Too Big to Regulate

With regulators providing little to no restraint, Wall Street megabanks still run wild, bullying the U.S. economy and financial system

By Kelly Pike

Three years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted, promising to end too-big-to-fail financial institutions and the taxpayer bailouts that saved them, surprisingly little, visibly tangible progress has been made.

Few of the congressionally mandated reforms have been implemented—and some question the efficacy of those in place. The biggest proof is in the markets and in the disproportionately lighter megabank regulation. Frequently throughout Washington and in various media, ICBA President and CEO Camden Fine continues to point out that megabanks and other too-big-to-fail financial institutions that pose risks to the financial system receive favorable treatment from regulators and enjoy an $83 billion taxpayer-backed funding advantage over community banks and other financial institutions.

“Not a day goes by without new reports on the financial and economic problems caused by too-big-to-fail financial institutions and their government guarantee against failure,” Fine says. “These institutions enjoy a privileged position in the financial markets because their size and interconnectedness make them systemically dangerous. Not only has their too-big-to-fail status led to riskier behavior and distorted financial markets—it has a real impact on community banks and their customers on Main Street.”

The continually accumulating overregulation of community banks has its root cause in the repeated policy responses to the abuses of not just too-big-to-fail but also too-big-to-regulate financial institutions, says ICBA Chairman Bill Loving, president and CEO of Pendleton Community Bank in Franklin, W.Va. Loving has played an active part in the association’s leadership in recent years in voicing community bankings’ various arguments aimed at pressing both regulators and lawmakers to continue to move aggressively toward ending too-big-to-fail.

“The problem has a tangible impact on community banks and the communities they serve,” he says. “The financial crises caused by too-big-to-fail firms led to stricter regulations on the entire banking industry, including the Main Street institutions that did not contribute to the calamity. The result: Resources that could be used to help local communities and small businesses prosper are instead directed toward regulatory mandates.”

Moreover, ending too-big-to-fail was in fact the primary goal of Congress enacting the Wall Street financial reform law in 2010, adds Karen Thomas, ICBA senior executive vice president, government relations and public policy. The main purpose behind the law was twofold, she explains: The first goal was to reduce systemic risk so that no troubled institution or small group of institutions could destabilize the financial system and the economy; the second goal was to end any perception of too-big-to-fail that gave megabanks a competitive advantage and a lower price of capital. “I don’t think we’ve seen that impact on the marketplace,” she says.

More than being too-big-to-fail—as if that status weren’t disturbing enough—the megabanks have also been shown to be “too big to jail” This March, Attorney General Eric Holder complained publicly, during congressional testimony, about the government’s hesitancy to prosecute large financial institutions due to fears of disrupting the national or even world economy. “I think that is a function of the fact that some of these institutions have become too large,” the attorney general said.

Fine quickly responded to Holder’s testimony: “Not only have these institutions received billions of dollars in taxpayer support because of the systemic risks they pose; they are also apparently immune from criminal prosecution. Meanwhile, community banks have been left to pick up the pieces under the weight of crushing laws and regulations enacted to halt Wall Street’s unscrupulous behavior. … Only after ensuring that all financial institutions operate on a level playing field can we begin to restore our financial system to proper health.”

Meanwhile, coast-to-coast megabanks and nonbank Wall Street firms have only grown bigger and more complex. Regulators continue to work on putting meaningful corrective measures in place as Congress watches over while debating further legislative steps.

Who’s too big?

The Wall Street financial reform law of three years ago requires regulators to identify and regulate large or interconnected financial firms that pose systemic risk to the financial system and economy. Known as systemically important financial institutions, or SIFIs, they are subject to enhanced prudential standards and supervision by the Federal Reserve.

While all banks over $50 billion in assets are automatically labeled SIFIs, the Financial Stability Oversight Council is tasked with identifying organizations, such as investment banks, insurance companies and hedge funds, among others, as nonbank SIFIs. The FSOC quickly approved procedures in 2011 for identifying SIFIs—then its progress slowed to a crawl.

In April, the Federal Reserve Board approved a final rule that establishes the requirements for determining when a company is predominantly engaged in financial activities. The FSOC will use those requirements when it considers whether to designate a nonbank financial company for consolidated supervision by the Federal Reserve. Under the rule, nonbank financial companies can be designated by the FSOC for supervision by the Federal Reserve only if they are “predominantly engaged in financial activities.” Companies are included if 85 percent or more of their revenues or assets are related to activities that are defined as financial in nature under the Bank Holding Company Act. The final rule takes effect this month.

As of May 2013, however, the council had not identified a single nonbank SIFI, although it says it plans to do so sometime within the next few months.

The delay concerns not just those most worried about too-big-to-fail, like ICBA, but others as well. “Can it be rocket science to say GE Capital and MetLife at least belong on list?” asks Arthur E. Wilmarth Jr., a professor at George Washington University Law School who worked as a consultant to the Financial Crisis Inquiry Commission, the body established by Congress to report on the causes of the financial crisis. “That they are not yet on the list is beyond astonishing.”

Chris Cole, ICBA legislative counsel, is also surprised by the delay. “We knew it would take time to do it right, but I don’t think anybody thought it would be this slow,” he says.

Part of the problem may be the FSOC’s structure. Chaired by the Treasury secretary, the council has 10 voting members, nine from the federal regulatory agencies and one independent member with insurance expertise. It also has five nonvoting members. That makes reaching a consensus difficult. Economic concerns may also play a role. This added structure of supervision will likely pose substantial costs to the affected firms, negatively impact their shareholder value and possibly jostle the overall economy, Cole says.

Regulatory bottleneck

Even when a firm is designated as a SIFI, there aren’t many regulations in place yet to remedy the danger they pose. The Federal Reserve issued a proposal on enhanced prudential requirements—including higher capital, leverage, liquidity standards, counterparty exposure limits and concentration limits—in December 2011, but there’s still no final rule. This November it put out a proposal for large foreign banks and then extended the comment period due to tremendous pushback.

Another long-awaited regulatory proposal strongly supported by ICBA, expected sometime this quarter, will deal with a SIFI capital surcharge designed to give megabanks an extra capital cushion while discouraging them from getting any larger or further interconnected. ICBA is pushing for a SIFI surcharge of at least 1 to 2.5 percent and a minimum Tier 1 leverage ratio of 6 percent for SIFIs.

“We hoped that by now there would be more progress toward putting systems in place that are able to address systemically risky firms,” notes Terry Jorde, ICBA senior executive vice president and chief of staff. “We need more incentives for big banks to become smaller.”

Similarly, the Wall Street reform law also mandates the regulatory implementation of the Volcker Rule, which prohibits banks from engaging in proprietary trading in securities and derivatives or owning or investing in a private-equity or hedge fund. The banking agencies have been working on implementing a final rule since they first solicited comments in October 2011. The agencies are expected to issue final regulations this quarter, but those rules are unlikely to take effect until July 2014 at the earliest.

Much of the delay stems from concerns, including those from ICBA, that the proposed regulations have so far been overly complicated.

ICBA supports the Volcker Rule but wants to ensure that community banks—which, of course, don’t engage in the speculative financial activities targeted by the rule—aren’t impacted, even inadvertently, by any additional compliance burden.

One implemented requirement the Federal Reserve has undertaken is the use of annual SIFI stress tests, which were implemented in 2012 and will impact financial firms with $10 billion or more in assets. These tests are designed to determine if SIFIs have sufficient capital to weather a significant economic or financial downturn.

“They are important because the regulators are relying on them more and more to determine the extent of how closely they want to examine and regulate,” Cole observes. “They are also important to dividends. For instance, BB&T would like to declare a bigger dividend, but regulators want them to conserve capital instead.”

Should a large financial institution fail to pass its stress tests or if the Federal Reserve determines that a SIFI poses a “grave threat” to financial stability, with an affirmative vote of two-thirds of the FSOC, the Wall Street financial reform law gives the Federal Reserve the power to restrict activities, mergers and acquisitions—or even break up a dangerously large or interconnected bank or nonbank. However, while ICBA has repeatedly encouraged the Federal Reserve to use its power, it’s very unlikely to wield it anytime soon, Cole says.

“There’s no really strong regulatory mechanism to break big banks up under statute,” he says. “If we wanted to do that, further legislation needs to be done, particularly if you wanted to downsize these institutions.”

Planning ahead

The FDIC has made the most progress implementing its portion of the Wall Street reform law, Thomas points out. The agency quickly implemented orderly liquidation rules that outline how it would handle a large bank failure and ensure that the bank’s shareholders absorb losses instead of taxpayers.

“Where regulators haven’t been so clear is about how to liquidate, say, a gigantic firm that has both a bank and a bunch of nonbank holding companies and other nonbank activities,” Cole adds. “By end of 2013, we should have a better idea of how the FDIC would handle the holding company situation.”

But most bank policy experts are concerned that the FDIC’s plans are not thorough enough because they are based on scenarios in which just one bank fails at a time. “No one believes that if a very big institution got into trouble it would just be one at a time,” Wilmarth says. “No one I know has confidence they could handle liquidations of multiple large banks at the same time. I’m not sure they can even handle one.” Others have voiced similar concerns that the complicated task of liquidating giant financial firms would become exponentially more challenging and the outcomes more uncertain in the middle of a broader crisis.

Wilmarth also worries that few foreign countries have a resolution process in place to complement the one in the United States. “Even if the FDIC is successful with the domestic segment of JPMorgan or Goldman Sachs, there’s no assurance of handling foreign subsidiaries. Most of these folks have hundreds or thousands of subsidiaries.”

That’s why ICBA is adamant that SIFIs need to become smaller and less complex, Jorde says. “The five largest banks have 19,654 nonbank subsidiaries. It’s extremely difficult to regulate an institution like that,” she adds. “How can the board of directors possibly get its arms around that?”

Former FDIC chairman Sheila Bair hoped to do just that by using the Wall Street financial reform law to require bank SIFIs and banks with more than $10 billion in assets to submit contingency resolution plans and quarterly reports on their business structure. These plans, or so-called living wills, describe the process for quickly liquidating an institution without posing systemic risk on the public or the financial system. Under extreme circumstances, if a company could not submit a credible plan, the FDIC and the Federal Reserve would have the authority under the Wall Street financial reform law to downsize the firm.

It was Bair’s hope that these plans would force large banks with more than 1,000 subsidiaries—many of them foreign—to simplify their corporate structure organically. So far this hasn’t happened, notes Cole, and despite ICBA’s encouragement, he believes it’s highly unlikely that the FDIC or Federal Reserve would use their powers to break up too-big-to-fail institutions in the foreseeable future.

Instead, ICBA worries that the biggest banks will continue to grow and gain market share as the public views them as targets for government rescue in a financial crisis.

A legislative solution

“The regulatory scheme of stress testing, capital surcharges, the Volcker Rule—all that helps, but it isn’t going to solve the problem,” says Cole. “It still is a too-big-to-fail problem, and the only way to resolve it is to limit the size of big banks. Really, the way to do that is legislatively.”

The good news is that Congress is taking an interest. Sens. David Vitter (R-La.) and Sherrod Brown (D-Ohio) have asked the Government Accountability Office to study the potential market distortions caused by too-big-to-fail financial institutions. Debate is also increasing among lawmakers and in the press that, as Attorney General Holder’s too-big-to-jail admission reinforces, action beyond the current regulatory playing field is necessary. Particular legislative ideas have already been suggested, if not outlined, by among others the Federal Reserve Banks of Kansas City and Dallas.

Additional too-big-to-fail bills are likely to be introduced this year, although enacting legislation in the 113th Congress is a long shot. Community bank support will be critical to advance support for further action by Congress to more fully and finally address too-big-to-fail.

“I thought that Dodd-Frank had limited possibilities—though it didn’t go nearly far enough,” Wilmarth says. “Even the limited possibilities have been largely blunted and have not been achieved. Any pressure has to come from the grassroots.”

But Loving, citing a recent survey showing that half of Americans favor a plan to break up the 12 largest megabanks, points out that everyday people understand the issue and want policymakers—both regulators and lawmakers—to do everything in their power to address it. “With continuing reports of the abuses of too-big-to-fail institutions and the favorable treatment they receive to continue operating on Wall Street,” he says, “Americans have rightly concluded that the nation’s largest banks and the systemic risks they pose must be reined in.”

Kelly Pike is a financial writer in Annandale, Va.