Small but critical fix needed for Senate banking bill

Small but critical fix needed for Senate banking bill
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The United States is fortunate to have one of the most diverse banking sectors of any industrialized country.  There are large, multinational banking organizations that provide an almost endless array of financial services, small community banks that focus on deposit-taking and lending, and just about everything in between.  

This gift of diversity brings with it a challenge: How best to regulate banks when one size does not fit all. This is among the key issues in the bipartisan Economic Growth, Regulatory Relief, and Consumer Protection Act, which the Senate will likely consider next week.  

The good news is that there is remarkable agreement, at least in the abstract, about the appropriate way to regulate the great majority of banks. Ninety-nine percent of banks in the United States are community banks with less than $10 billion in assets. The law already imposes less stringent regulatory and supervisory demands on these banks, reflecting the fact they pose little risk to systemic stability. The Senate bill would provide additional relief, making it even easier for these banks to serve their communities.

There is also broad consensus about how to regulate banks at the other end of the spectrum.  The largest banking organizations are also the most complex, interconnected, and internationally active. These banks pose a distinct threat to financial stability.  This matters for two reasons.  

First, the failure of such a bank can threaten the health of the overall financial system, causing credit to contract and forcing the real economy into recession.  Second, governments have often bailed out systemically significant banks to avoid these spillover effects.  This weakens the market discipline and can lead to excess risk-taking.  To address these dynamics, the law subjects the largest banking organizations to an array of demanding regulatory and supervisory requirements.  For the most part, the Senate bill protects this regime.

The difficult question is how to regulate banks that lie between these two extremes.  Under the Dodd-Frank Act, all banks with more than $50 billion in assets face a subset of the enhanced prudential standards imposed on the megabanks.  There is a growing consensus that this may be too conservative approach, but far less agreement on how best to proceed.

The challenge is that for banks in this middle space, size is not a very good proxy for systemic significance.  This is vividly illustrated in a recent paper from the Office of Financial Research on how large banks measure up against a range of metrics correlated with systemic significance.  The OFR paper reveals that there is ongoing disagreement about how best to assess a bank’s systemic significance and, apart from the biggest banks, it can be hard to determine which banks pose the greatest systemic threat.

One way to address this diversity would be to eschew the use of size in lieu of a multi-factor test. Congress is right to avoid this approach.  Banks and bank regulation are already laden with excess complexity.  Particularly considering the lack of agreement regarding the best metric and the gamesmanship such an approach could invite, size remains a useful first-cut.

A second approach, and that embodied in the current bill, is a default rule that excludes all but the largest banks from enhanced prudential regulation.  The bill gives the Federal Reserve limited authority to require banks with more than $100 billion comply with specific enhanced prudential requirements, but it requires the Fed to initiate and justify each such deviation.  

A third and better approach would use this framework but flip the default. Under this approach, banks with more than $100 billion in assets would have to demonstrate that they should be exempt from heightened regulatory requirements.  Banks could also be required to provide periodic statements attesting to the continued appropriateness of the exemption.   

Basic design principles emphasize the importance of information and incentives.  A bank understands its business model, compliance costs, and risk exposures better than any regulator.  Forcing banks to opt out and justify their exemption puts the informational burden where it belongs. The periodic attestations would help counter status quo bias and could deter banks below the $250 billion threshold from taking on new risks that might threaten systemic stability.

The banks at issue are not small, community banks. These are large, sophisticated banking organizations. With just a small tweak, the Senate bill could effectively the address the diverse and evolving regulatory challenge that these banks pose.  

Kathryn Judge is a professor of Law at Columbia Law School. She serves on the Financial Research Advisory Council of the Office of Financial Research and as an editor of the Journal of Financial Regulation.