Peering back into the bank abyss

Speaking in Philadelphia last week, Federal Reserve Governor Dan Tarullo made news by calling on Congress to set a hard cap on the maximum size of American financial firms. It may have sounded like tough regulatory talk. In reality, it was an admission of abject failure. Remember Dodd-Frank, the financial reform to end all financial reform? The legislation designed to deliver stability, solvency, and the end of “too big to fail”? Tarullo’s stance means that the 848 pages and 400 regulations of Dodd-Frank somehow didn’t get the job done.

Not only does Tarullo think we need a new law limiting bank size, but the big banks have been getting bigger despite — or perhaps because of — Dodd-Frank. In 2006, America’s five largest banks held assets equal to 43 percent of GDP. Five years later, that figure had expanded to 53 percent.


In fact, the biggest fallout from the new regulations — about a quarter of which have been implemented to date — is a disproportionate burden on smaller banks. Without the scale of the big five, compliance costs for community banks eat directly into their bottom line. As lower profits translate into slower growth, they fall ever further behind.

Tarullo’s preoccupation with size may also be missing the point. During the peak of the financial crisis, the firms that failed weren’t the large universal banks. Instead, they were specialty financial firms such as Countrywide, Lehman Brothers, and AIG. Hedge funds and proprietary trading desks, two particular targets of Dodd-Frank, had even less to do with the crisis.

The real culprits — too much leverage, not enough capital, and shaky mortgage standards — are easy enough to deal with. Regulators already had the power to demand more capital. As for underwriting risks, don’t hold your breath. Today, Federal Housing Administration loans require a minimum down payment of just 3.5 percent. Mortgage giants Fannie Mae and Freddie Mac have higher standards, but with the three entities guaranteeing 90 percent of the mortgages written today, taxpayer exposure is higher than ever. Maybe capping their growth — or protecting taxpayers from their bad bets — would be a better place for Tarullo to start.


Instead, extraordinary time and effort have been spent labeling and analyzing “systemically important financial institutions” that are deemed critical to the stability of our capital markets. Yet by defining such creatures, regulators may be bringing them to life. Looking back on the crisis, the problem wasn’t that one single firm took dozens of others down. The combination of high leverage, mispriced risk, and a tumbling housing market affected firms across the entire economic spectrum.

The most difficult moment of the 2008 financial meltdown, the failure of Lehman Brothers, caused a crisis of confidence precisely because everyone on Wall Street had assumed it would eventually be bailed out — just like Bear Stearns had been. Expectations matter. That’s not to say the failure of a bank as large as JPMorgan Chase wouldn’t be disruptive. But the “systemically important” label, which allows firms to benefit from the government’s “orderly liquidation authority,” makes investors more likely to expect a bailout, or some similar special treatment, in a crisis. Tarullo’s call for a cap implicitly acknowledges this: If the concepts of systemic importance and orderly liquidation were an effective regulatory framework, the size of a bank shouldn’t matter.


The United States hasn’t yet cornered the market on bad regulatory policy. Last week, 11 European countries agreed to impose a tax on all financial transactions. The plan has proved divisive: Britain has been adamant in its opposition, and the Swedish finance minister called the tax “a very dangerous thing.” Meanwhile, when the Austrian finance minister responds that the 50 billion euros to be collected could be used for a “joint European safety net,” it sounds like a precursor to bailing out banks in Greece, Spain, or France. Time will tell.

The bigger problem is that these proposals move the world toward more fragmented and complex regulation of financial services, and with complexity comes unintended consequences. Plus, governments are setting expectations, without saying so explicitly, that institutions will be rescued, supported, or coddled when things go wrong. That is precisely the type of moral hazard that led to disaster at Fannie and Freddie, by far the most expensive failures of the global financial crisis.

If Congress is waiting for Dan Tarullo to take a stand against this moral hazard, they’ll have a lot of time to kill. He has other things on his mind.

John E. Sununu, a former Republican senator from New Hampshire, writes regularly for the Globe. His father, former Governor John H. Sununu, is a frequent surrogate for the Mitt Romney campaign.