MHI Brookings Brief

Add caption I was special envoy to fight the Islamic State. Our gains are now at risk. As the Trump administration seeks to withdraw U.S. troops from Syria, Brookings President John R. Allen examines the current condition of the Islamic State and warns that the group remains a threat both in the Middle East and in regions around the world. In the absence of U.S. global leadership and, where necessary, its forces, along with a real, long-term alternative to the terrorists’ allure as a regional and global actor, the gains made these past three years against ISIS remain fragile and incomplete, and could easily unravel, writes John R. Allen. I recommended that this coalition, once formed, be tasked with halting the group’s forward momentum, empowering indigenous forces to be the final and lasting agents of the Islamic State’s defeat, and coordinating much-needed stabilization efforts once the fighting had subsided. I believed then, and remained convinced after taking on the role of special envoy, that only through a comprehensive and multilateral approach could the Islamic State be truly eliminated from the world stage. Ultimately, the broad strategy executed by the Obama administration and largely continued by the Trump administration was a success—the Islamic State was halted in its tracks and was slowly but surely rolled back in Iraq and Syria. Yet, President Trump’s recent decision to announce the defeat of the Islamic State and pull U.S. forces from the region demands that we confront the question: After more than three years of the coalition campaign against the group, what is the condition of the Islamic State today? The answer requires a bit of context. After splitting with the al-Nusra Front in the chaotic Syrian battlespace of 2014 and styling itself as a caliphate, the Islamic State quickly grew into a well-coordinated, internationally focused group. Fueled in part by a striking adeptness at digital propaganda that attracted thousands of foreign fighters to its ranks, the group evolved into a three-headed monster—with a core territory spanning Iraq and Syria; with control of discrete external territories in Asia and Africa; and with a permanent and highly sophisticated presence online. Islamic State Income 2014-2016 2014 2015 2016 Taxes and Fees $300-400 million $400-800 million $200-400 million Oil $150-450 million $435-550 million $200-250 million Kidnapping $20-40 million Unknown $10-30 million Antiquities Unknown Unknown Unknown Foreign Donations Insignificant Insignificant Insignificant Looting, Confiscations, Fines 500 million – 1 billion $200-350 million $110-190 million Total $970 million – 1.89 billion 1.035 – 1.7 billion $520-870 million Source: “Caliphate in Decline: An Estimate of Islamic State’s Financial Fortunes”by theInternational Centre for Study of Radicalisation and Political Violence Today, the core Islamic State has lost most of its contiguous territory and nearly all of its subjugated population in Syria and Iraq. Islamic State fighters in Syria still number in the thousands, though their unit integrity has been vastly diminished by coalition firepowerand by the Syrian Democratic Forces on the ground. In fact, were it not for the 60,000 coalition-trained indigenous forces operating in northeast Syria, roughly one-third of that country would still be under the caliphate’s control. In Iraq, the Islamic State is essentially defeated, but, as in Syria, hundreds of its fighters have melted into a Sunni landscape still wracked with political chaos. In outposts in Africa, Central Asia and Southeast Asia, however, the caliphate is anything but defeated, and is, in fact, barely degraded. U.S. and coalition special operators and intelligence assets are helping to battle these groups, but this is a long-term fight relying largely on local actors. Each of the Islamic State’s more than three dozen outposts has the capacity for local violence and could evolve into platforms for larger attacks at any time. The Christmas Eve blast in Kabul, which killed 43 people, was the work of Islamic State forces entrenched in Afghanistan and Pakistan, and is a telling example of their capabilities. Finally, the caliphate is alive and well across the Internet, spewing its toxic message and recruiting youth globally. Its cyberdomain affords the Islamic State a truly frightening and enduring presence beyond the reach of traditional forces, giving it the capacity to inflict mayhem long after it has been neutralized on the ground. International efforts to mitigate the Islamic State’s online influence have been a major and ongoing challenge, with encrypted messaging apps making traditional analysis, counterintelligence and countermessaging efforts exceptionally difficult. The Islamic State’s cyberpresence remains a potent tool for generating support nearly anywhere in the world and seemingly at random. Indeed, the ongoing threat of directed or inspired “lone wolf” attacks is directly linked to the group’s online campaign. To be clear: The Islamic State is not defeated. It remains a local, regional and global threat, and notions to the contrary are misinformed. Though coalition efforts have successfully degraded the Islamic State’s core territories, the departure of U.S. forces leaves the door wide open for the group’s resurgence. Even if, as some reports indicate, this departure may be more drawn out than initially expected, the damage done by the broader message—the abandonment of our local partners and others in the coalition—remains unchanged. The Islamic State is not defeated until the idea of the caliphate has been defeated. In the absence of U.S. global leadership and, where necessary, its forces, along with a real, long-term alternative to the terrorists’ allure as a regional and global actor, the gains made these past three years remain fragile and incomplete, and could easily unravel—and indeed, under this administration, I fear they will. 7 questions for Janet Yellen on financial stability From financial system reforms to corporate lending practices, former Federal Reserve Chair and Distinguished Brookings Fellow Janet Yellen discusses her concerns with developments in U.S. financial regulation in the years since the Great Recession. Ten years after the worst of the financial crisis, are we safer? Yellen: The reforms put in place significantly boosted the resilience of the U.S. financial system. Banks are better capitalized and have more liquidity.  The risk of runs owing to maturity transformation has declined. New mechanisms to make it easier for the government to resolve systemically important firms have promoted market discipline and reduced the problem of too big to fail. And a system was devised to more effectively monitor risks that arise outside the regulatory perimeter. But the structure created by Dodd-Frank has shortcomings that create ongoing vulnerabilities, such as a limited toolkit to address emerging risks and insufficient regulatory authority for the Financial Stability Oversight Council (FSOC) and its member agencies to address systemic threats. In addition, although Congress in Dodd-Frank created valuable new powers to resolve a failing nonbank financial firm, it simultaneously scaled back the Fed’s emergency liquidity powers, leaving it with a toolkit that could prove inadequate to cope with a situation like the Crash of ‘08. When the Obama administration ended, regulatory reform was a work in progress with significant ongoing efforts. In contrast, the Trump Administration has focused on reducing regulatory burden rather than completing unfinished financial stability-related work. After eight years and thousands of pages of rule writing by multiple financial regulatory agencies, it is certainly appropriate to simplify regulations that impose unnecessary burdens, particularly on small community banks. We should also revisit regulations that are overly complex or have unintended consequences. But I’m greatly concerned that the regulatory work needed to address financial stability risk has stalled. There have been some worrisome reversals. The financial crisis revealed that banks’ capital cushions weren’t nearly large enough to absorb the losses they suffered. As a result, the banks have been required to hold substantially more capital. Do they have enough? Yellen: The banking system is better capitalized. The quantity and quality of capital required relative to risk-weighted assets have been increased substantially and capital requirements are higher for the largest, most systemic firms. This lowers the risk of distress at such firms and encourages them to limit activities that could threaten financial stability. Among the largest banks, Tier 1 common equity capital has more than doubled since 2009. Importantly, the largest U.S. banks participate in annual stress tests, which are the most important supervisory innovation since the financial crisis. These tests contribute to greater loss-absorbing capacity. The Comprehensive Capital Analysis and Review (CCAR) also improves public understanding of risks at large banking firms, providing a forward-looking examination of firms’ potential losses during severely adverse economic conditions. The stress tests have contributed to significant improvements in risk management at the largest firms. That said, there remains an argument—most passionately articulated by Anat Admati at Stanford—that capital requirements should be higher. The imposition of these requirements should reflect a cost-benefit judgment. Higher levels of bank capital mitigate the risk and adverse effects of a financial crisis but raise the cost of intermediation in normal times. Even now, U.S. capital requirements are closer to the lower, not the higher, end of those that could be justified by cost-benefit analysis. In addition, the stress tests do not yet capture important avenues for the propagation of systemic risk. For example, they generally do not directly take account of second-round effects of stress on the financial system, such as the possible fire sale of assets by financial firms in need of capital or funding. Such sales can further depress asset values of other firms below levels resulting from an initial economic or financial shock. The Fed has the authority to require banks to add to their capital temporarily if it sees a risk that excess credit growth threatens financial stability. This Countercyclical Capital Buffer (CCyB) is now zero. Do you think it should be raised? Yellen: I would urge the Federal Reserve Board to carefully consider raising the CCyB at this time.  Some key financial indicators, such as the ratio of credit to GDP, do not currently signal growing financial stability risk; and the Board’s recent Financial Stability Report assessed vulnerabilities overall as moderate.  But I am concerned that asset valuations, including in sectors such as commercial real estate, are elevated and I see dangers relating to the large volume leveraged lending where there’s been a significant weakening of underwriting standards.  The high debt burdens of riskier nonfinancial corporations could deepen the next downturn and impose losses on the banking system that would intensify a downturn by restricting the supply of credit.   Raising the countercyclical capital buffer now would improve the resilience of the banking system, enabling it to better weather a future downturn.  Extra capital can be released when stresses in the economy and the banking system emerge. Have we licked “too big to fail”? While the new Orderly Liquidation Authority process provides a valuable resolution method, it will be extremely challenging to carry out in “real time.”A firm’s reorganization would typically need to be completed over a “crisis” weekend. Success requires a very high degree of international coordination with a great deal of advance planning among financial authorities here and abroad. Work of this sort received high priority at the Fed and at the Bank of England during the Obama years, but it remains very much a work in progress. Moreover, while it would be challenging, but conceivable, to resolve a single systemic firm hit by an idiosyncratic shock with the new tools that are available, I view the prospects for resolving multiple firms, in a situation characterized by general financial panic—the situation that prevailed in September 2008—as dim. For this reason, I am very concerned that Dodd Frank eliminates the Fed’s legal authority under its 13(3) emergency lending powers to make loans to support an individual systemic institution that would otherwise fail. The law permits the Federal Reserve to implement “broad-based lending programs” to support liquidity in markets—programs like the commercial paper lending facility and the Term Asset-Backed Securities Loan Facility (TALF), that the Fed used successfully in 2009 and 2010 to help the markets meet credit needs of households and small businesses. But loans like those made to support AIG and JP Morgan Chase’s acquisition of Bear Stearns, are now forbidden. Going further, I believe that a strong case can be made for allowing the Fed, on an ongoing basis and not just in a financial crisis, to make its discount window available to broker-dealer subsidiaries of bank holding companies. These entities are now supervised by the Fed and I believe that normal discount window access would diminish the odds of destabilizing runs. Because so much of the trouble in 2007-09 came from outside the more heavily regulated banks and instead from financial institutions like Bear Stearns, Lehman and AIG, Congress created the Financial Stability Oversight Council (FSOC) and gave it the power to designate institutions that pose a risk to financial stability. How’s that going? Yellen: In the aftermath of the financial crisis many countries established financial stability committees charged with monitoring and addressing financial stability risk. The U.S. counterpart, the Financial Stability Oversight Council has a similar charge. The most important tool granted by Congress to the Council is the ability to designate nonbank financial institutions that are systemically important for prudential regulation by the Federal Reserve. The purpose of designation is to help guard against the risk that vulnerabilities in firms like AIG that are outside the existing regulatory perimeter grow to levels that jeopardize financial stability. Between 2013 and 2015, the FSOC designated four firms for such supervision: AIG, GE Capital, Prudential Insurance and MetLife. Two of these firms—GE Capital and AIG—chose to radically alter their business models. Those decisions led to substantial reductions in the potential financial system repercussions of their material distress. In recognition of these changes, both firms were subsequently “de-designated” by the FSOC—decisions I supported. The FSOC also recently decided to de-designate Prudential. In contrast, MetLife sued to repeal its designation. In 2016, a district court ruled in its favor, overturning the FSOC’s designation. The Obama Justice Department appealed with the support of the FSOC. The court’s interpretation of Dodd Frank, if accepted, set standards that would make future designations all but impossible. It required that a full-blown cost-benefit analysis and an assessment of the likelihood of the firm’s material financial distress become part of the designation process. Regrettably, the Trump Administration chose to drop the appeal—a decision I strongly opposed – and expressed support for the requirements that, in effect, were imposed by the lower court. That all but eliminates the chances of future designations. A Trump Administration Treasury report on designation argues FSOC should regulate activities, rather than firms that pose systemic risk. I agree that it’s important to regulate activities that heighten systemic risk and, in many cases, this approach makes more sense than regulating firms. But individual firms, such as the pre-crisis AIG, also pose systemic risks. When that’s the case, it is important to supervise and regulate them. Is impeachment a top priority for voters? A recent survey of American voters found that impeaching President Trump ranks rather low on a list of 21 possible priorities for the new Congress, beneath hate crimes, the opioid epidemic, and federal education spending. Of 21 possible priorities for the new Congress, impeaching the president was tied for last, with only 38 percent of Americans deeming it “extremely important.” Republicans are united against it; no surprise there. But tellingly, it receives less support among Independents than does any other option, and Democrats rank it only 14th on their priority list. This poll is anything but an outlier. Exit polls from the midterm elections found 41 percent of voters in favor of impeachment, with 57 percent opposed. Support among Independent voters stood at 34 percent. A Monmouth survey released on November 14 showed 36 percent in favor, 59 percent opposed, with Independents splitting 26-67 and moderates 42-52. A month later, CNN found 42 percent of registered voters in favor of impeachment, 51 percent opposed. Only 36 percent of Independents and 44 percent of moderates supported this move. Political history also counsels caution. If you strike at the king, you must slay him, runs an ancient aphorism. Republicans found this out the hard way in the 1998 midterm election, when their focus on Bill Clinton’s misdeeds yielded such disappointing results that House Speaker Newt Gingrich felt compelled to resign. In the ensuing impeachment struggle, a narrow, partisan Republican majority in the House ran into a stone wall in the Senate, where numerous members of their own party voted to acquit the president. In 1974, by contrast, Democrats held their fire—and Republicans continued to support Richard Nixon– until the release of the Oval Office tapes revealed the smoking gun. Within days, Republican support for President Nixon withered. Faced with certain conviction in the Senate, the president chose to resign, to the relief of a large majority of the people. There is, finally, an argument based on the long-term public interest. In the absence of far more public consensus than now exists, removing Mr. Trump from the presidency through impeachment would enrage and embitter his hard-core supporters—about one-third of the country. A deep state, state-in-the-back conspiracy theory would take root, and his successor would endure the taint of illegitimacy. Only a clear and present threat to our basic institutions could justify such a risky step. Relying on the normal electoral process would be a safer course—unless those who want to force Mr. Trump from office before January of 2021 have lost faith in the common sense of the American people.

MHI Brookings