Tarullo Wants Banks to Pay for Being Too Big: Who Will Pay the Banks?

The Federal Reserve’s Daniel Tarullo, the Fed governor who oversees regulatory policies, testified before the Senate that the central bank is going to propose new capital requirements for large banks.

It appears these new requirements will be even more stringent than those called for under the latest round of international regulations.  According to Tarullo, the Fed expects the new rules will “improve the resiliency of these firms.”  Tarullo also thinks that these new measures could “create incentives for them [large banks] to reduce their systemic footprint and risk profile.”

That last part is Fed-speak for “these banks are too large.”  How large should the banks be?  Tarullo hasn’t told us.

And that’s probably because the Fed, like any other federal financial regulator, doesn’t want to pick a number.

Instead, the strategy appears to be to impose higher costs on the banks so they will shrink themselves, all in the name of reducing their systemic risk.  Exactly what causes this systemic risk seems to evolve continually, but right now the supposed culprit is short-term wholesale funding.

Traditionally, banks’ main source of funds was customer deposits.  However, banks have relied less and less on this source for decades.  Instead, they’ve drawn more heavily from the federal funds market, brokered deposits, and even foreign deposits.

Collectively, these sources are commonly referred to as the “wholesale funding” market.

In general, all this change means is that now banks rely more on borrowing funds to make loans rather than relying on depositors’ funds.  Because the borrowing is typically on a short-term basis, and because banks then use the funds to make longer-term loans, wholesale funding is viewed as a risky activity.

Tarullo argues that “the case for including short-term wholesale funding in the surcharge calculation is compelling given that reliance on this type of funding can leave firms vulnerable to runs that threaten the firm’s solvency.”

Tarullo would have us believe that the Fed is good at figuring out which activities are risky and which aren’t.  They’re not, and neither is any other federal agency.

These institutions are, however, experts at finding ways to socialize the costs of financial failure and shore up private profits for some groups.  Especially for creditors.

It’s not a problem per se that banks (and other financial firms) borrow short and lend long.  Incidentally, they don’t have to do this.

Many of them do so because it can be lucrative, but there are no illusions among financial executives and their investors regarding the risks involved.  The real problem is that when the government encourages these activities it creates systemic risk.

And that’s precisely what decades of federal policies have done via saving firms and their creditors from bankruptcy.  The solution is to stop encouraging these risky investments by protecting creditors, not to sanction activities for firms that hold a statutory minimum of some type of capital.

Allowing regulators to set rules for these activities effectively sanctions them and creates a false sense of security.  The recent crisis provides the perfect example.

Why did so many banks load up on mortgage-backed securities? Because their statutory capital requirements let them.

Why were the rules written this way? Because regulators – including the Fed – thought these securities were safe.

The Fed has been involved in bank regulation since it was created, but you would never know that listening to likes of former Rep. Barney Frank, co-author of the Dodd-Frank 2010 Wall Street Reform and Consumer Protection Act.  Supposedly, it was a lack of regulation that caused the crisis.

Dodd-Frank’s solution?  Increase the scope of the Fed’s regulatory power.  The truth, though, is that the Fed’s regulatory power – along with all federal financial regulators – has been steadily increasing for a century.  Yet critics insist that deregulation caused the crisis.

It’s true that there have been many regulatory changes through the years, but these changes modified the way financial firms were regulated.  They did not decrease firms’ regulations.

The 1999 Gramm–Leach–Bliley Act (GLBA), for example, is often cited as the bill that repealed Glass-Steagall and led to the blending of deposit and investment banking.  But all the GLBA did was amend the Bank Holding Company Act of 1956 so that bank holding companies could affiliate with subsidiaries in the (regulated) securities and insurance industries.

The GLBA left the Fed in place as bank holding companies’ primary regulator.  Serving in this capacity, the Fed approved holding company applications only after certifying that both the holding company and all of its subsidiary depository institutions were “well-managed and well-capitalized, and…in compliance with the Community Reinvestment Act, among other requirements.”

In fairness, the term “well capitalized” has evolved through the years, but the Fed has been instrumental in developing its meaning.

In the 1950s, the Fed developed bank capital requirements known as the “risk-bucket” approach, designed to better match capital with the riskiness of a bank’s various asset types.  The risk-bucket approach formed the basis for the Basel I capital accords, which the Fed and the FDIC imposed on commercial banks in 1988.

Since then, U.S. commercial banks were considered “well capitalized” if they maintained capital ratios above specified minimums.  Oddly enough, according to the FDIC, U.S. commercial banks (on average) exceeded these requirements by 2 to 3 percentage points for the six years leading up to the recent crisis.

So what did Dodd-Frank do to fix this situation?  It basically made new versions of risk-based capital requirements the centerpiece of its new “heightened regulations.”  Despite what Fed Governor Tarullo says, history provides excellent evidence that these regulations will not prevent future financial crises.

If we really want to reform our financial markets, we’ll start with completely eliminating the Fed’s emergency lending authority and closing its discount window.  Then, we’ll get rid of the Basel III capital standards and their subjective risk assessments.

Finally, we’ll deregulate firms and go back to a liability structure that increases the risk faced by firm managers, owners, and creditors.  Otherwise, we’ll simply stay the course we’ve been on for a century.  And we shouldn’t expect different results.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes