William Dudley wasn't the first regulator to endorse the idea of allowing banks to convert debt into equity if they need capital in a pinch, but the president of the Federal Reserve Bank of New York has gone further than any other policymaker in making the case that "contingent capital" is key to averting another banking crisis.
While there are less-complex proposals out there, like simply requiring large banks to hold more capital, Dudley worries that when bad loans begin piling up, even well-capitalized banks can find themselves with thin buffers and few options for raising capital. They wouldn't have such worries if debt could be automatically converted into equity in the event of a capital crisis.
There are drawbacks to be sure, the biggest being the potential cost to bankers. Most investors purchase bank debt knowing that they will likely be repaid even if the bank fails, and if they stand to be wiped out with other shareholders when their debt is converted to equity, they are likely to demand higher premiums.
But Dudley argues that bankers need to be looking at the bigger picture. "Such instruments could have reduced the likelihood of failure of large, systemically important institutions, reducing the significance of the 'too-big-to-fail' problem and its associated moral hazard problems," he told a group of bankers at a conference in October.
Dudley's positions on contingent capital and other public policy issues matter, of course, because, as the head of the most important of the Federal Reserve banks, he has as much influence as any regulator inside or outside of the Beltway. His bank oversees many of the institutions considered too big to fail, such as Goldman Sachs, Citigroup Inc. and JPMorgan Chase & Co. It is running nearly a dozen of the Federal Reserve's liquidity programs aimed at fighting the financial crisis. And when the Fed's policymaking committee decides to back away from zero-percent interest rates and the programs that helped keep banks solvent, it will be Dudley's team that will carry out those commands.
Dudley, 57, is wrapping up his first year as head of the New York Fed. An economist by trade, he headed up the bank's markets desk under Tim Geithner and was promoted in January 2009 after President Obama tapped Geithner to head the Treasury Department.
In an interview in his office two blocks from Wall Street, Dudley himself sometimes seems awed by the sequence of events that elevated him to the second-most powerful position in the Federal Reserve System. He never worked at the Treasury Department, as Geithner had, and spent just two years working in other parts of the Fed, compared to the 17 years E. Gerald Corrigan toiled in Washington and Minneapolis before taking the helm in New York. Moreover, Geithner was nine years his junior and did not seem poised to go anywhere soon.
"I came here without any expectation that I was going to be president of the bank," he says.
Still, though Dudley doesn't possess the resume of some of his predecessors, industry observers say his combination of expertise in the capital markets - which will be crucial to unwinding the Fed's liquidity efforts - and his experience on the front lines of the financial crisis prepared him unusually well for the job.
"When all these books get written after the crisis, you will find that there will be some people who played a very important role but maybe didn't get enough recognition at the time," says Jamie Dimon, the chief executive of JPMorgan. "He was a key person behind the scenes who was very quietly adding an awful lot of value."
There are things he's still learning. Dudley has largely steered clear of the debate surrounding the reform of the financial system, which observers chalk up to his relative inexperience in bank regulation and supervision. Meanwhile, as a Goldman Sachs alumnus, he has to fight the perception that he's too close to Wall Street.
Yet while Geithner and Federal Reserve Chairman Ben Bernanke seem to have to defend their response to the financial crisis almost daily, Dudley is mostly winning kudos.
"He's doing a superb job," says H. Rodgin Cohen, the chairman of Sullivan & Cromwell LLP. "Markets have never been in such disarray, so his experience is truly invaluable."
Dudley was far from the spotlight as the financial system was becoming unhinged. During 2008, he gave public remarks just once, in a speech aptly titled "May You Live in Interesting Times." But as the head of the markets desk - the arm of the New York Fed that buys and sells government securities to influence interest rates and, during the financial crisis, helped fund the Fed's liquidity programs - his impact was enormous.
While Bernanke and Geithner were calming public anxiety and dealing with Congress, Dudley was in his office thinking up new programs aimed at taming the crisis. He was instrumental in the creation of the Term Asset-Backed Securities Loan Facility, which provided Fed loans for asset-backed securities and older commercial mortgage-backed securities. The program has been credited with cutting interest rates for consumer lending. He was also a driving force behind a program for the New York Fed to buy commercial paper from a broad range of companies and for the central bank to auction off cash and Treasuries to banks that shied away from more traditional borrowing from the Fed.
The New York Fed has also taken the lead in purchasing debt and mortgage-backed securities from the government-sponsored enterprises in an effort to keep mortgage rates manageable and aid Fannie Mae, Freddie Mac and the Federal Home Loan Banks with funding. The central bank plans to buy $1.25 trillion worth of MBS and $175 billion worth of debt from the GSEs by March.
Alfred DelliBovi, the president of the Federal Home Loan Bank of New York, says the debt purchases were vital to helping his bank continue providing liquidity to community bank members.
"With all this uncertainty, their buying the debt provided assurance to investors," he said. "If you think about what was happening a year ago, investors were uncertain about investing in anything very long and since the debt we issue is designed to fund long-term mortgages, that was a problem. Anything that helped restore confidence in those markets was a good thing."
These programs were often the outgrowth of conversations Dudley had with Fed policymakers in the heat of the crisis. During the most turbulent periods, Geithner, Bernanke, Fed Gov. Kevin Warsh and Donald Kohn, the central bank's vice chairman, would gather around their phones several times a day to discuss the latest developments in financial markets.
Dudley led these conversations and tried to connect all the information coming into the central bank - for instance, pointing out the latest funding breakdowns in the market - to give the policymakers some much needed perspective.
"It was remarkable the way he was able to make sense of a lot of disparate trends in markets," Kohn says. "Bill was able to step back from it all and put a lot of threads together and see the underlying trends."
But for all the programs Dudley is credited with influencing, he says he is most proud of the one that got perhaps the least attention. As the credit crunch was spreading around the globe, the Fed decided to swap currencies with foreign central banks all with the goal of infusing more dollars into foreign financial institutions. The program allowed big, global banks to keep running, even in countries where the local currency was in short supply.
"In a very short period of time, we convinced central bankers around the world to conduct auctions just like ours on the same terms, conditions and frequency to provide dollar liquidity to banks not just in the United States but around the world," Dudley says. "It demonstrated that policymakers around the world could work together."
For Dudley, assuming the New York Fed's presidency is the culmination of one of his biggest goals: returning to public policy. He was an economist at the Fed in Washington from 1981 to 1983 and showed a talent for policy work. Some of his former colleagues privately say he left after two years because the Fed was not fully tapping his skills.
After leaving the Fed, he was the vice president of what was then the Morgan Guaranty Trust Co. He moved to Goldman three years later, in 1986, where his name would be made as a top-notch economist.
At Goldman, he worked closely with Robert Rubin, who by the 1990s was heading to Washington to advise President Clinton on economic policy. When Rubin became Treasury Secretary in 1995, former colleagues say Dudley hoped to also move south and work with him again. That did not happen - a development that was said to be disappointing for Dudley - and he instead focused on expanding the role of Goldman's chief economist.
"I've been trying to get back into policy for a long, long time," Dudley said. "I really did want to do policy work. In fact, when I worked at Goldman Sachs, I tried to define the economist's role pretty broadly. So we did lots of policy work on health care reform, social security reform, capital gains tax - stuff that was much broader than the macro economy financial markets stuff that economists do."
It was as Goldman's economist that he gained notoriety in the financial markets. His thoughts on market developments were held in high esteem on Wall Street - Institutional Investor magazine often named him the top economist - and he was read very closely by top Fed officials in Washington.
But his status as a Goldman alumnus is also a liability in some circles that view with suspicion the number of government officials who have spent time at the firm.
"Perceptions are very important to the public," said Robert Gnaizda, of counsel to the Black Economic Council. "People think this means that Goldman Sachs is going to have more influence."
That perception may exist, but it's not as if Wall Street is warmly embracing his positions on such issues as contingent capital and the trading of credit derivatives.
In a speech at a conference of international bankers in October, Dudley said that the mere existence of contingent capital would force banks and their boards to make better decisions.
"If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted," Dudley said. "This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside."
Fed officials in Washington are receptive to the proposal, though they are still haggling over how it would work in practice. A central question is whether the conversion would be triggered by a slide in the bank's book value or a decline in its market price. Though no official decision has been made on that front, Dudley said regulators should focus on equity.
The banking industry, though, has given the idea of issuing contingent capital a big thumbs down, arguing that the cost "makes it prohibitive," says Scott Talbott, a senior vice president with the Financial Services Roundtable.
Dudley disagrees, and says costs could be kept down if banks held a substantial amount of contingent capital. That, in theory, would limit investors' exposure if they'd only need to convert a portion of the debt to equity to meet capital requirements.
But Talbott, whose group represents many of the country's largest financial services firms, says bankers don't see it that way.
"The problem is that someone has to go first," he says. "That would be the focus of the investors. Would you be willing to be the first lemming?"
On bank supervision, Dudley is less forceful in his comments. While he acknowledges that supervision of large institutions needs to improve, he has yet to take a firm stand in the debate over whether the Fed's consumer protection powers should be taken away, as Obama envisions, or whether bank supervision powers should be stripped from its duties, as Senate Banking Committee Chairman Chris Dodd advocates.
The closest he has come to an endorsement of the administration's regulatory reform framework was during the October speech, where he expressed appreciation for a plan that would create a central clearinghouse for derivatives trading.
"Not only would this more effectively capture the risks the banks are taking, but it also would create incentives to move the trading and settlement of such instruments more rapidly to central clearing parties and to exchanges," he said.
But in this instance, Dudley is mostly picking up where Geithner left off. The New York Fed has long been obsessed with derivatives and pushed even harder to centralize the transactions after they helped cause the downfall of American International Group Inc.
In the interview, Dudley take a stab at describing his regulatory philosophy.
"Regulation is necessary," he says, "in cases where there are externalities, where actions generate consequences for the broader financial system or for society and if the firms don't internalize those externalities, then you may need to put in place regulatory standards or requirements that basically lean against the fact that their behaviors may generate bad outcomes from a public policy perspective."
In other words, regulation is necessary when one firm's actions jeopardize the entire financial system. Compensation is a good example of that, he says.
"If compensation practices create incentives in terms of taking risks that are inconsistent with what we may want to do on financial stability, then we may want to have in place guidelines or rules in terms of compensation practices to reconcile that potential for conflict," he says.
The Fed released a proposal in October that would subject the 28 largest banks to a horizontal review on compensation practices. Institutions whose compensation standards are unusual compared to their peers will have to explain their pay packages to the Fed. The central bank will review pay at smaller institutions as part of their normal examination process.
After the compensation proposal was released, it fell to Dudley to drive home the point to Wall Street that the Fed was serious. He summoned the CEOs of the 28 banks to a meeting where he drove home the goal behind the Fed's plan: to align pay with longer-term performance.
Still, he says regulation has limits.
"To me, it's important to say you don't say go out and regulate everything. I don't think that works well for a couple of reasons: One, it's very hard to write regulations that are flexible enough in practice to be able to adjust to developments in markets and the financial industry in real time. Second, you write down a regulation then you're sort of creating a target for regulatory arbitrage."
While well intended, that sentiment could fuel the perception that the central bank and the New York Fed remain too close to the industry they regulate. The characterization of the Fed as a lax regulator - combined with election year politics - is one of the main reasons Dodd is pushing to take supervision powers away from the central bank.
The New York Fed has always been one of the most important parts of the Fed machine. Its president is the vice-chair of the Federal Open Markets Committee, where governors appointed by the president and confirmed by the Senate are the only other permanent members. The Fed receives the bulk of its information about financial markets through buzz picked up by the markets desk in New York.
With so many big banks in its district, the New York Fed's importance is expected to grow even more in the years ahead as the central bank moves toward a system of overseeing firms in a more holistic manner, looking at all of their parts and judging their interaction with broader markets. "It has become more important because it is in the center," says Cohen, of Sullivan & Cromwell. "They are helping shape policy which affects Wells Fargo just as much as JPMorgan."
The renewed emphasis on supervision highlights an important challenge for Dudley: how can the New York Fed step up its efforts on the supervision front while not forgetting about other parts of its portfolio, which include monetary policy and payment systems?
"I still think we have to be focused on financial markets broadly," he says. "I do take time thinking about monetary policy and the macro economy, but I also spend a lot of time on regulation of payments and settlements systems, capital markets and banking. I wouldn't say one is more important than the other. They're all part of the financial system."
As he looks ahead, Dudley hopes to oversee a banking system that will become considerably less complicated than the one that plunged the economy into a deep recession.
The Obama administration is hoping to make that happen by requiring banks to develop "living wills" that would serve as a roadmap to winding down mammoth institutions and their tentacles. That plan would force banks to account for all of their parts. Dudley, meanwhile, is working with other regulators in the U.S. to implement rules enacted by the Basel Committee on Banking Supervision that would require higher capital for trading, the very activity that helped many banks become mired down in subprime and other risky assets.
Though he has been on the job for just a year, there is already speculation about what Dudley might do next. Unlike Fed officials in Washington, regional Fed presidents do not have term limits. Some say Dudley would be a logical candidate to fill a seat on the Fed's board. Others say he has the potential to become a Treasury Secretary, though that option might be muddied by Geithner's rough transition from Wall Street cop to political operative.
Dudley, however, says he is simply focused on the work ahead. "We're on the journey and making progress," he says. "But it's not like three years from now, we'll be done. Three years from now, we'll be better than where we are today...[but] we'll have to keep going and improve."
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