Balancing Smart Regulation and Innovation with Gene Ludwig

As the banking world turns, I’m Al Dominick, coming at you from Washington, D.C., while my co-host, Steve Williams, attempts to steal my normal studio seat in Scottsdale, Arizona, before retiring to his office.

The two of us are delighted to welcome an expert on banking regulation, risk management, and fiscal policy.

With so much happening in the world today, we were thinking about who we could invite for this new episode of Plugged In, and we called. Lucky for us, Gene Ludwig answered.

For those of you who aren’t familiar with Gene’s career, this is someone who served from 1993 to 1998 as Comptroller of the Currency. He founded Promontory Financial Group and served as vice chairman of Bankers Trust and Deutsche Bank.

Today, he’s the chairman of the Ludwig Institute for Shared Economic Prosperity, a co-managing partner of the venture capital firm Canapi Ventures, and CEO of Ludwig Advisors.

So yes, he’s a man of experience, perspective, and, we hope, some opinions. Truly a fitting guest for this latest episode of Cornerstone Advisors’ Plugged In.

Gene, thanks for joining Steve and myself.

This is great, Al. The only thing I can say is that introduction was so over-the-top nice that I’m going to make sure my office records it so I can play it to my two daughters and son, who will not believe a word of it.

At least I’ll have competitive equity next time.

That’s Dad, right?

That’s Dad.

That can be memorialized for posterity, so it’s there and on the record.

Look, Gene, you’ve been someone who’s shared the stage with both Steve and myself at various points over the last few years.

We’ve had opportunities to look at how different factors shape our great industry. For Plugged In, what Steve and I have tried to do is take another great industry and pull it in, and that’s the music scene.

We pulled five different tracks that we could use for our conversation today because we are talking about the business of banking.

We have folks like John Mellencamp, who wrote “Authority Song,” which really gives us a nice lead-in to talking about some of the congressional matters.

If you’re not familiar with John Mellencamp, I’m going to put this on the Spotify playlist that we’ve created for Plugged In.

He’s got some lyrics about authority putting you in a compromising position and thinking it’s funny when they get you there.

I think, and we think, it’s a total disgrace.

Steve, I know John Mellencamp, but for that lyric, let’s talk a little bit about the House and Senate. What would you like Gene to focus on?

Gene, given all your experience, you see the entrepreneurs out there trying to do interesting things and transform financial services.

Now you see the navigation of a lot of macro policy and incidents in the banking industry.

If you could advise Congress on smart policy to deal with what people are saying, “We need to do something about this,” is there anything that needs to be done from the congressional standpoint?

What would you advise Congress to think about as it relates to addressing what’s happened recently in the banking world?

It seems to me there are several things that Congress ought to be exploring.

Number one, and these aren’t necessarily in order of priority, they have got to make sure that the government and the regulators in the executive branch have tools that can deal with a crisis swiftly and without the complications we now have, in part as a result of Dodd-Frank.

One of the things Dodd-Frank changed, which seems to me was a step backward rather than forward, was making it very complicated for the FDIC, the Fed, and the Treasury to act promptly in a crisis.

Number two, we’ve got to explore having a more robust deposit insurance system.

It’s crazy to have a $250,000 limit.

That limit ought to be much higher.

Maybe it ought to act more like a real insurance company, where people can buy the amount of insurance their institution needs.

If you’re going to have bigger deposits that you want insured, you pay more.

If you’re a smaller institution and don’t have all those big deposits, you pay less.

There should be some proportionality here and a system that is appropriate for the time and place we’re in today.

The third thing we ought to be exploring is giving regulators new tools to deal with the modern day.

We’ve just seen a big change as a result of this crisis, but it was brewing. It’s a technology change.

We are living in an immediate-media world.

We want our payment systems to be rapid-fire, same-day, real-time payments.

We want the internet to be something that we can converse over instantaneously.

All those factors make speed a real factor in how you do financial services and how easy it is to attack a financial services institution.

We have to give regulators the tools to deal with that.

For example, one thing we ought to be exploring is a way to unplug for a few hours, a circuit breaker or some other mechanism that gives regulators and the public time to act.

Otherwise, people take advantage of these situations.

Short sellers and other people can manipulate the market.

Right now, we have regulators having to utilize tools that were created too long ago.

I think what’s really interesting is the point about assessment being risk-based, as assessed by the FDIC.

You’re not necessarily talking about private deposit insurance. You’re saying it should be a risk-based system of deposit insurance that expands past $250,000.

Yes.

Private insurance does not work.

We tried that period 10, 20 years ago, or longer.

No, no, no. It must be FDIC insurance.

That’s why we put it in place in the 1930s, and it worked rather well to avoid contagion, which had been part of the history of American banking.

It worked well, but it’s outdated in the sense that it’s not prepared to respond to the realities of this marketplace.

It’s insane that one of the reasons these institutions apparently were attacked is because they had uninsured deposits.

For business banks, they’re always going to have uninsured deposits.

Right. If you have a business account, it’s going to be bigger than $250,000.

Gene, as you’re talking, I’m just jotting a few notes down.

We’re using some music, and I’m going a little bit sideways when I think of Pete Townshend writing for The Who: “Meet the new boss, same as the old boss.”

That’s from “Won’t Get Fooled Again.”

I’m thinking about these tools that banks and regulators could develop.

I believe you shared something on LinkedIn recently that used a pretty creative analogy about the space we’re in and the time that’s needed.

You said something along the lines of a firefighter being called in to stop a wildfire before it spreads. He or she doesn’t have time to convene a committee and vote before dousing it with water.

We’re talking about banks and regulators developing new tools that might address new problems.

Can you elaborate on where you think more time and effort should be paid by both sides?

Absolutely.

First, the nature of tail risk generally is worth focusing on.

What happened with SVB and Signature were really tail events.

They were unanticipated.

Everybody’s pointing the finger at these holdings of Treasuries in the held-to-maturity account.

That’s a part of the story, but I think a much smaller part of the story than people realize.

There are all kinds of tail events that can happen, unexpected events.

Nobody had expected, when they created these accounts and regulated these institutions, that things would happen as instantaneously and rapidly as they did.

That wasn’t anticipated.

The secret to dealing with tail risk is to cut it off the second you know the tail is expanding.

I’ve dealt with tail-risk matters in finance most of my professional career because that’s where there’s always the biggest risk and the biggest dangers.

What I’ve learned is they don’t just explode.

They fatten out over a period of time.

It can be short, but if you can take action quickly, you can cut them off and really save the situation.

That means you have to act quickly, particularly in today’s day and age, which, as I’ve said, is so moved by modern technology in all kinds of different ways, payment systems, the internet, et cetera.

Right now, for a lot of the things regulators could theoretically do, they basically have to have committee meetings by law and by practice.

They’ve got to get together and have the Federal Reserve Board vote, the FDIC board vote, get together and jointly agree, go to the Treasury Secretary, and then, in terms of some of this, go to the president.

Finally, if they have a real contagion, they’ve got to get a vote by both houses of Congress.

Just imagine a firefighter having to put out a fire going through that rigmarole.

All of California would have burned down.

That’s really interesting, the idea of cutting the tails off.

Steve, are you trying to bring some music into this?

I would love to throw it your way so you can be part of the DJ committee that Gene is hiring for his next get-together.

I’d like that.

This is very hip, I’ve got to say. I hadn’t expected this.

I thought this was going to be trying to bring a little sound effect to the table right here.

What was that sound effect?

“I Can See Clearly Now.”

Yep, by Johnny Nash.

It was.

Wouldn’t it be nice to talk about the future of banking?

Johnny Nash, “I Can See Clearly Now,” and the future of banking.

If we’re talking about the future of banking, maybe we could talk about some of the building blocks of a smarter bank or that next wave of top performers.

What do you think are some of the key elements, Gene, that go into making a strong and smarter bank in the coming years?

It’s in part both the old and the new.

Let me focus on the new.

You can’t have a smarter bank in the future if it doesn’t ingest modern technologies promptly.

The only way to deal with the reality of a marketplace that has become speedier, more competitive, more global, and more technologically driven is for your own institution to have modern technologies that can both protect you and give you competitive advantages in the marketplace.

Ingesting those technologies promptly is very, very important.

But the other part of this, when I say it’s a little bit the old and the new, is that we have to have people who are excited enough to join banking and who are of the quality we historically have had and have today in the banking industry.

We have top people in the banking industry, and historically that’s been a great advantage to the American banking system.

There are top people at institutions of different sizes and shapes who can deal with the public in different ways all over the United States.

It’s been, in its own way, a happy, blooming, buzzing confusion.

People could start new banks with new ideas.

People can do banking a little bit differently or in a specialized way for their own customer base.

We’ve got to be able to attract these people.

That means we’ve got to have regulation, of course, but we’ve got to have smart regulation.

We need regulation that does not overburden the system to the point where you have a heavily regulated bank dealing with all these regulations while its competitor next door has no regulation and is doing the same thing.

When you asked me earlier what Congress could do, I failed to mention number four on my list, which again is not in order of priority.

Nonbanks doing the same thing as banks need to have the same regulation that banks do.

We should not have a situation where you have entities doing the same activities at the same size, and one is regulated heavily while the other isn’t regulated at all.

Can I get an amen?

Gene, I’ve heard you say this: regulate by activity, not by charter.

I could not agree more.

With data today, there is so much opportunity.

If we can get a better data infrastructure across the industry that is more real-time, and that was not the case with, as I understand it, some of SVB’s data, smart regulation could be driven a lot by analyzing data across the whole system.

To your point, regulators could grab the tail before it grows too big.

I think there’s a real opportunity to have a data strategy around regulatory oversight and looking for where risk pops up, because we can never predict it.

Steve, that’s very smart.

I couldn’t agree with you more as you’ve articulated it.

Absolutely, we need a broad data strategy.

But I’ll tell you, there’s a danger here.

We’re going to be fighting last year’s fight and fighting it incorrectly.

The notion that the problem here was banks that were specialized, or banks that had utilized the held-to-maturity account in and of itself, yes, you could make choices and change.

But it really wasn’t that in and of itself.

The big thing here was speed, speed, speed.

A new kind of tail risk.

Neither the regulators nor the institutions had the tools to react quickly enough.

Gene, The Economist kind of ticked me off in the last week because they talked about reciprocal deposits.

You’ve been a visionary with Promontory, now IntraFi.

They used the term “depositors gaming insurance,” and that really ticked me off.

To me, a reciprocal deposit system for community and regional banks makes a ton of sense to create that dynamism and vibrancy you talked about, that diversity in the industry.

Where do you see the need for a growing reciprocal deposit network in America?

I think it’s a good thing.

Obviously, I created it. I’m proud of what we did.

It’s hardly gaming the system.

It’s simply making the system more efficient.

When I came up with the idea, it was both easy on the one hand.

I saw community banks of all different sizes, shapes, and communities they were serving, but they couldn’t get enough deposits.

They couldn’t compete because the big guys would say, “How dare you bank at that thing? They’re not big enough,” or whatever.

This gave the community bank competitive equity.

On the other hand, I remembered my Aunt Betty.

Betty Chadwick, God bless her, was a secretary in Philadelphia, Pennsylvania.

In her day, the deposit insurance cap was $35,000.

She had a little bit more than $35,000.

Maybe she had as much as $300,000.

She went from bank to bank, getting enough insurance at each bank so she could put her deposits below $35,000 and have enough insurance coverage to feel secure.

She’d have to get on the bus in Philadelphia and go from bank to bank to bank.

That’s perfectly legitimate.

That is legal. That is permitted.

It’s a longstanding okay by the FDIC and the government.

The only thing reciprocal deposits actually do is allow Aunt Betty the opportunity to go to one bank and get that service provided to her by the one bank.

What’s wrong with that?

They’re acting as her agent to do this.

Frankly, for Aunt Betty, it would have been a godsend because I think she died and a bunch of her accounts were lost.

She’d gotten up in years and couldn’t remember all the banks she went to.

It’s ridiculous.

This is a modernization of the system in a lot of ways, as it was intended, but in a modern fashion.

That’s right.

I think banks would be smart to double down on making that customer experience even better through the digital world and through mobile.

“I can see where my IntraFi is.”

Make that really fit today’s world.

I think it’s exactly what the customer would want.

I agree.

I respect The Economist. I read it, but I think they got that one wrong.

Having worked alongside folks at The Economist years ago, it tugs at my heart to hear you upset, Steve, but I understand.

I agree with the points you’re both making.

We’ve talked about Gene’s aunt.

What if we looked ahead to the future, and people in your family, Gene, were looking back on Uncle Gene?

Back in his day, there was an opportunity to do some stuff. Did they do it or not?

We’re living in this time where fintech continues to rise and fall.

Last year, Steve, we had some great turns working on some DeFi projects that I think still have potential.

I’ve made note that Gene has predicted that fintech and DeFi will be integrated into the regulatory story of traditional financial institutions, and you think this presents a great opportunity for banks.

Again, if this is looking out into the future and your family is having that retrospective, how have banks been able to pursue this opportunity?

To date, it’s been okay.

Unfortunately, DeFi has gotten mixed up with the term “crypto,” and regulators have turned their faces away from crypto of late.

I find this amusing in a couple of different ways.

It’s not amusing if you’re in the business.

First, if you’re going to pick up a term the next time you sell your product, don’t pick the term “crypto.”

Crypto is like a Darth Vader idea. It sounds illicit on its face.

Come up with a better term.

The second thing about “crypto” is that it’s been used so broadly and misunderstood.

DeFi is not crypto in and of itself.

It can be used to cover the blockchain mechanism and distributed technologies for accomplishing all kinds of tasks, including noncurrency tasks like smart contracts.

There’s tremendous opportunity here.

Regulators really are going to have to differentiate what they mean so they don’t basically block banking out of a lot of legitimate activities.

But the other thing I think is very important goes back to this idea of the same activity, same regulation.

If the United States has turned its back on cryptocurrency, okay.

I’m not going to sit here and argue in favor of or against cryptocurrency today.

But if that’s the way it is, then it should be true for banks and nonbanks.

It shouldn’t be true only for banks.

In fact, it’s a little odd today to exclude banks when banks actually can be regulated in terms of what they do with crypto, and then nonbanks can go willy-nilly.

It’s a Wild West show.

That seems to be particularly nuts.

There is a huge danger here.

Keeping banks out of things that are modern and advancing will strangle the banking industry, and it will hurt America.

It will not be durable over time.

This whole business of having these big nonbanks and supposedly walled-off and therefore safer banks is not going to be able to exist over time.

It will create an explosion.

Either regulation matters in terms of increasing safety and soundness or it doesn’t.

Presumably, it does.

If it does, it means what’s going on out there in nonbank land isn’t safe.

Something will happen that is explosive, and then we’ll get back to our senses.

Ideally, we won’t have to wait until something happens.

We’ll have a real competitive level playing field, which we should have.

I always say about this stuff, go back to James Madison.

“If men were angels,” we wouldn’t need all this.

But they’re not.

I think what 2022 proved, Gene, was that institutions of trust have a place in our society.

Things like oversight and governance are there for a reason.

I agree. Let the modernization come to the industry, but support institutions of trust that have governance, oversight, and smart regulation.

You’re going to end up with better vibrancy without as much volatility for the economy.

Amen, brother. Amen.

You and I are good friends, but I like your thinking.

You’re thinking James Madison.

As I’m listening to Gene, I’m thinking Huey Lewis and the News because he’s saying crypto needs a new name.

I just want to play “I Want a New Drug.”

I feel like that’s the soundtrack for this particular part of the podcast.

I’m having more fun than I probably should when it comes to music selections today.

We’ve got one more question, Steve.

I’m going to let you talk stress testing.

I don’t know if you have any track in mind that could line up with using stress testing as a more strategic tool than just a compliance one.

I hear the bassline of John Deacon from Queen.

Boom, boom, boom.

It’s probably “Under Pressure.”

I talk to CEOs right now, and they’re wondering what the next circular on liquidity stress testing is going to look like.

Obviously, there was a stress-test model fighting the credit-risk war when this came along.

To your point, it wasn’t simply liquidity risk.

It was liquidity risk put on steroids in a new digital world.

Gene, what do you think is going to happen next for banks in terms of stress testing?

If you were going to give a CEO advice, how should they set up a stress-testing capability that isn’t fragile and isn’t fighting the last war?

Have you seen banks do this well?

Yes, actually.

But before I answer your question, I can’t help myself but go back and refine the prior comments and question on crypto.

Al analogized crypto a moment ago to a new drug in terms of your music.

There is no doubt that you have to be skeptical, particularly if you’ve been a former Comptroller of the Currency, of people inventing a new kind of currency that nobody’s regulating and nobody’s controlling.

Somehow people are basically putting their money in, particularly folks who don’t have the money to do it.

You can’t look at that as an unregulated thing and feel good about it.

But my point about crypto is that the term has been used so willy-nilly that it covers more than that activity, which we’re all skeptical of.

It covers all kinds of other DeFi and blockchain activities that really are not about currency or necessarily about nonregulation.

Just to make that distinction, I’m not advancing cryptocurrency or your new drug. Hardly.

Now, to stress testing.

Yes, I have seen it used well.

I know a number of U.S. banks do this, but I was first impressed years ago when I was dealing with the board of directors of National Australia Bank in about the year 2000.

We were in for a project.

I had created Promontory Financial Group, and we were helping them with something.

The board of directors had an off-site to do stress testing, which they called scenario analysis.

They would look at the range of things that could happen and ask, “How would this affect our bank?”

Interestingly enough, one of the things the board wanted to review back then was a pandemic.

I thought that was very odd, to be honest with you.

But if you’re in Australia and you’re so close to China and Southeast Asia, it makes a little bit more sense to be worried about that than I had appreciated coming from North America.

In any case, they were right.

They were a couple of decades early.

They were quite prescient.

But they were serious about it. They got into it.

I was naive in a way because I assumed, one way or another, every bank was doing this on its own.

It’s something I did when I was at Bankers Trust.

You look at different scenarios and have your people go through how they would affect the bank, including things that were more like tail-risk events.

Every bank should do that on its own.

We shouldn’t have regulators requiring it.

Frankly, having banks do it on their own within maybe some loose set of rules, doing it every year and doing it seriously, is, I think, even better than a CCAR analysis.

That’s a government-organized stress test.

I’m not against CCAR, and I think CCAR and the fact that Dodd-Frank focused banks on having stress tests is fundamentally a good thing.

But number one, it should not crowd out banks doing it on their own.

Number two, it’s not necessarily the be-all and end-all because you can’t come up with one stress scenario and expect it to be right all the time or cover all the possibilities.

I think no matter what the regulation is, what you mentioned about the culture of a bank is important.

It should be one of data-driven debate all the time, creating scenarios and saying, “What if?”

I always say this with directors.

I might not be the most technical banker if I’m on a board, but I can ask scenario questions, and management can answer those with analysis and facts.

That culture of debate is hugely important when you’re in the risk business.

Yes, Steve. That couldn’t be better said.

The culture of debate.

I often like to call it, as the Comptroller’s Office does, a critical challenge or a challenge function.

But you’ve put it quite well.

Gene, I think you put a lot of things quite well for us today.

Steve Williams and I want to send our appreciation for joining us on this new episode of Plugged In.

We’ll be catching up with more folks in the coming weeks.

I encourage everyone to subscribe on their favorite platform, wherever they choose to get their information.

Again, on behalf of Steve, I’m Al.

Thank you, Gene.

Thanks, Gene. Really loved the discussion.

Thank you very much. Honored to be with you.