deposit insurance. I'm curious where you think, sort of, as a policymaker, where we're at and how we should be thinking about the regional banking crisis of 2023 and what we should be doing about deposit insurance from a policy perspective.

 

 

>> Randal Quarles: So, so, so I do buy in, you know, at maybe an 85% level to the view that the liquidity need for the current banking system, and particularly for sort of banks of, of Silicon Valley bank size, regional banks and, and smaller, is durably different than it was 15 years ago as a result of advances in communications technology and in bank technology exactly as you described it.

 

So that the ability of Iran to form and to be severe is much greater than it was. I mean, just referring back to the WAMU example, you know, WaMu failed because it was losing $1.6 billion a day, I think, and it did that for 10 days in a row.

 

And that was viewed as an unsustainable, you know, a completely unsustainable deposit outflow. It was slightly larger than Silicon Valley Bank. Silicon Valley bank lost $40 billion in an afternoon, and $100 billion was lined up to be going out the next morning. This is a, and WaMu was the largest and most severe bank failure in American history up to that point.

 

Something was different, and I don't think that it was purely idiosyncratic to Silicon Valley bank, although we all know what its idiosyncrasies were, that made that a particularly severe case. So I do think that the liquidity need of the system is greater than it was. There are two ways, two principal ways to address that systemically as opposed to through draconian supervisory measures.

 

One is to increase deposit insurance and therefore to increase the amount of comfort that I don't have to go for a run on the bank because my deposit is protected and to cover a much higher percentage, if not all of the sorts of business deposits that were, you know, that.

 

That were the lifeblood of Silicon Valley Bank. The other, which I think is the preferable approach because there are significant, obvious moral hazard concerns with excessive deposit insurance, is for the Federal Reserve to return to its role as the liquidity provider to the system in the. One of the mistakes, I believe, that was made in the aftermath of the great financial crisis the focus on the liquidity position of banks, you know, the, the increased focus on the liquidity position of banks was, and the Fed has been the most extreme about this, is for the banks to self insure their own liquidity.

 

Basically to say you must have enough liquidity in your institution to withstand a very severe run. And, and we're going to measure that in a variety of ways with liquidity stress tests. And a large part of this has to be intraday liquidity. And that was an issue even when we were talking about a liquidity need that was of the sort that we still thought we were talking about at the time of the Dodd Frank act and Basel III.

 

If we're talking about a liquidity need where a $220 billion able to support the outflow of $140 billion over the course of 24 hours, that is, that's unsustainable that, that you can't, you can't remain a bank and have that many liquid assets inside of your system and self insure yourself.

 

And the Fed has been quite insistent on that. For example, when, when the Fed goes in to do a supervisory assessment of the bank's liquidity, it doesn't allow it to take into account that it has the right to borrow from the Fed. And as a consequence, many banks do not prepare 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 in order to borrow because why should it? The Fed had said, you have to have, you know, we're only counting the liquidity that you keep on your books. So it borrowed from the Federal Home Loan bank of San Francisco in order to fund putting liquid assets on its books that it could show the Fed that I have enough hqla.

 

So. I think the Federal Reserve should go back to the fundamental reason that it was created. It's the reason we don't call it the central bank of the United States, but call it the Federal Reserve, which is that it exists to pool the reserves of the banking system and direct them to where they are most needed at 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 assets to maturity, it was perfectly solvent. It could not hold on to maturity during Iran but the Fed could hold those assets to maturity. The Fed could have very safely simply lent the money to Silicon Valley bank to pay off those deposits.

 

And eventually what would happen with every run is, I'm going to get my Money I don't have to run. But you would do that through the Fed's provision of liquidity as opposed to kind of non discriminant deposit insurance which allows for kind of much more intelligent decisions to be made about the ultimate viability of an institution that the liquidity is being provided to and therefore an amelioration of the moral hazard problem of any sort of government intervention.

 

So, so, so that's again that's my logaric answer to the deposit insurance question, which is I don't think we should be increasing deposit insurance, but the Fed really needs to kind of go back to basics in thinking about its role as the lender of last resort and reinvigorate it to what it was originally intended to be.

 

 

>> Jon Hartley: That's great. One last question. Any last. Any thoughts at all on stablecoin regulation? There's some legislation that's going through Congress right now. There's been I think a lengthy debate about this. You know, how much should stable coins be treated like banks and so forth and what should the sort of guide rails be?

 

And we've had sort of circle which runs USDC led by Heath harbor mutual friend of ours that this much I think been historically wanting to be regulated. Tether on the other side that's been a bit more controversial, doesn't kind of quite want to be regulated, hasn't been quite as transparent 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 both investing in treasury bills and taking the, investing the float and taking this and the interest and maintaining a stable asset. But I'm curious from a regulatory perspective, how do you think about stablecoins?

>> Randal Quarles: 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 problem with, but I don't think is ever going fundamentally be transformative of the payment system or the financial system.

 

But stablecoins could be quite. Important in the financial system and particularly with respect to international payments and across border payments. And, and the official sector has some legitimate issues with regard to how the pool of assets by which the stablecoins value is measured is constructed and run. I think those issues are pretty obvious.

 

They're well addressed in the stablecoin legislation that's passing. They've been well addressed since the President's working group with Janet Yellen as chair of the treasury, as chair, as Secretary of the treasury put out at the end of 2021. You know, the, the issues are clear, the way to address them is clear.

 

The stablecoin industry is actually quite happy 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 that whole process was being stymied by well intentioned but aggressive regulator who wanted to be the crypto cop and didn't want a, you know, a framework that kind of put clear responsibility, you know, clearer responsibility on 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 or intellectually difficult to do and so I think it will be done over the course of this year probably we have a great framework for stablecoins to grow. I think that's not only good for the financial system, I think it's good for the US dollar and I think it then prevents some of the concerns that I have about tether.

 

The people will live in that framework. 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 will kind of be relegated I believe once we get that done.

>> Jon Hartley: Yeah, it's fascinating.

 

And there's now word that the consortium banks may be starting their own stablecoin. It's gonna be very interesting to see where the stablecoin industry goes as it sort of becomes more regulated. Randy, I really want to thank you for coming on. It's been an amazing conversation.

>> Randal Quarles: Thank you very much for having me.

 

That was a great pleasure.

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