NY Fed’s Dudley: “Blunter approach may yet prove necessary” for too-big-to-fail banks

November 19, 2012

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It was kind of a big deal coming from the Federal Reserve Bank of New York’s influential president William Dudley. The former Goldman Sachs partner and chief economist has offered a fig leaf to those who say the problem of banks considered too-big-to-fail must be dealt with more aggressively. Some regional Fed presidents have advocated breaking up these institutions. But Dudley and other powerful figures at the central bank have maintained recent financial reforms have already laid the groundwork for resolving the issue.

At a gathering of financial executives in New York last week, Dudley said he prefers the existing approach of making it costlier for firms to become big in the first place. Still, he left open the possibility of tackling the mega-bank problem more directly:

Should society tolerate a financial system in which certain financial institutions are deemed to be too big to fail? And, if not, then what should we do about it?

The answer to the first question is clearly ‘no.’ We cannot tolerate a financial system in which some firms are too big to fail—at least not ones that operate in any form other than that of a very tightly regulated utility.

The second question is the more interesting one. Is the current approach of the official sector to ending too-big-to-fail the right one? I’d characterize this approach as reducing the incentives for firms to operate with a large systemic footprint, reducing the likelihood of them failing, and lowering the cost to society when they do fail. Or would it be better to take the more direct, but less nuanced approach advocated by some and simply break up the most systemically important firms into smaller or simpler pieces in the hope that what emerges is no longer systemic and too big to fail?

As I will explain tonight, I believe we should continue to press forward on the first path. But, if we fail to reach our destination by this route, then a blunter approach may yet prove necessary.

That caveat is particularly interesting in light of a recent speech from the Fed’s regulation maven Daniel Tarullo, in which he backed a cap on the size of banks in relation to U.S. gross domestic product.

The remainder of Dudley’s remarks are filled with interesting anecdotes about the banking sector from a man who knows Wall Street well. For instance, did you know Bank of America was the product of more than 160 mergers?

And how’s this for some perspective on just how rapidly the financial industry expanded during the last two decades:

In the mid-1990s, the top five banks in the United States had total assets of $1 trillion or about 14 percent of gross domestic product (GDP). The top securities firms had total assets of $718 billion, or about 9 percent of GDP. By the end of 2007, the top five banks had assets of $6.8 trillion or 49 percent of GDP. Similarly, the top securities firms accounted for $3.8 trillion, or about 27 percent of GDP. In addition, the firms’ off-balance-sheet exposures rose sharply

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