Size isn’t the be-all, end-all in banking regulation

The passage of S. 2155, the so-called Economic Growth, Regulatory Relief and Consumer Protection Act, in May was a watershed event because it was the first significant broad-ranging legislative change to the historic Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010.

Like the Dodd-Frank law itself, the latest changes have to be implemented by the financial regulators. Unsurprisingly, Wall Street executives, an army of financial lobbyists and lawyers, as well as elected officials have been clamoring to get these changes implemented quickly.

{mosads}However, they are too often presenting the law in an all-or-nothing framework, which is misleading. While S. 2155 requires regulators to undertake certain actions, it also provides them with ample discretion to use their best judgment to ensure the safety, soundness and stability of the financial system.

Put differently, the law does not mandate unwise deregulation that would undermine financial stability, increase the likelihood of future bailouts and once again harm hard-working Americans who are still paying the bill for the last crash that they did not cause.

For example, some have argued that the new $250 billion threshold for enhanced supervision is “arbitrary,” but that claim fails to recognize that it is merely a trigger for consideration of enhanced regulation based on an individualized, multifactor risk analysis that includes size, activities, complexity, interconnectedness, leverage and other risk factors.

Some have also urged the Fed to discontinue the use of Comprehensive Capital Analysis and Review (CCAR) stress tests “and other enhanced supervision regulation designed for systemically important financial institutions on non-systemic financial companies,” by which they mean every bank with less than $250 billion in assets and even some with more.

That is a very dangerous argument because its substitutes mere size for actual risk, which requires a multifactor analysis. It’s obvious why such assertions are unsupported by data or analysis and why they should be given no weight by financial regulators.

After years of falsely claiming that Dodd-Frank Act and the Fed improperly regulate by size alone, it is ironic that so many of the industry’s allies turn right around and use size as the basis to determine what does and does not make a financial company systemically risky.

It is simply not the case that systemic risk lies only with a handful of the very largest firms. The claim that financial institutions with between $100 billion and $250 billion in assets are by definition incapable of posing a risk to the financial system is unsupported by history and evidence.

Moreover, big banks in the $100 billion to $250 billion asset range provide critical credit to large parts of the economy and the failure of one or more of them would have devastating effects on their borrowers, which could well spill over into a larger crisis.

Regulators have to be careful not only regarding which banks they apply stress tests to, but also how they apply them. The results and value of stress tests are only as valid as the assumptions upon which they were based and the rigor with which they are conducted.

Financial institutions, including those with hundreds of billions of dollars in assets and were the focus of the law, face risks that are interlinked and complex. By their very nature, these risks are difficult to predict.

For that reason, reliance solely on stress tests can provide regulators with false assurances about the stability of the financial system as a whole, as well as the individual firms operating within it. 

A particularly dangerous suggestion is that implementing S. 2155 should automatically include a number of foreign banks operating in the U.S., many of which received very significant bailouts during the financial crisis.

In fact, nine of the top 20 largest users of the Fed’s emergency lending facilities during the crisis were foreign banks. However, foreign banks engage in unique and often high-risk financial activities unlike similarly sized U.S. banks.

Treating them the same solely due to size, rather than individual risk profile, would make the U.S. financial system less resilient and more susceptible to the importation of risk from foreign banks.

Foreign banks in the U.S. need to be regulated based on the systemic risk they, their activities and their affiliates pose to the U.S. financial system and U.S. taxpayers who already bailed them out just 10 years ago.

As the Fed implements the provisions of S. 2155, it must continue to apply sensible and prudent financial protection measures to banks based on their individual risk profiles and to reject efforts to blindly and mechanically eliminate those measures based solely on size or unsupported assertions. The American people, who have suffered and continue to suffer, deserve no less.

Dennis M. Kelleher is president and CEO of Better Markets, a Washington-based independent organization that promotes the public interest in financial reform, financial markets and the economy.