Executive Commentary
As prepared for delivery

"Regulatory Consequences: Financial Inclusion and Economic Recovery"

Vikram Pandit, CEO, Citigroup
Manhattan, Buttonwood Conference, CUNY Graduate Center, New York


October 25, 2010

Last year, this conference served as a call to action on banking reform. Much has been accomplished in the intervening twelve months. Most importantly, in the United States we've seen the implementation of the CARD Act and the passage of Dodd-Frank. Internationally, the Basel Committee has presented an outline of its new rules.

Everyone involved in these processes deserves enormous credit. We at Citi strongly supported reform here in the U.S. We did so in spite of the fact that some of the changes present challenges to banks' current business models. Yet our economy needs a strong banking system, one with the potential to fuel strong economic growth. Smart reform will help accomplish that goal.

The Basel Committee reforms are headed in the right direction. But in some respects they don't go far enough and in others they miss the mark. Thankfully the process is still open for debate—because further calibration is required to ensure that the rules are right for these times and for future growth.

Today I want to talk about the potential impact of all these new regulations from two perspectives. The first is financial inclusion—ensuring that as many people as possible have access to basic financial services. The second is their impact on the broader economy, particularly on aggregate demand.

Let's start with Dodd-Frank. The goal of mitigating risk through systemic safety rules is laudable. We're waiting for regulators to write the specific rules and until those rules are complete there will be some uncertainty in the industry.

The biggest positive impact of Dodd-Frank, and also of the CARD Act, will be to strengthen consumer rights. Change was definitely needed here. The excessive fees charged to some consumers needed to be addressed—and they have been. The new Bureau of Consumer Financial Protection will focus on creating more transparency, choice, and control for banking customers—all goals that we at Citi fully support and had begun implementing even before the new laws were passed and the Bureau created.

But these gains in consumer protections do not come without costs. First, available credit is shrinking. $1.5 trillion in credit card lines were cut even before key provisions of the CARD Act took effect earlier this year, and more is being cut every day.

Some of that is understandable belt-tightening following the financial crisis. But some is the result of new rules that make serving the less affluent less economically viable. We can expect a further contraction of credit as the system adjusts to the new reality. As always, the least affluent will feel this credit pinch the most—indeed, they already are.

Second, as old revenue streams from overdraft fees and debit interchange shrink, retail banks are going to have to reinvent their business models to remain profitable. It's not much of an issue for Citi because we charged few such fees and were never very reliant on them for revenue. But for the banking system as a whole, as a primary revenue stream is taken away, banks may respond by not serving less-profitable communities and customers, or by serving them less. We could see the retail branch footprint of some banks shrink—particularly in lower-income and more rural areas. Many people could suddenly find themselves shut out of the banking system.

At Citi we consider this a call to action for our industry. A business model that depends on unfair fees needs to be revised. The challenge is to work with regulators to develop a new model with lower cost structures that make it economically viable for banks to serve the less-affluent fairly. Innovation and technology will be key—and will allow us to provide the same services at far lower costs. Developing this new model will take time but I know we'll get there.

On Basel, my concerns are deeper.

Basel is designed to help keep the banking system from falling into crisis again. I want to focus on four of the problems that led to the crisis and that Basel seeks to address.

The first and most obvious was excessive leverage.

The second was the pro-cyclical nature of the old capital requirements. Levels were set too low for good times and too high for bad times. So when banks needed capital the most—when the risk of a bubble was highest—they didn't have enough on hand. And during economic slowdowns, when lending was most urgently needed, capital was required to remain tied up in the system.

Third, the playing field was not level across the financial system. Different rules applied to different kinds of institutions—for instance, insurance companies were held to lower capital requirements than banks for the same kind of assets. Some institutions weren't required to follow any rules, which led to the creation of a parallel and unregulated shadow banking system. The resulting opportunities for regulatory arbitrage allowed certain players to measure risk and make loans more loosely than the formal banking system and also to create products that were not economically sound.

Fourth, the playing field was also not level geographically. Countries set their own rules, adopted international rules at their own pace, and interpreted what rules they did implement differently. As a result, opportunities for arbitrage were plentiful.

Basel addresses the over-leverage problem. But on the other three, it is either silent, doesn't go far enough, or makes the problem worse.

On the first, I support Basel III's higher capital ratios. I fully expect my company to meet and exceed them. And I believe that these higher capital levels will help make the banking system safer.

That is because the effective levels of the new Basel ratios are far higher than advertised owing to changes in the risk weightings. Hence the quip you've heard that the new 7 percent minimum is really the old 12 percent. That is a substantial level and there is a point beyond which "more" is not necessarily "better"—for the banking system, for consumers, or for the economy.

Yet there seems to be a bidding war in which some regulators internationally are now attempting to outdo Basel—and one another. In this war, whichever country imposes the highest additional capital requirements "wins." Let's be clear: double-digit ratios will have direct negative impacts on lending, capital formation, aggregate demand and growth. And with proper regulatory supervision, they aren't necessary to make the system any safer.

On the second issue, Basel takes an already pro-cyclical system and makes it more so. It further raises capital requirements for bad times and further lowers them for good times. Hence once a recovery is fully underway, Basel encourages banks to begin over-leveraging again—in full compliance with the rules—thereby piling risk into the system.

Conversely, high capital requirements today could impede recovery by raising the cost of credit precisely when credit is needed the most. Higher credit costs shut many potential borrowers—including the small and medium-sized businesses that are the economy's primary job-creators—out of the system.

This is not Basel's only blow to financial inclusion. The latest rules judge risk for consumers and small business owners largely on the basis of FICO scores and data from the worst outlier years of the recent crisis. That's like calculating the future personnel needs of the Army based on end strength from 1942-1945. A consumer or small business seeking a loan will be assessed largely on what happened from 2008 to 2010. Very little weight is given to expectations for the future—to bankers' personal knowledge of our clients and assessment of those clients' prospects. The past, literally, will count for more than the future.

There are two problems with this approach.

First, it won't create an accurate measurement of risk for these loans. It merely replaces an economic or market-based measurement with a regulatory measurement. This will reduce credit creation today, slowing our recovery, and lead to the misallocation of capital in the future.

Second, this history-based approach will raise capital costs for a large group of consumers and many small and medium-sized businesses. Under Basel, capital requirements for loans to people with FICO scores lower than 700 rise by 75%. For consumers with scores over 700, requirements drop by 20%. Some 124 million Americans—40% of the U.S. population—have credit scores lower than 700.

No one disputes that riskier loans should be backed by higher levels of capital. But basing risk measurements almost entirely on credit scores and data from the crisis years will mean that the "haves" who need credit the least will get the most—and pay the least for it. The "have-nots" who need credit the most will be hurt the most.

On the third and fourth problems, Basel does not level the playing field—either institutionally or geographically.

Institutionally, Basel reinforces incentives for the development of another shadow banking system. The old one was severely hurt by the crisis and won't recover to pre-crisis levels. But a new one could arise as capital flees the formal banking system looking for less or unregulated sectors.

Any time the amount of capital required by regulation exceeds the levels judged necessary by the market, opportunities for arbitrage arise. It probably won't be mortgage brokers who fuel the next bubble. But some unregulated financial niche will arise, posing similar—or greater—dangers.

Remember, the banking system is not synonymous with the financial system as a whole—and Basel only affects the former. Shifting risk into unregulated or differently regulated sectors won't make the banking system safer. On the contrary, overall risk in the system could actually rise.

Put simply, the new rules don't cast a wide enough net. And they create new incentives to rebuild some of the worst features of the very environment that led to the crisis.

Finally, Basel is no better geographically. Europe, Asia, Latin America and the U.S. all interpret and implement the three iterations of Basel differently—in some cases on a regional and in others on a country-by-country basis. Nothing in Basel III will change that—nor do the non-binding rules even attempt to do so. And this is to say nothing about accounting or reserve standards.

If Basel is implemented as written, banks will be able to make bigger profits lending to certain emerging markets with lower capital requirements than to domestic markets saddled with Basel's procyclically high capital levels.

The solution to this problem is proper calibration and greater uniformity. To make any reform really work, we all need to play by the same rules.

In sum, let me be even more provocative. Under Basel, the "sweet spot" business model for banks in the developed world will be to take retail deposits from "mom and pop"—small but stable customers—and lend only to big business and the wealthy.

I don't believe this is the banking system we want.

What can be done to change things? As I noted, the process is not over. Much remains to be determined—from lending limits to liquidity requirements. We have time to fix what's wrong and strengthen what's right. We should take a page from the Dodd-Frank process—which was relatively open, transparent, and reported. Basel should be debated just like Dodd-Frank—in the open. Good process makes for good policy. And good policy makes for good economics.

The urgency of good economics at this time need hardly be stressed. Our most critical priorities are re-igniting growth and creating jobs. Good financial reform that helps with both should therefore be our most urgent priority.

The problem for us is that we are right now in a policy "Goldilocks" moment. The worst of the crisis is behind us. Unemployment is high and growth is sluggish but the economy seems to have stabilized. None of us likes the current environment—particularly this high unemployment. But the downside of stability is that it undermines the sense of urgency.

By creating an illusion of safety, Basel actually dulls the sense of urgency further. In many respects—particularly on higher capital—Basel is headed in the right direction. In other respects, it is making some of the problems worse. Pro-cyclicality, limits to financial inclusion, continued unlevel playing fields, and curbs on aggregate demand are all likely consequences of Basel as it now stands. These issues can be addressed—but doing so will take honesty and courage from all concerned.

This is bigger than Basel, and bigger than regulation. It's about the kind of financial system we want, the levels of economic growth we need, and the economic opportunity for all to which we aspire. These issues affect all of us. And we all need to make our voices heard.

Thank you.

I am happy to take your questions.