Is the New York Fed Making a Big Mistake?

On the one hand, current and former senior officials now generally agree with the proposition that our leading banks need more capital – that is, more equity relative to what they borrow. (The argument for this has been made most forcefully by Prof. Anat Admati and her distinguished colleagues.)

The language these officials use is vaguer than would be ideal, and they refuse to be drawn out on the precise numbers they have in mind. The Swiss National Bank, holding out for 19 percent capital, and the Bank of England, pushing for at least 20 percent capital, seem to be further ahead and much more confident of their case on this issue.

But an important split appears to be emerging within the Federal Reserve, with the Board of Governors (perhaps) and some regional Feds (definitely) tending to want higher capital levels, while the New York Fed is – incredibly – working hard to enable big banks actually to reduce their capital ratios (in the first instance by allowing them to pay increased dividends).

Officials at the New York Fed with whom I and others have spoken appear to be hardening their position against requiring big banks to maintain more capital (beyond the insufficient increases in the Basel III agreement), though no formal position has yet been taken. These officials will not speak on the record nor provide any details about their arguments or whatever evidence they have developed to support them.

So it is hard to know if any analytical basis exists for their evolving position. They have certainly put up no meaningful counterarguments to the powerful points made by Professor Admati and her colleagues – both in general and against allowing United States banks to increase their dividends now (see also this letter published in The Financial Times).

The single public document from the New York Fed on this issue is a working paper that appeared recently on its Web site. This paper simply assumes the answer it seeks: that higher capital requirements will lower growth, and it refuses to engage with the arguments and evidence to the contrary. www.wdalaw.com The empirical findings presented fall somewhere between weak and unbelievable. If this is the basis for policy making within the Federal Reserve System, I will be very surprised.

The key point is this. Given that the final capital requirements under Basel III remain to be set by the Fed – and top officials say they are still working on this – what’s the big rush to pay dividends? Retaining earnings (that is, not paying dividends) is the easiest way to build capital (shareholder equity) in the banks. There is strong logic behind not paying dividends until capital is at or above the level needed for the future. Without any substance on its side, the New York Fed is increasingly creating the perception that it is just doing what its key stakeholders – the big Wall Street banks – want.

Bankers traditionally dominate the boards of regional Feds. We can argue about whether this is a problem for most of them, but for the New York Fed the predominance of big Wall Street institutions has become a major concern.

At the bottom of the Web page listing its current board members, you can review who belonged to the board every year from 2000 to 2008. Note the presence of influential bankers in the past such as Richard Fuld (Lehman), Stephen Friedman (Goldman) and Sanford Weill (Citigroup). Their firm hand helped guide the New York Fed into the crisis of 2007-8.

The Dodd-Frank legislation reduced the power of big banks slightly in this context, so that the president of the New York Fed is no longer picked by Wall Street’s board representatives (as was Timothy F. Geithner, who was president of the New York Fed until being named Treasury secretary, and William Dudley, the current president and former Goldman Sachs executive).

But the current board of the New York Fed still includes Jamie Dimon, the head of JPMorgan Chase and an outspoken voice for allowing banks to operate with less capital by paying out dividends.

In fact, Mr. Dimon has a theory of “excess capital” in banks that is beyond bizarre – asserting that banks (or perhaps any companies) with strong equity financing will do “dumb things.” This is completely at odds with reality in the American economy, where many fast-growing and ultimately successful companies are financed entirely with equity.

If the New York Fed’s top thinkers have convincing reasons for not wanting to increase capital in our largest banks – if, for example, they agree with Mr. Dimon – they should come out and discuss this in public (and some evidence to support their thinking would be nice). If the New York Fed were really pushing for higher dividends at this time — for example, by constructing a stress test to justify this action — it would be setting us up to mismanage credit, allowing the megabanks to misallocate resources during the good times and crash just as badly when the next downturn comes.

The top leadership of the New York Fed has a responsibility to engage constructively and openly in the technical debate. Yet some Federal Reserve officials act as if they have a constitutional right to run an independent central bank. This is not the case: Congress created the Fed, and Congress can amend how the Fed operates. The legitimacy of the Federal Reserve System rests on its technical competence, its ability to remain above the political fray and the extent to which it can avoid being captured by special interests.

The danger that the New York Fed will fatally undermine the fragile credibility of the rest of the Federal Reserve System is very real.