Thomas Hoenig on Bank Capitalization and Fed Policy after COVID-19

Episode Summary

Executive Summary: Thomas Hoenig argues that banks entered COVID-19 better capitalized than in 2008, but still need more capital and likely should suspend dividends to support lending and absorb losses. He supports the Fed’s aggressive crisis response on rates, QE, and liquidity facilities, but warns the Fed’s new credit programs and persistent balance-sheet expansion could erode independence and deepen leverage over time.

Main Topics: Bank capital entering the COVID-19 shock (Priority: 5/5): Hoenig says large banks improved their capital positions after 2008, though not to the level he would prefer, and are better prepared to absorb pandemic-related losses. Dividends, buybacks, and capital conservation (Priority: 5/5): He supports stopping buybacks and urges banks to delay or suspend dividends so capital can be preserved for losses, borrower relief, and future lending. Fed traditional monetary policy response (Priority: 4/5): Hoenig endorses the Fed’s zero rates, QE restart, and broad easing as rational crisis responses aimed at preventing collapse and preserving confidence. Liquidity facilities and the shadow banking system (Priority: 5/5): He views the Fed’s emergency backstops for repo, commercial paper, money funds, and dealers as necessary in crisis, but sees them as symptoms of a highly leveraged system. Credit facilities and political risk (Priority: 5/5): He is more skeptical of Fed lending into corporate, municipal, and small-business credit markets, arguing this is fiscal policy and risks politicizing the Fed. Leverage, balance-sheet growth, and long-run reform (Priority: 5/5): Hoenig argues the deeper problem is excessive leverage in the economy and that sustainable reform requires slower debt growth, higher capital, and a very independent central bank. Policy framework review and future Fed tools (Priority: 3/5): He expects the strategic review to be delayed by the crisis, favors rethinking inflation targeting, and says yield curve control is possible but negative rates should be avoided.

Key Arguments: Banks were better prepared for COVID-19 than for the 2008 crisis because regulatory pressure and their own experience pushed capital higher. Large banks should seriously consider suspending dividends because retained earnings strengthen balance sheets, absorb losses, and support more lending later. A stronger capital base matters because each dollar of retained capital can support roughly $15 of loans. The Fed was right to cut rates to zero, restart QE, and provide ample liquidity because the immediate goal was to prevent a collapse in confidence and market functioning. Emergency liquidity support for repo, money markets, and commercial paper is appropriate in crisis, but these interventions reflect a financial system that has become too leveraged and dependent on central-bank backstops. Fed credit facilities aimed at corporations, municipalities, and smaller businesses are understandable but risk blurring monetary and fiscal policy and weakening Fed independence. The fundamental long-run problem is not a lack of Fed activism but too much leverage across the economy; reform should be gradual deleveraging, higher capital, and slower debt growth. Negative interest rates should be avoided because they distort resource allocation and have not worked well in Europe or Japan. A level target, whether NGDP or price level, deserves serious review, but the Fed should not rush a framework change during an unsettled crisis. The Fed will face its biggest independence test when it tries to shrink its balance sheet and resist pressure to finance ever-growing government debt at artificially low rates.

Data Points: Years at Kansas City Fed: 20 years - Hoenig served as president of the Kansas City Federal Reserve Bank from 1991 to 2011. FDIC vice chair tenure: 2012 to 2018 - He served as vice chair of the FDIC after the financial crisis. Large-bank leverage ratio: around 6.5% to 7% - Hoenig says average tangible capital/leverage ratios for the largest banks were in this range entering the pandemic. Regional/smaller-bank leverage ratio: 8% to 10% - He says regional and smaller banks entered the crisis with stronger leverage ratios than the largest banks. Large-bank leverage ratio in 2008: around 3.5% - He contrasts current large-bank capitalization with the pre-2008 crisis period. Ideal large-bank leverage ratio: minimum 10% - Hoenig says he would want large banks to hold at least this much tangible capital. Alternative safer capital level: 15% - He references research suggesting 15% capital gives much greater staying power in serious downturns. Loan support per capital dollar: approximately $15 of loans per $1 of capital - Hoenig explains why retained capital can materially expand future lending capacity. Federal debt around 2008: around $9 trillion - He uses this as a benchmark to argue public debt has surged since the last crisis. Federal debt by 2019: over $20 trillion - He cites this to show accelerating leverage and debt accumulation before COVID-19. Federal debt today: over $24 trillion - He points to current debt levels as evidence of an increasingly leveraged economy. Private debt in 2019 vs. 2007: higher in 2019 than in 2007 - Hoenig argues leverage was already elevated before the pandemic began. Expected recovery timing: third quarter - He repeatedly expresses the view that economic recovery should begin in the third quarter. Fed balance sheet in next crisis (hypothetical): $8 to $9 trillion now; $15 trillion next time - He warns that repeated interventions could ratchet up the balance sheet to unsustainable levels.

Pivotal Quotes: "I would encourage them to delay dividends or cease dividends temporarily." — Thomas Hoenig: On how banks should conserve capital during the pandemic shock. "We are where we are, and how do you make sure there's enough liquidity to assure confidence in the economy so that it doesn't collapse upon itself." — Thomas Hoenig: On why the Fed’s crisis liquidity response was necessary. "The only everyone who is not the central bank wants more money." — Thomas Hoenig: On incentives that push toward more leverage, more credit creation, and pressure on the Fed.

Implications: Listeners should expect banks to remain under pressure but better positioned than in 2008. The Fed may have to keep intervening, but its biggest future challenge will be unwinding support without fueling excess leverage or losing independence.