Is The New York Fed Making A Serious Mistake On Bank Dividends?

By Simon Johnson
An uncomfortable dissonance is beginning to develop within the Federal Reserve.  On the one hand, senior current and former officials now generally agree with the propositions put forward by Professor Anat Admati and her distinguished colleagues – our leading banks need more capital, i.e., more equity financing relative to what they borrow.
The language these officials use is vaguer than would be ideal and they refuse to be drawn 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 intellectually on this issue. 
But an important split appears to be emerging within the Federal Reserve system, with the Board of Governors and most regional Feds tending to want higher capital levels from today’s levels, while the New York Fed is – incredibly – pushing hard to enable big banks actually to reduce their capital ratios (in the first instance by allowing them to pay increased dividends).
The New York Fed will not go on the record in any detailed way and my attempts to engage constructively with them have proved futile, so it is hard to know if there is any analytical basis whatsoever for their position.  They have certainly put up no meaningful counterarguments to the powerful points made by Anat Admati and her colleagues – both in general and against allowing U.S. banks to increase their dividends today (see also this letter to the FT).
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 (i.e., not paying dividends) is the easiest way to build capital (i.e., 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 their 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 board of directors for regional Feds.  We can argue about whether this is a problem for most of those organizations, but for the New York Fed the predominance of big Wall Street institutions has become a major source of controversy. 
At the bottom of the NY Fed’s current board membership webpage, 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 Dick Fuld (Lehman), Stephen Friedman (ex-Goldman), and Sandy Weil (Citigroup).  Their firm hand helped guide the New York Fed into the crisis of 2007-08.
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 (unlike Tim Geithner, the previous head and current Treasury Secretary, and Bill Dudley, the current head and former Goldman Sachs executive.)  But the current New York Fed board still includes Jamie Dimon, head of JP Morgan Chase, and an out-spoken voice for allowing banks to operate with less capital (by paying out dividends). 
In fact, Dimon has a theory of “excess capital” in banks that is beyond bizarre – arguing banks (or perhaps any firms) with strong equity financing will do “dumb things”.  This is completely at odds with reality in the US 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, e.g., because they agree with Dimon, they should come out and discuss this in public (and providing some evidence would be nice).  Hiding quietly behind official walls is, at this stage, beyond irresponsible.
If the New York Fed were really pushing for higher dividends at this time, for example by constructing a stress tests 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.
Some Federal Reserve officials act as if they have a constitutional right to run an independent central bank.  Fortunately or unfortunately, 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.
There is a very real danger that the New York Fed now will fatally undermine the fragile credibility of the rest of the Federal Reserve System.
An edited and expanded version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.