One-size-fits-all bank regulation is really one-size-fits-none

One-size-fits-all bank regulation is really one-size-fits-none
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As The Hill has reported Wednesday, the Federal Reserve released a framework for matching the regulation of 29 large banking companies with their individual risk profiles.

The Fed will accept public comments on this complex, 124-page proposal until Jan. 22.


Perhaps given that the release occurred on Halloween, the Fed’s proposal generated frightening talk about the risks this regulatory initiative poses to the safety of large banks and the overall financial system, as well as the health of the entire economy.

Fed Governor Lael Brainard, an Obama appointee, voted against the proposal, arguing “it went beyond Congress’s intent and exposed the financial system to unnecessary risk.”

Dennis Kelleher, president of the pro-reform group Better Markets, asserted that “deregulating some of the largest banks in the country will make the financial system less safe, less stable and less protected from another crash.”

A more insightful comment, though, came from Greg Baer, head of the Bank Policy Institute, when he stated that the proposed regulatory framework “does not do enough to tailor regulations based on banks’ risk profiles.”  

Baer’s criticism reflects the fundamental challenge, and problem, of banking regulation: No matter how much Congress and the regulators attempt to refine banking regulation and tailor it to reflect the ever-changing risk profiles of individual banks, banking regulation still reflects the one-size-must-fit-all characteristic of all regulations.

Worse, complex financial regulations often have unintended consequences when individual regulations work at cross-purposes, while bank managements try to game the regulations to purse specific business strategies and profit objectives.

An appendix to the proposal graphically illustrates the challenge of regulating large, complex financial institutions. Each of the 29 companies pursues its own business strategy within a unique geographical footprint, but the banks are slotted into one of five regulatory buckets, based primarily on total assets. One company, Northern Trust, even gets its own bucket!

Anyone at all familiar with the eight largest companies classified as global systemically important bank holding companies (GSIBs) understands the extent to which they differ from each other in myriad ways.  Consequently, the regulatory mechanisms needed to keep each company operating in a safe manner must be tailored to that company. In other words, one size fits none well.

Though they are loath to admit this publicly, regulators have long been aware of the shortcomings of banking regulation and its one-size-must-fit-all rules. Therefore, they complement regulatory activity (bank examinations to ensure compliance with the rules) with banking supervision (enforcement actions and face-to-face confrontation with senior bank management and boards of directors when a bank appears to be going off the rails).

Unfortunately, bank supervision’s track record is spotty, at best. In their recent book about Citigroup’s travails, “Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi,” James Freeman and Vern McKinley observed:

“[P]reventing such moments from occurring was of course the job of the Federal Reserve and the Office of the Comptroller of the Currency … [B]ut on-site examinations and off-site surveillance by teams of regulators had not succeeded in averting disaster … [U]nfortunately, those seeking a safer regulatory system are regularly disappointed.”

Large, complex and highly integrated economies — like the U.S. — need large, complex banks to efficiently serve those economies. Attempts to squeeze risk out of those banks through complex regulation are similar to squeezing a balloon — the risk merely bulges elsewhere.

Worse, the current regime imposes regulatory costs on large banks that drive financing activity into the world of shadow banking, where financial crises often erupt.

For whatever comfort it may offer, the challenge of ensuring the safe, sound operation of large banks and other types of large financial institutions is not unique to the United States; it is a global challenge that no country has successfully met.

The market economies of the world, not just the United States, need to undertake a fundamental rethink of how to ensure the safe, ongoing functioning of financial institutions of all sizes without triggering periodic financial crises that lead to inevitable taxpayer bailouts. 

That need is one of the greatest challenges facing the still young 21st century.  The Fed’s just-released regulatory refinements fall far short in meeting that need.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, and the growing federalization of credit risk.  Prior articles by Ely on banking issues and cryptocurrencies can be found here.  Follow Bert on Twitter: @BertEly.