A little over a week Governor Tarullo gave a fascinating speech that focused on creating different regulatory approaches for different sized banks. This is a must read for policymakers and scholars (and further evidence of the value of having at least one lawyer or expert in prudential regulation on the Federal Reserve Board). Tarullo advocates pushing further the approach in Dodd-Frank of having a sliding scale with different regulatory standards for different tiers of banks.
Several news outlets picked up on Tarullo’s call to reduce compliance costs for community banks. Tarullo’s welcome approach recognizes that not all banks pose the same amount or types of risk. It contrasts sharply with the views of folks like Tim Geithner, who in his Stress Test memoir, discounts reform proposals that targeted the “popular villain” of size (see pages 391-2). Oddly, Geithner’s memoir also makes the case that the government did not have enough “foam for the runway” when some of the jumboest jetliners started to plummet in the Panic of 2007-2008.
Still Geithner makes a point that serves as a mild corrective addendum for Tarullo’s sliding scale approach: many financial crises started with the risk-taking and failure of smaller institutions. Indeed, too-big-to-fail is but one problem. It should not completely overshadow the risks of herd behavior and too-correlated to fail. The collective actions of stampeding small institutions can generate big doses of systemic risk.
Tarullo’s speech implies that “macroprudential” regulation should only kick in for medium sized banks and ramp up further still for the behemoths. But the case for no macroprudential regulations for smaller firms depends on what we mean by “macroprudential.” One kind of macroprudential regulation focuses on correlated risks across financial institutions (what Claudio Borio labels the “cross-sectional” dimension). What does this mean concretely? Regulators need to worry when even small financial institutions collectively have too much risk exposure to the same types of losses (e.g. subprime residential mortgages, the Sunbelt, the energy sector, etc.). So even community banks need to come under the macroprudential umbrella.
The good news for community banks is that the monitoring cost of looking at correlated risks should (and likely has to) sit with regulators. No individual community bank would be able to assess the overlap between its risk portfolio and that of hundreds or thousands of competitors. Regulators, by contrast, are built to serve these information-gathering and coordination (or anti-coordination if you want to get technical) functions.
Regulators must also carry the burden of looking at how regulations can promote dangerous herd behavior by financial institutions and how this herd behavior can increase during bubble periods (the subject of Chapter 7 of my book). But that is a topic for another day.
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