Richard Fisher, president of the Dallas Fed, has long been a proponent of serious financial sector reform. As a former commercial banker, he sees quite clearly that the legislation now headed into "reconciliation" between House and Senate versions amounts to very little. He also knows that pounding away repeatedly on this theme is the best way to influence his colleagues within the Fed and across the policy community more broadly.
He is now taking his game to a new, higher level. Couched in the diplomatic language of senior officials, his speech on June 3 to the SW Graduate School of Banking was both a carefully calibrated assault on the administration's general "softly, softly" approach to the big banks and a direct refutation of arguments put forward by Larry Summers in particular.
As the title of Mr. Fisher's speech implies, if the legislation is not real financial reform (and it is not, according to him), then our current policy trajectory amounts to facilitating further rounds of financial dementia.
As a statement of our true problems -- dismissing the red herrings and focusing on the core issues -- Mr. Fisher's speech is a succinct classic. Cutting to the chase:
"Regulators have, for the most part, tiptoed around these larger institutions [big banks]. Despite the damage they did, failing big banks were allowed to lumber on, with government support. It should come as no surprise that the industry is unfortunately evolving toward larger and larger bank size with financial resources concentrated in fewer and fewer hands."
This is most definitely not a market outcome.
"Based on these considerations, coupled with studies suggesting severe limits to economies of scale in banking, it seems that mostly as a result of public policy -- and not the competitive marketplace -- ever larger banks have come to dominate the financial landscape. And, absent fundamental reform, they will continue to do so. As a result of public policy, big banks have become indestructible. And as a result of public policy, the industrial organization of banking is slanted toward bigness."
This is an unfair, nontransparent, and dangerous taxpayer subsidy at work.
"Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF ["too big to fail"] support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition."
Mr. Fisher is agreeing with arguments sometimes heard from the left of the political spectrum, but he is most definitely coming at this more from what is traditionally -- and accurately -- regarded as the right (like Gene Fama of Chicago or Tom Hoenig of the Kansas City Fed).
"It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system."
In this context, attempts to regulate big banks more effectively will fail because the underlying political economy dynamic (i.e., how the creditors understand government policy towards big banks) encourages excessive risk-taking and greater leverage one way or another.
"The system has become slanted not only toward bigness but also high risk. Consider regulators' efforts to impose capital requirements on big banks. Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized. Indeed, large banks have been so bold as to claim that the complex constructs used to avoid capital requirements are just an example of the free market's invisible hand at work. Left unmentioned is the fact that the banking market is not at all free when big banks are not free to fail."
Add to this the deference of the US Treasury to the international negotiations on capital requirements, and the manifest problems of the G20 in this regard -- held to the lowest common denominator again over the weekend (i.e., no mention of capital requirements or other substantive re-regulation in the communiqué). Fisher's assessment is right on target: relying on regulation alone is unwise and most definitely the triumph of hope over experience.
"Regulatory reform discussions portray the need to control systemic risk as a new game in town -- as if it were a new responsibility that need only be assigned. This is not the case: Bank regulators have long viewed the containment of systemic risk as a primary rationale for capital requirements. The problem is that capital regulation has rarely been truly successful."
"'... While we do not have many examples of effective regulation of large, complex banks operating in competitive markets, we have numerous examples of regulatory failure with large, complex banks. "
And just saying, "let 'em fail", is also quite unrealistic as policy for megabanks -- because this has been proven, time and again, not to be "time consistent", i.e., you can promise to do this all you want, but:
"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."
"... Even a combination of enhanced regulation and resolution would likely be inadequate. The temptation to use regulatory discretion to avoid disruptions is just too great."
But Mr. Fisher is most devastating when it takes on the arguments developed by Larry Summers (and used by many Senators) against imposing binding size caps on the largest banks.
Larry Summers, you may recall, argued that "most observers" agree that breaking up big banks would actually make the financial system more risky. It turns out that "most observers" are actually just a few commentators -- with what Fisher assesses as "hollow" arguments. For example, on the idea that smaller banks would all copy each other and follow identical high-risk strategies,
"... going by what we see today, there is considerable diversity in strategy and performance among banks that are not TBTF. Looking at commercial banks with assets under $10 billion, over 200 failed in the past few years, and as we have seen, failures in the hundreds make the news. Less appreciated, though, is the fact that while 200 banks failed, some 7,000 community banks did not. Banks that are not TBTF appear to have succumbed less to the herd-like mentality that brought their larger peers to their knees."
And reference to the banking problems of the 1930s is simply not relevant.
"Such a liquidity crisis among small banks would be unlikely today, as we now have federal deposit insurance, which protects deposits for funding. And, I might add, the Federal Reserve has demonstrated quite effectively over the past two years that we not only have the capacity to deal with liquidity disruptions but also the ability to unwind emergency liquidity facilities when they are no longer needed."
Overall, Fisher is blunt.
"...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."
This is most definitely not a retreat to some financial stone age.
"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."
And, he points out, if his fellow regulators could only think clearly about this issue, there is hope.
"...the financial regulatory reform bill has left regulators (specifically, the Board of Governors and the Federal Deposit Insurance Corp.) with the authority to impose greater restrictions on firms whose living wills are not credible. That authority, as I mentioned previously, could include "[divesting] certain assets or operations ... to facilitate an orderly resolution." I would argue that regulators should freely use this broad authority to commit credibly to resolution with creditor losses by reducing big banks' size and interconnectedness."
Sadly, the indications are that too few officials are likely to agree with Mr. Fisher any time soon.
A version of this piece appears on The Baseline Scenario.