I’m slowly making my way through Tim Geithner’s book; I might wind up writing a proper review somewhere, some time. But already one thing has become generally-received wisdom about the book: whatever you might think of Geithner’s actions and opinions, he’s at least presenting himself in an honest and unvarnished manner. Michael Lewis describes this as a “near-superhuman feat”: “there’s hardly a moment in Geithner’s story when the reader feels he is being anything but straightforward,” he writes.
If Geithner isn’t being honest about his actions and the actions of others, then the whole book becomes much more problematic. And already critics on the right have, predictably enough, accused Geithner of lying.
Most of the time, such accusations boil down to a he-said-she-said about private conversations held in secret. But sometimes, Geithner makes simple declarations which are easily fact-checked. So let’s turn to pages 79-81*, where Geithner is covering his early tenure as the president of the New York Fed. You’ll forgive me for quoting at some length:
At the Fed in Washington, at the time, there was little apparent concern about the stability of the financial system. In New York, with some exceptions, there was also a general sense that things were under control… One former New York Fed board member, Bob Wilmers of M&T Bank, once told me that 70 percent of his bank’s examination process involved anti-money-laundering and consumer protection.
Those were important issues, but they seemed to be eclipsing more subjective and challenging systemic questions, such as whether banks were adequately managing their risks and retaining enough capital and liquidity to survive a crisis. In those days, systemic risk—the vulnerability of the financial system to a severe crisis—wasn’t prominent on the national radar screen… There was growing confidence that derivatives and other financial innovations designed to hedge and distribute risk—along with better monetary policy to respond to downturns and better technology to smooth out inventory cycles—had made devastating crises a thing of the past.
I did not share that confidence. I had no particular knowledge or insight into whether the new financial innovations were stabilizing or destabilizing, but I was reflexively skeptical of excess conviction in any form, especially excess optimism. My dominant professional experiences had involved financial failures. I had seen during the emerging-market crises of the previous decade how long periods of stability and growth could breed instability and disaster. Confidence had always been an evanescent thing, and in this new age of mobile capital, trauma in one part of the world or one corner of the financial system could spread quickly. I didn’t see how a few years of calm or some clever financial innovations would cure the basic human ten- dency toward mania and self-delusion. History suggests that financial crises are usually preceded by proclamations that crises are a thing of the past.
In my very first public speech at the New York Fed in March 2004, I tried to push back against complacency, telling a room full of bankers that the wonders of the new financial world would not necessarily prevent catastrophic failures of major institutions, and should not inspire delusions of safety on Wall Street. I even cited my favorite theorist on financial irrationality, the leading promoter of the idea that periodic financial crises are practically inevitable.
“These improvements are unlikely to have brought an end to what Charles Kindleberger called ‘manias and panics,’ ” I said. “It is important that those of you who run financial institutions build in a sufficient cushion against adversity.” …
The Fed shared responsibility for supervising commercial banks with insured deposits. And if one of those banks ran into liquidity problems, it could go to the Fed’s discount window for emergency loans that could help prevent a run. But as I started thinking about a potential crisis on my watch, one glaring danger stood out. Huge swaths of the financial system—investment banks, Fannie Mae and Freddie Mac, and many other large firms that behaved like banks without having to obey bank safety and soundness rules—were outside the Fed’s jurisdiction as well as the Fed’s safety net. These “non-banks,” or “shadow banks,” were borrowing short and lending long, just like George Bailey’s bank or any other bank. But they were not subject to the capital requirements and other safeguards imposed on banks to limit risk, they did not have deposit insurance to prevent runs, and they would not be able to access the discount window if they faced runs. In that initial March 2004 speech, I suggested that financial innovation was driving risk and leverage into corners of the financial system with weaker supervision, and that our tools for monitoring systemic risk weren’t keeping up.
This is Geithner at his most prescient and heroic. He enters a hidebound wood-paneled institution where coffee is brought to his desk on a silver tray while briefings involved precious little discussion or debate; and in his very first speech he decides to speak truth to entrenched financial power, trying to “push back against complacency” and warn against the rise of the shadow banking system.
But here’s the thing: we can read the speech, it’s archived on the Fed’s website. And so it’s pretty easy to tell whether Geithner did indeed try to push back against complacency, in his speech, and warn of the rise of the shadow banks.
Spoiler: he didn’t.
The speech is long, and I encourage you to read the whole thing to see for yourself just how aggressive Geithner was when faced with a room full of bankers. Here’s how he starts:
It is a pleasure to join you at the New York Bankers Association Financial Services Forum. The institutions represented in this room, together with the rest of the New York financial community, remain at the center of the U.S. and global financial systems.
Your meeting today takes place against the backdrop of a relatively favorable national and global economic outlook. The U.S. financial system is in reasonably strong shape. Financial innovation has enabled substantial improvements in the quality of risk management and in the capacity of the system to handle shocks. But the benefits of innovation have come with significant challenges to the people who run financial institutions and to those responsible for supervision and oversight. How effective we are in responding to these challenges will determine whether the U.S. financial system is as successful in the future as it has been in the past.
And here’s how he ends:
Although the present economic environment looks quite favorable, these broader macroeconomic policy challenges make it even more important that we build on the substantial progress we have already made in strengthening risk management and the resilience of critical market infrastructure. Our success in meeting these challenges will help ensure that our financial system proves as resilient in the future as it has in the recent past.
None of this sounds like a warning — and indeed, Geithner’s main cautionary message seemed to be directed not so much at the bankers as at their regulators, including at the NY Fed. Between the beginning of his speech and the end, moreover, Geithner said a lot of things which, let’s say, don’t really withstand the test of time. He said that there were four big “changes in the nature of financial intermediation” which had “played a role in improving the overall resilience and performance of the U.S. financial system”; he was effectively saying “you’ve done these four things, which is great, can we have more like this please”. What were those four things?
The first: “Innovation in financial technology continues to expand the opportunities for financial institutions to separate and distribute, and to manage and hedge, different types of risk.” Or, to put it another way, “yay derivatives! Please use lots more derivatives!”
The third: “The increases in the sophistication of risk management techniques and enhancements to risk management processes have delivered substantial improvements in how banks and other financial institutions actually manage risk in practice. Banks, for example, have aligned their pricing of credit products much more closely with credit risk.” This is Geithner embracing the kind of mark-to-market accounting which is devastatingly pro cyclical: when credit is booming, risks just magically disappear, and when a credit crunch starts, all the banks suddenly need to dump all their assets at the same time.
The fourth: “The increased scale of cross-border financial intermediation, the growing role of securitized financial instruments in those overall flows, and the growth in the size and breadth of financial institutions with global operations may also mean that, as shocks are transmitted more rapidly, they are diffused more broadly.” In English, the US financial system had grown far outside US borders, to the point at which no one regulator could keep track of it; it was creating enormous numbers of CDOs and other mortgage-backed toxic waste; and lots of massive foreign banks were getting in on the same game. All of these were considered to be good things, because they meant that any crisis would be global, or something.
But wait, I seem to have missed something here. Oh, that’s right, what was second on Geithner’s list? Here you go:
The increasingly greater role played by the capital markets in the financial intermediation process relative to banks — both relative to the past and compared with most other major economies — has improved the capacity of our system to handle stress. Loans and securities held by commercial banks today account for less than 20 percent of overall U.S. credit market debt, roughly two-thirds of their 1975 levels.
In other words, Geithner was saying that the shadow banking system is getting bigger, that the banks the NY Fed regulated were accounting for a smaller and smaller part of the total financial system — and that this was a positive development. Geithner wasn’t warning his audience about the risks of shadow banking, he was extolling it, on the grounds that it had “improved the capacity of our system to handle stress”!
Geithner did then say that all of these positive developments were accompanied by “new challenges for those of you who manage financial institutions and for those of us charged with supervision and market oversight”. But you don’t push back against complacency by saying things like this:
To the extent that diversification achieves lower overall volatility in earnings for the major financial institutions, it is clearly good for the stability of the system. But to fully exploit these potential gains requires careful attention to the design of the control and compliance infrastructure, to monitoring and managing credit risk and concentration across diverse types of financial activities, and to managing conflicts of interest.
Every banker in the world thinks that he (and it’s nearly always a he) is great at control and compliance and managing credit risk: not a single member of Geithner’s audience would have taken this kind of thing as a real warning. Especially when Geithner took a large part of the job onto his own shoulders:
Financial innovation will, in some ways, always move ahead of the evolution in risk management techniques. As supervisors, our challenge is to work to ensure that the sophistication of the supervisory process evolves to keep abreast of the pace of change in financial innovation. This is a formidable challenge, and we need to continue to work hard at it. The revisions to the Basel Capital Accord, which aim to align supervisory assessments of capital adequacy more closely with the frontier of risk management techniques, are a good example of these efforts.
This is a bright green light to all the bankers in the room, saying “go ahead with all your whiz-bang new innovative products, we think they’re great, even if we don’t really understand them or know how to regulate them, it’s our job to keep up with you, and we have people in Basel who are on it.” Not once did Geithner indicate that the financial system was getting too complex and that the Canadian approach of forcing banks to keep things simple was maybe a good idea. Instead, he embraced all of the complexity, and just said that the regulatory architecture would have to cope, somehow.
Yes, towards the end of his speech, Geithner did quote Kindleberger, but he didn’t say anything about crises being “inevitable” — he just used the book to say that banks ought to have “a sufficient cushion against adversity”. (Which, of course, every banker always thinks he has already.) And rather than concentrate on the risks being built up in the financial system, Geithner chose to end on his mentor Larry Summers’s favorite global risk at the time.
The stability of the financial system also depends significantly on the quality of macroeconomic policy, not only in terms of the credibility of monetary policy, but also in the degree of confidence investors have in U.S. fiscal management. The current deterioration in the U.S. fiscal position and the acute decline in the net national savings rate represent risks to the financial system and the economy as a whole. These risks are magnified by the size of the U.S. external imbalance and the unprecedented scale of financing requirements it reflects.
Summers — and Geithner too, it seems — was very worried that America’s “twin deficits”, the fiscal deficit and the current-account deficit, could end up causing a major global crisis. As it turned out, of course, both Summers and Geithner ended up being at the forefront of the thesis that the US fiscal deficit wasn’t big enough to fight the crisis, and ought to be much bigger.
There are two big worrying things here. The first is that Geithner didn’t see the crisis coming at all, and indeed was something of a cheerleader for all of the dangerous activities that the banks were getting up to. The second, which is just as bad, is that with hindsight, Geithner sees this speech as being prescient and heroic — that it’s something to be proud of, rather than sheepishly ashamed of.
As I read the rest of Geithner’s book, then, I’m basically forced to treat the author as an unreliable narrator. Geithner might seem to be straight-up and guileless, but his report of this speech shows that he can remember things — even things which are easily found on the internet — in an extremely self-serving manner. Maybe that’s only to be expected, from a political memoir. But it’s disappointing, all the same.
*Update: Geithner revisits this same speech 15 pages later, where he is more self-critical. “I probably made it easy for people who just wanted to hear good news to block out the caveats,” he writes. “I was careful to express my concerns in understated, nuanced, deliberately dull language that wouldn’t move markets or depress confidence.”
But Geithner doesn’t explain why depressing confidence would be a bad thing, in an overconfident world. And although he admits that he spent a lot of time on “positive developments,” he doesn’t cop to the fact that those positive developments, according to the speech, were things like credit derivatives and shadow banking.