Sunday, April 18, 2010

Small Banks and the Fed

Thomas Hoenig (President, Kansas City Fed) has an op-ed in the New York Times this morning, which is quite interesting, on a number of dimensions. It's important that we understand our FOMC members better (though this one is retiring soon), and he raises some key issues concerning the financial regulation legislation that is starting to wend its way through Congress.

Hoenig clearly has adopted the pervasive view, that I discussed before in Big Banks, that too-big-to-fail is primarily responsible for the increase in concentration in US banking. He writes:
This explains why it undermines the very foundation of our economic system when the government decides that a financial institution is too big or too powerful to fail. The big banks and investment companies hold a significant advantage in the competition for funds (for example, from depositors and bond holders), because creditors know that they will be bailed out when a crisis occurs. This advantage has systematically undermined the competitive position of every smaller bank, and has enabled the largest banking organizations to more than double their share of industry assets since the 1990s.
Though too-big-to-fail is a problem that needs to be solved, there is a strong case that the increase in concentration in US banking occurred mainly due to inherent economies of scale in banking coupled with the elimination of regulatory restrictions that kept banks small.

Hoenig then goes on to discuss two aspects of the Senate regulatory reform bill. The first has to do with the systemic-risk-regulation component of the the legislation. The proposed legislation includes a means for quickly resolving a failed financial institution, akin to the resolution authority currently given to the FDIC over banks. What is important here is that this authority will apply to large (i.e. "systemically important") non-bank financial institutions - i.e. Goldman Sachs, AIG, etc. Hoenig complains that the proposed resolution authority will not work quickly enough, and proposes this instead:
Instead, the new law should require that any institution deemed insolvent, based on an established, objective set of criteria, be placed into receivership and resolved in an orderly fashion — just as banks on Main Street are.
I think Hoenig is missing the point.

We need a comprehensive approach to regulating large financial institutions - large banks and large non-banks. I am willing to be convinced that systemic risk is a problem, but I have never seen convincing evidence that we cannot deal in a sensible way with the failure of a large financial institution - Citigroup for example. Indeed, one could make a case that people screaming "systemic risk" is just a feature of too-big-to-fail. If you want your bailout, you have to make a big noise about how systemically important you are. The problem is not systemic risk, it's moral hazard and the need to regulate risk-taking. Of course if I believe in systemic risk, then solving the moral hazard problem solves the systemic risk problem too.

Hoenig seems naive in arguing that we can somehow treat large financial institutions in the same way we treat small banks. For example, under current arrangements all of the large US banks are owned by bank holding companies, which makes resolution particularly difficult. The regulation of banks under bank holding companies may involve multiple regulators, including the FDIC, the Comptroller, the Fed, and the SEC. What a mess! For large non-bank financial institutions, it seems ludicrous to argue that I can handle AIG in the same way I handle Mom and Pop Bank of Peoria.

On this issue, it is useful to look at Canada, which I've been using as a nice reference point. Canada has one key financial regulator, the Office of the Superintendent of Financial Institutions. This is the regulatory authority for banks, insurance companies, and pension funds. Further, in Canada, the big 5 chartered banks appear to essentially be much like Bank of America, AIG, and Goldman Sachs rolled into one. This is the direction the US is headed in. Banks will become increasingly indistinguishable from other financial intermediaries, and the too-big-to-fail problem has to be solved in the same way for all these institutions. Multiple and competing regulatory authorities are not going to solve the problem - they are the problem.

The second feature of the proposed financial regulatory legislation Hoenig focuses on is a proposal to narrow the Fed's supervisory role to large banks and eliminate supervision by the regional Feds of small banks in their district. Head offices of most bank holding companies reside in New York, so all regulatory authority would go to the New York Fed.

One can easily see why the regional Feds would be bothered by this. Employment at the regional Feds has already dropped because of the vanishing demand for check-clearing services. If it loses authority over bank regulation, the activities of a regional Fed will mainly consist of the distribution of new currency, the shredding of old currency, and economic research. The regional Feds would then be concerned that this is a slippery slope, with power in the Fed system ultimately concentrated in New York and Washington. This is certainly a legitimate concern. One of the strengths of the Fed system is its decentralization, which allows for competing viewpoints on policy issues.

For social welfare, however, the elimination of Fed regulation of small banks looks like a good thing. One argument in favor of Fed bank regulation might be that this is important for its role as lender of last resort. However, if the Fed cannot get sufficient information from the FDIC concerning how it should evaluate collateral posted against discount window loans, then something is wrong. Indeed, the Fed was quite willing to lend in the commercial paper market during the financial crisis, to firms which it was not regulating. Fewer regulators (and better regulation by these few) seems like the way to go, and this is a small step in that direction.

One final remark. Hoenig, like Charlie Plosser, wants a preemptive tightening in monetary policy. Unlike Plosser, he is currently a voting member of the FOMC, and has voted against the policy action at the previous 2 meetings (see here). I tried to debunk the case for preemptive tightening in Inflation Control.

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