Financial Firms Do Not Need Consolidated Federal Supervision

COMMENTARY Markets and Finance

Financial Firms Do Not Need Consolidated Federal Supervision

Nov 12, 2020 6 min read
COMMENTARY BY

Former Director, Center for Data Analysis

Norbert Michel studied and wrote about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
The Federal Reserve building is pictured in Washington on Monday, Nov. 9, 2020. Caroline Brehman / Contributor / Getty Images

Key Takeaways

If federal officials truly want to benefit consumers, they should radically scale back the existing framework, not extend it.

It would be unjust to place all of the blame on the Fed, but the fact remains that the U.S. experienced major banking problems during the 1970s, 1980s, and 2008.

The nation’s largest banks—and many of the smaller ones—have decided it is in their best interest to maintain the current system.

An article released last week by the Bank Policy Institute (BPI) calls for non-bank financial firms, including “FinTech and Big Tech companies,” to face the same regulatory regime as large banks. Exempting these firms from bank-like consolidated federal supervision, it maintains, is dangerous to “consumers and financial stability.”

While many of its arguments might seem plausible, the article actually draws attention to how bad the U.S. financial regulatory framework really is. If federal officials truly want to benefit consumers, they should radically scale back the existing framework, not extend it.

The article takes issue with several types of financial charters that federal regulators have supported in the last few years. It claims that providing national charters to industrial loan companies (ILCs), payments companies, and special purpose depository institutions amounts to “regulatory arbitrage.” That is, giving national charters to these nonbank firms is unfair to banks because it allows the nonbank companies to avoid “federal consolidated supervision at the parent company level.

This really amounts to a complaint that the parent companies of nonbanks will not be regulated by the Federal Reserve, something that the parent companies of banks cannot avoid.

The article argues that “consolidated supervision of organizations engaged in the business of banking makes good sense, as bad things tend to happen without it.” However, it offers no real evidence to support this claim, and it ignores the many reasons to doubt the efficacy of consolidated supervision.

The current consolidated regime arose primarily due to the Bank Holding Company Act (BHCA) of 1956. The article notes this, but omits a few key details.

First, the BHCA was a legislative response to what had become an unworkable feature of the U.S. regulatory framework: a prohibition against branch banking. While banks generally could not open multiple branches, a separate holding company could own multiple banks. The BHCA codified this process.

Separately, while the Fed is in charge of regulating these parent companies, it is limited in what it can require of the parent companies in terms of saving the subsidiaries, and those actions are themselves part of a convoluted mess. (Dodd-Frank, arguably, makes this problem even worse. See Chapter 4.)

From an efficiency standpoint, the U.S. system makes little sense.

If the underlying subsidiaries really are dangerous, then regulations should address the problem in those companies. Instead, the U.S. has a system that, in addition to regulating those subsidiaries, includes a nebulous arrangement that effectively puts extra capital in a separate entity, where it might support a subsidiary in some way, in some circumstances.

Perhaps most importantly, the article merely assumes that a chief regulator can keep everyone safe. History shows this view to be wrong.

It would be unjust to place all of the blame on the Fed, but the fact remains that the U.S. experienced major banking problems during the 1970s and 1980s, and then again in 2008. All of these disruptions occurred on the Federal Reserve’s watch. In 2008, Fed Chairman Ben Bernanke testified before the Senate that “Among the largest banks, the capital ratios remain good, and I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.” 

That mistake was bigger than just being wrong about the banks’ problems. The Fed helped develop the capital requirements that (ultimately) became the Basel I requirements, the same criteria that Bernanke and his colleagues used to evaluate the banks, and the same rules that allowed banks to hold less capital for mortgage-backed securities than for mortgages.

Again, the point is not that the Fed uniquely screwed something up. Rather, it is that this sort of system provides a false sense of security. It asks regulators to judge future financial risks, a process that is inherently error prone. They are, in reality, tasked with the impossible.

The BPI article also misses the mark when it claims that “We need look no further than Europe earlier this year for an example” of why nonbanks should be subject to consolidated supervision.

The article refers to Wirecard AG, a European payments company similar in its operations to the U.S. firms PayPal and Square. According to the article:

…on June 18, it was revealed that nearly $2 billion that the company [Wirecard] claimed to be holding in a pair of banks in the Philippines was missing, or perhaps never existed in the first place. The missing funds would have accounted for the entire corporation’s profits over the last decade. Wirecard quickly crumbled. Its market cap, which was once nearly $30 billion, now hovers around $75 million.

It appears that all of this information is, in fact, exactly as has been reported by several news outlets. And, to be sure, Wirecard was not subject to the type of consolidated regulation that the Fed conducts of bank holding companies.

However, the Wirecard problem is the quintessential example of accounting fraud, and it happened under the watchful eye of a federal-level regulator. The article’s argument is the equivalent of claiming that Enron executives would not have committed fraud if only the Securities and Exchange Commission regulated the company.

It appears even worse. According to the Wall Street Journal, “More details have emerged in recent weeks showing that government agencies, led by securities regulator BaFin, had ignored red flags about Wirecard for years before the fintech company’s collapse in Europe’s largest accounting fraud in decades.”

What this example really demonstrates is that financial regulation should focus on harsher penalties and better deterrence for fraudulent behavior.

The BPI article is 100 percent correct that FinTech firms have many incentives to seek special charters that keep them out of the existing regulatory framework for banks. But that’s because the regulatory framework for banks is expensive, inadequate, and even harmful.

Somewhat unsurprisingly, the nation’s largest banks—and many of the smaller ones—have decided it is in their best interest to maintain the current system. Rather than fight for a more sensible regulatory approach, they have decided to make peace with the existing arrangement and use it to keep upstart competitors at bay.

As a result, consumers lose for the sake of maintaining the status quo.

This piece originally appeared in Forbes