For the first time, the Federal Reserve Board is borrowing giant bins from Goodwill in which to receive industry comment letters on Monday. OK, it isn’t, but it probably will wish it had when the heft of all the letters on the Board’s systemic proposals weighs in. Some companies are readying the equivalent of the Encyclopedia Britannica on the systemic surcharges stipulated in Dodd-Frank to bring too big to fail to heel. At the least, these comments will slow down a final rule – even pretending to read them all will take the FRB through spring before it can contemplate crafting a final rule. But, will the FRB be fundamentally deterred from its sweeping standards? We think not.
The FRB is feeling ferocious for two reasons: it has come deeply to distrust big BHCs in the wake of the crisis and, even if it still liked them as much as before, its own neck is now on the line. The more the FRB is seen to coddle colossi, the louder the calls not only for express size standards that break up big BHCs by brute force, but also for getting the FRB out of big-bank supervision. This, the Fed fears, would do untold damage even if anyone really knew what the size or other criteria were upon which to base a big BHC’s break-up. Thus, the Board is trying to craft a middle course that may well make absolutely no one happy.
Chairman Bernanke made a case for the FRB’s standards most recently on Wednesday. Under questioning about why the Board doesn’t buy express TBTF bans, Mr. Bernanke argued that tough FRB rules will combine with Dodd-Frank’s orderly-liquidation authority to corral TBTF far more effectively than any simple systemic barriers. But, with this policy, Mr. Bernanke fails to satisfy many populist advocates calling for severing big firms. Some of these are within the Federal Reserve System, a particularly thorny problem for the Board and its chairman. As long as these critics doubt the stringency of the systemic standards and the resilience of OLA under stress, loud calls will continue for express BHC constraints. However, even as the FRB faces these populist critics, it can’t turn its back on the biggest BHCs. They too hate the systemic standards and not just because they could make lots more money without them. Some of the tomes on the Section 165/166 rules will marshal impressive data to show the proposal goes too far too fast in too many untested directions all at the same time. Any FRB give to big BHCs based on this research will quickly be seen as a sign of surviving systemic risk at remaining TBTF firms. Thus, even where the banks are right, the FRB will find it hard to give them comfort.
That’s too bad. In many areas, the proposal throws caution to the winds in favor of a slam-bam systemic structure that could well do irreversible damage before anyone truly figures out how all of it taken all together will work. It’s not that the big BHCs are right all the time or even that all of the research they will muster necessarily proves what the banks say it does. The point is, though, that no one – the FRB included – knows how well all of these structural changes to U.S. financial markets will work either in theory or practice. This might argue for a go-slow approach, but that would leave too many problems in place too long. It would also prolong the regulatory uncertainty continuing the financial-market freeze.
Thus, as before, I suggest that the FRB pick a few things it knows will work because the ideas are backed by sufficient research and reasonable theory. Ending TBTF through a resilient U.S. orderly-liquidation regime is the top priority because, once that is done, then many rules premised on taxpayer support will, rightly, be moot. Along the way, address shadow banking so that the full force of systemic regulation doesn’t rely solely on big BHCs and, thereby, create the next crisis. Do this, tackle a few other obvious reforms, and, then, move on to perfecting the systemic regulatory framework when more is known and markets are more stable.