Jeremy C Stein: Regulating large financial institutions
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the "Rethinking macro policy II," a conference sponsored by the International
Monetary Fund, Washington DC, 17 April 2013.
* * *
Thank you. I'm delighted to be here, and want to thank the International Monetary Fund and
the organizers of the conference for including me in a discussion of these important topics. I
will focus my remarks today on the ongoing regulatory challenges associated with large,
systemically important financial institutions, or SIFIs.1 In part, this focus amounts to asking a
question that seems to be on everyone's mind these days: Where do we stand with respect
to fixing the problem of "too big to fail" (TBTF)? Are we making satisfactory progress, or it is
time to think about further measures?
I should note at the outset that solving the TBTF problem has two distinct aspects. First, and
most obviously, one goal is to get to the point where all market participants understand with
certainty that if a large SIFI were to fail, the losses would fall on its shareholders and
creditors, and taxpayers would have no exposure. However, this is only a necessary
condition for success, but not a sufficient one. A second aim is that the failure of a SIFI must
not impose significant spillovers on the rest of the financial system, in the form of contagion
effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are
closely related. If policy does a better job of mitigating spillovers, it becomes more credible to
claim that a SIFI will be allowed to fail without government bailout.
So where do we stand? I believe two statements are simultaneously true. We've made
considerable progress with respect to SIFIs since the financial crisis. And we're not yet at a
point where we should be satisfied.
All of you are familiar with the areas of progress. Higher and more robust capital
requirements, new liquidity requirements, and stress testing all should help to materially
reduce the probability of a SIFI finding itself at the point of failure. And, if, despite these
measures, a SIFI does fail, the orderly liquidation authority (OLA) in Title II of the Dodd-Frank
Wall Street Reform and Consumer Protection Act now offers a mechanism for recapitalizing
and restructuring the institution by imposing losses on shareholders and creditors. In the
interests of brevity, I won't go into a lot of detail about OLA. But my Board colleague Jay
Powell talked in depth about this topic in a speech last month, and I would just register my
broad agreement with his conclusion - namely that the Federal Deposit Insurance
Corporation's (FDIC's) so-called "single point of entry" approach to resolution is a promising
one.2 The Federal Reserve continues to work with the FDIC on the many difficult
implementation challenges that remain, but I believe this approach gets the first-order
economics right and ultimately has a good chance to be effective.
Perhaps more to the point for TBTF, if a SIFI does fail I have little doubt that private investors
will in fact bear the losses - even if this leads to an outcome that is messier and more costly
to society than we would ideally like. Dodd-Frank is very clear in saying that the Federal
Reserve and other regulators cannot use their emergency authorities to bail out an individual
failing institution. And as a member of the Board, I am committed to following both the letter
and the spirit of the law.
Still, we are quite a way from having fully solved the policy problems associated with SIFIs.
For one thing, the market still appears to attach some probability to the government bailing
out the creditors of a SIFI; this can be seen in the ratings uplift granted to large banks based
on the ratings agencies' assessment of the probability of government support. While this
uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still
significant.3 All else equal, this uplift confers a funding subsidy to the largest financial firms.
Moreover, as I noted earlier, even if bailouts were commonly understood to be a
zeroprobability event, the problem of spillovers remains. It is one thing to believe that a SIFI will
be allowed to fail without government support; it is another to believe that such failure will not
inflict significant damage on other parts of the financial system. In the presence of such
externalities, financial firms may still have excessive private incentives to remain big,
complicated, and interconnected, because they reap any benefits - for example, in terms of
economies of scale and scope - but don't bear all the social costs.
How can we do better? Some have argued that the current policy path is not working, and
that we need to take a fundamentally different approach.4 Such an alternative approach
might include, for example, outright caps on the size of individual banks, or a return to
GlassSteagall-type activity limits.
My own view is somewhat different. While I agree that we have a long way to go, I believe
that the way to get there is not by abandoning the current reform agenda, but rather by
sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions.
In this spirit, two ideas merit consideration: (1) an increase in the slope of the
capitalsurcharge schedule that is applied to large complex firms, and (2) the imposition at the
holding company level of a substantial senior debt requirement to facilitate resolution under
Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt
requirement could also potentially be made a function of an institution's systemic footprint.
To illustrate my argument, let us take as given the central premise of those who favor size
limits: namely, that society would be better off if the distribution of banks were not so skewed
toward a handful of very large institutions. (To be clear, I am using the word "size" as
shorthand for the broader concept of an institution's systemic footprint, which in addition to
size, might reflect complexity, interconnectedness, and global span of operations.) In other
words, let's simply posit that a goal of regulation should be to lean against bank size, and
ask: What are the best regulatory tools for accomplishing that goal? As in many other
regulatory settings, this question can be mapped into the "prices-versus-quantities"
framework laid out by Martin Weitzman nearly 40 years ago.5 Here a size cap is a form of
3
For example, in June of 2012, Moody's described its ratings process for Bank of America, Citigroup, and JP
Morgan Chase as follows: "[Their] ratings benefit from three notches of uplift from the standalone credit
assessment at the bank level, and from two notches of uplift at the holding company, reflecting Moody's
assumptions about a very high likelihood of support from the US government for bondholders or other
creditors in the event such support was required to prevent a default... .The negative outlook on the parent
holding company reflects Moody's view that government support for U.S. bank holding company creditors is
becoming less certain and less predictable, given the evolving attitude of U.S. authorities to the resolution of
large financial institutions, whereas support for creditors of operating entities remains sufficiently likely and
predictable to warrant stable outlooks."
4
See Fisher (2013), who said: "...we recommend that the largest financial holding companies be restructured
so that every one of their corporate entities is subject to a speedy bankruptcy process, and in the case of the
banking entities themselves, that they be of a size that is 'too small to save'. Addressing institutional size is
vital to maintaining a credible threat of failure, thereby providing a convincing case that policy has truly
changed."
5
See Weitzman (1974). Haldane (2010) also uses Weitzman's framework to talk about price-versus-quantity
regulation in the TBTF context. It should be noted that there are various hybrid approaches that are neither
pure quantity nor pure price regulation. For example, Tarullo's (2012) discussion of limits on uninsured
liabilities is not a rigid size cap, since it does not constrain an institution's absolute size, to the extent that it is
able to adjust its funding mix.
quantity regulation, whereas capital requirements that increase with bank size can be
thought of as a kind of price regulation, in the sense that such capital requirements are
analogous to a progressive tax on bank size.6
A key challenge with quantity-based regulation is that one has to decide where to set the
cap. Doing so requires a regulator to take a strong stand on the nature of scale and scope
economies in large financial firms. Moreover, even if one reads the empirical literature as
being quite skeptical about the existence of such economies beyond a certain point in the
size distribution - a proposition which itself is debatable - the most that such large-sample
studies can do is make on-average statements about scale and scope economies.7 These
studies still leave open the possibility of considerable heterogeneity across firms, and that
some firms are able to add considerable value in a given line of business by being very big,
even if the average firm in the population is not. And such heterogeneity alone is enough to
create significant drawbacks to quantity-based regulation.
Consider the following example. There are three banks: A, B, and C. Banks A and B both
have $1 trillion in assets, while C is smaller, with only $400 billion in assets. Bank A actually
generates significant economies of scale, so that it is socially optimal for it to remain at its
current size. Banks B and C, by contrast, have very modest economies of scale, not enough
to outweigh the costs that their size and complexity impose on society. From the perspective
of an omniscient social planner, it would be better if both B and C were half their current size.
Now let's ask what happens if we impose a size cap of say $500 billion. This size cap does
the right thing with respect to Bank B, by shrinking it to a socially optimal size. But it
mishandles both Banks A and C, for different reasons. In the case of A, the cap forces it to
shrink when it shouldn't, because given the specifics of its business model it actually creates
a substantial amount of value by being big. And in the case of C, the cap makes the opposite
mistake. It would actually be beneficial to put pressure on C to shrink at the margin - that is,
to move it in the direction of being a $200 billion bank instead of a $400 billion one - but
since it lies below the cap, it is completely untouched by the regulation.
Suppose instead we attack the problem by imposing capital requirements that are an
increasing function of bank size. This price-based approach creates some incentive for all
three banks to shrink, but lets them balance this incentive against the scale benefits that they
realize by staying big. In this case, we would expect A, with its significant scale economies,
to absorb the tax hit and choose to remain large, while B and C, with more modest scale
economies, would be expected to shrink more radically. In other words, price-based
regulation is more flexible, in that it leaves the size decision to bank managers, who can then
base their decision on their own understanding of the synergies - or lack thereof - in their
respective businesses.
This logic can be thought of as supporting the approach taken by the Basel Committee on
Banking Supervision in its rule imposing a common equity surcharge on designated global
systemically important banks. The exact amount of the surcharge will range from 1 percent to
2.5 percent, and will depend on factors that include a bank's size, complexity, and
interconnectedness, as measured by a variety of indicator variables.8 These progressive
surcharges are effectively a type of price-based regulation, and therefore should have the
advantages I just noted.
However, a proponent of size caps might reasonably reply: "Fine, but how do I know that
these surcharges are actually enough to change behavior - that is, to exert a meaningful
influence on the size distribution of the banking system?" After all, the analogy between a
capital requirement and a tax is somewhat imperfect, since we don't know exactly the implicit
tax rate associated with a given level of capital. Some view capital requirements as quite
burdensome, which would mean that even a 2 percent surcharge amounts to a significant tax
and, hence, a strong incentive for a bank to shrink, while others have argued that capital
requirements impose only modest costs, which would imply little incentive to shrink.9
This uncertainty about the ultimate effect of a given capital-surcharge regime on the size
distribution of banks could potentially tip the balance back in favor of quantity-based
regulation, like size caps. And indeed, if we were faced with a static, once-and-for-all
decision, I don't think economic reasoning alone could give us a definitive answer as to
whether caps should be preferred to capital surcharges. This ambiguity is in some sense the
central message of Weitzman's original analysis.
One way to resolve this tension is to refrain from putting ourselves in the position of having to
make a once-and-for-all decision in a setting of substantial uncertainty. Rather, it might be
preferable to try to learn from the incoming data and adjust over time, particularly since the
recent changes to capital regulation already on the books may represent an informative
experiment. In my view, this observation about the potential for learning tips the balance in
favor of capital surcharges. For example, the capital-surcharge schedule proposed by the
Basel Committee for globally important systemic banks may be a reasonable starting point.
However, if after some time it has not delivered much of a change in the size and complexity
of the largest of banks, one might conclude that the implicit tax was too small, and should be
ratcheted up.10 In principle, this turning-up-the-dials approach feels to me like the right way to
go: It retains the flexibility that makes price-based regulation attractive, while mitigating the
risk that the implicit tax rate will be set too low. Of course, I recognize that its gradualist
nature presents practical challenges, not least of which is sustaining a level of regulatory
commitment and resolve sufficient to keep the dials turning so long as this is the right thing to
do.
Before wrapping up, let me briefly mention another piece of the puzzle that I think is
sometimes overlooked, but strikes me as having the potential to play an important
complementary role in efforts to address the TBTF problem - namely, corporate governance.
Suppose we do everything right with respect to capital regulation, and set up a system of
capital surcharges that imposes a strong incentive to shrink on those institutions that don't
create large synergies. How would the adjustment process actually play out? The first step
would be for shareholders, seeing an inadequate return on capital, to sell their shares,
driving the bank's stock price down. And the second step would be for management, seeking
to restore shareholder value, to respond by selectively shedding assets.
But as decades of research in corporate finance have taught us, we shouldn't take the
second step for granted. Numerous studies across a wide range of industries have
documented how difficult it is for managers to voluntarily downsize their firms, even when the
stock market is sending a clear signal that downsizing would be in the interests of outside
shareholders. Often, change of this sort requires the application of some external force, be it
from the market for corporate control, an activist investor, or a strong and independent
board.11 As we move forward, we should keep these governance mechanisms in mind, and
do what we can to ensure that they support the broader regulatory strategy.
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