MacroScope

Too-big-to-fail banks are bigger than ever before. But top regulators tell us not to worry. They say the problem has been diminished by financial reforms that give the authorities enhanced powers to wind down large financial institutions. Moreover, supervisors say, the new rules discourage firms from getting too large in the first place by forcing them to raise more equity than they had prior to the financial meltdown of 2007-2008.

New York Fed President and former Goldman Sachs partner William Dudley said in a recent speech:

There has already been considerable progress in forcing firms to bolster their capital and liquidity resources. On the capital side, consistent with the Dodd-Frank Act, Basel III significantly raises the quantity and quality of capital required of internationally active bank holding companies. This ensures that the firm’s shareholders will bear all the firm’s losses across a much wider range of scenarios than before. This should strengthen market discipline. Meanwhile, to the extent that some of the specific activities that generate significant externalities are now subject to higher capital charges, this should cause banks to alter their business activities in ways that reduce both the likelihood and social cost of their failure.

Moreover, the new Basel regime explicitly adjusts capital requirements upward based on size, complexity, interconnectedness, global exposure and substitutability – attributes that are proxies for the negative externalities generated by failure. If a bank is deemed a global systemic financial institution or G-SIFI, then it will have to hold a greater amount of capital relative to its risk-weighted assets compared to a less systemic institution.

One could make a good case that the capital surcharge for systemically important firms should be higher than that contemplated by the Basel Committee.

But for proponents of much higher capital requirements that would force banks to rely less heavily on leverage, there is no question. They argue Basel III changes are not nearly sufficient to allow supervisors – and therefore taxpayers, who are still on the hook for these supersized financial firms – to sleep soundly.

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?

Here’s a snapshot of FDR & Co. in 1933 as they signed Glass-Steagall, which separated the financial sector into safer, deposit-taking commercial banks and risk-taking investment banks – Wall Street.

And here’s a photo of Bill Clinton & Co. repealing Glass-Steagall in 1999, with the passage of the Graham-Leach-Bliley act known as the Financial Services Modernization Act. 

Federal Reserve Board Governor Daniel Tarullo’s call for limiting bank size is sparking debate in unexpected places. Keith Hennessey, who ran the National Economic Council under President Bush, was in Chicago late last week for a discussion with Democratic lawmaker Barney Frank. The topic of the panel, sponsored by CME Group Inc., was the housing crisis.

But the most spirited exchange took place after Hennessey said that banks are simply too big to regulate adequately. “I think Tarullo has got a good point,” he said, referring to Tarullo’s argument for the need to cap bank size. Hennessey, as Bush’s economic policy assistant in 2008, was among administration officials that worked to win Congressional approval for the bailout of insurance major AIG, as its failure threatened to plunge the nation’s financial markets, already reeling from the failure of Lehman Brothers, even deeper into crisis.

Lawmakers eventually relented. On Friday, Frank, who co-authored Wall Street reform legislation designed to prevent another bailout of a too-big-to-fail financial institutions, was not about to cede ground this time to Hennessey. “I didn’t ask what Tarullo thinks – are you for breaking up the banks, and if so, to what size, and by what method?”  “Right now I don’t see any better solution than what Tarullo has suggested – yes, a size cap on banks… The alternative is a repeat of the 2008 crisis.” After the panel, Frank said he took issue with the idea, both from a technical perspective – “How do you do it? Do you sell it? Who’s going to buy it? The other banks by definition can’t.” – and because of concern that trimming bank size will hurt the ability of U.S. financial institutions to compete internationally.

To say former New York Governor Eliot Spitzer is no fan of the Federal Reserve Bank of New York would be an understatement.

After arguing financial regulatory reform proposals being discussed in Washington fall short, he said:

“One institution needs to be completely overhauled: The New York Fed,” he said.

This picture was making the rounds on Wall Street on Thursday, after President Obama proposed limiting big banks'  financial risk-taking.