January 29, 2014

The Federal Reserve's 'Too-Big-To-Fail' Paternalism

Hester Peirce

Former Senior Research Fellow
Summary

The Federal Reserve on January 24 issued guidance for "eight domestic bank holding companies that may pose elevated risk to U.S. financial stability." The guidance, which is part of Dodd-Frank resolution planning, is intended to "clarify" expectations for these companies and guide the Federal Reserve staff charged with supervising them. But the fact that such guidance is necessary illustrates what is wrong with our financial system and its regulatory framework.

The Federal Reserve on January 24 issued guidance for "eight domestic bank holding companies that may pose elevated risk to U.S. financial stability." The guidance, which is part of Dodd-Frank resolution planning, is intended to "clarify" expectations for these companies and guide the Federal Reserve staff charged with supervising them. But the fact that such guidance is necessary illustrates what is wrong with our financial system and its regulatory framework.

The guidance identifies areas in which, absent proper precautions, the covered banks-Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo-might run into trouble. The Fed's list focuses on getting firms to think about things such as collateral management, the fickleness of funding sources and service providers, the ability of their computer systems to produce reliable data, and contingency plans for unexpected disruptions. The Fed also wants these banks to know what each major business unit does, who its key employees are, who regulates it, and where it operates.

Although billed as part of "recovery and resolution preparedness," the Fed's itemized list is made up of things that the targeted banks should be doing of their own volition in order to stay in business. Most private companies do not need the government to tell them to keep tabs on their exposures to other firms, plan for potential disruptions to important funding sources or service providers, or know who key employees are. In a normally functioning market, these large financial institutions and their smaller competitors all would constantly be thinking about and testing their risks, vulnerabilities, potential exposures, and contingency plans. If they didn't, a more alert rival would eat their lunch.

But banking, as the contemporary American regulatory system has shaped it, is not a normally functioning, competitive market. Bank regulators see it as their mission to perpetuate a handful of big banks. Dodd-Frank cast its support behind that mission by drawing lines between systemically important and other financial institutions. Banks that aren't deemed systemically important are permitted to fail - as they should be - when they make poor decisions. Their failure is made more likely, however, by the fact that they are forced to compete for capital, customers and creditors with the large banks that the regulatory apparatus has deemed too big to fail. By singling out these eight behemoths for special regulatory spoon feeding, as the Fed did in this latest guidance, the Fed is reinforcing the too big to fail message. It is saying that these banks are so important that the Fed needs to tell them to do things they would be doing on their own if the government were not standing ready to clean up their messes.

Of course, the Fed and other bank regulators should be checking to see whether all of the entities they regulate are striving to understand themselves, their counterparties, their customers, their risks, and the changing landscapes in which they operate. But fundamentally, the task of running a bank of any size belongs with the bank's directors and the managers they hire to make day-to-day operational decisions. If these private decision-makers are doing a lousy job, the market will effectively convey that message to them, unless the government intervenes to dampen that message.

This latest Fed guidance is not in itself particularly remarkable as it is one of a series of such directives. But it underscores the degree to which the government views large financial institutions as incapable of running themselves. One important source of that incapacity is the regulatory structure that fosters private market reliance on government decision-making, risk spotting, monitoring, and rescuing.