Fed Governor Blasts FinReg as Ineffectual Against Too Big to Fail

Friday, June 04, 2010 at 11:24 am

In a speech given at the SW Graduate School of Banking yesterday evening, Richard Fisher, the president of the Federal Reserve Bank of Dallas, blasted the financial regulatory reform effort currently in conference committee as ineffectual. In particular, Fisher said the bill would do nothing to end the issue of “too big to fail banks,” leaving the “debilitating disease” of systemic risk to “spread.”

The point is this: The arguments against shrinking the largest financial institutions are found wanting. And sufficient or not, ending the existence of TBTF institutions is certainly a necessary part of any regulatory reform effort that could succeed in creating a stable financial system. It is the most sound response of all. The dangers posed by institutions deemed TBTF far exceed any purported benefits. Their existence creates incentives that will eventually undermine financial stability. If we are to neutralize the problem, we must force these institutions to reduce their size.

I do not want to be naïve here. I am not suggesting that our banking system devolve into institutions like the Bailey Building and Loan Association in It’s a Wonderful Life. Large institutions have their virtues. They can offer an array of financial products and services that George Bailey could not. A globalized, interconnected marketplace needs large financial institutions. What it does not need, in my view, are a few gargantuan institutions capable of bringing down the very system they claim to serve.

Fisher described the bill’s reliance on regulators — foremost, the Federal Reserve, where he is a major figure — as dangerous. The House and Senate bills give regulators the power to shut down systemically important and overly risky firms. But Fisher doubts whether, in a climate of financial insecurity, regulators would really do so:

The sad truth is that when the chips are down, regulators become reluctant to put their money where their mouths are — or more precisely, they become too eager to put their money where they said they would not. Few, if any, policymakers have been willing to let large banking organizations fail, thereby missing an opportunity to impose significant losses on failed institutions’ creditors. We know from intuition and experience that any financial institution deemed TBTF will not be allowed to fail in the traditional sense. When such an institution becomes troubled, its creditors are protected in the name of market stability. The TBTF problem is exacerbated if the central bank and regulators view wiping out big bank shareholders as too disruptive, extending this measure of protection to ordinary equity holders.

The Treasury Department and figures on the Hill argue that the other prudential measures in the bill — capital and leverage requirements, and the Volcker Rule splitting commercial and investment banking functions, for instance — would prevent too-big-to-fail banks from becoming risky in the first place. But Fisher seems to support the Safe Banking Act, which would have put hard caps on the size of banks. The provision, by Sens. Sherrod Brown (D-Ohio) and Ted Kaufman (D-Del.), did not make it into the final Senate bill.

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