New York Fed president William Dudley really wants to kill off the notion that some banks are "too big to fail." Many of his colleagues at the Federal Reserve agree with him, but it's unclear how – or if – the Fed has the firepower to do so.
"Such a regime is unacceptable," said Mr. Dudley in a gloomy speech at the Global Economic Policy Forum in New York. Several other Fed members have echoed this complaint, revealing a growing consensus that the central bank must end the implicit safety net beneath Wall Street's heavyweight banks.
The Fed has plenty of motivation to condemn too big to fail. As the "lender of last resort," the Fed swooped in during the dark days of 2008, providing emergency funding to collapsing banks in order to prevent catastrophic financial panic.
Now, Fed members are seeking ways to mitigate the risks big banks pose to Main Street, as well as to prevent big banks from gaining unfair benefits from this perceived safety net. "It creates an uneven playing field between large and small firms," Mr. Dudley said. "A funding advantage creates incentives for firms to become bigger and more complex … that just increases financial stability risks."
It is less obvious how the Fed might tackle this mission. Mr. Dudley said that action after a crisis is not enough: regulators must prevent failure of large banks in the first place. Mr. Dudley endorsed the Basel III rules, which boosted capital requirements and requires some institutions to hold more capital based on their complexity. However, he lamented that "it will take considerable time for the surcharge to have a meaningful impact on size and complexity." Mr. Dudley also pushed for changes to management compensation structure, so that compensation is based on capital losses, in order to "alter management's risk tolerance."
There's also a question of jurisdiction. Dodd-Frank gave the Fed a new official mandate: regulating systemic risk and protecting financial stability. The Fed would no longer just write checks to bail out struggling banks; it is now tasked with monitoring their potential risks to the financial system. The Financial Stability Oversight Council (FSOC), established by Title I of Dodd-Frank, is intended to bridge these responsibilities amongst the Fed, SEC, and other U.S. regulators.
"The Fed's mission is now based on systemic issues, but it does cross jurisdictional lines," said Jim Overdahl, former chief economist of the Commodity Futures Trading Commission, admitting there have been "turf battles." For example, the Fed had to backstop certain money market funds during the financial crisis, but the regulation of money market funds is under the aegis of the SEC.
The FSOC is intended to solve cross-jurisdictional issues, although it remains to be seen whether this will be effective. The Fed is now implementing Basel III capital requirement reforms. But other regulations, such as the compensation schemes that Mr. Dudley mentioned, would require collaboration with other watchdogs, which is unchartered territory for the regulators. As Mr. Overdahl warns: "There isn't a lot of history to go on here."
Senators will likely grill Janet Yellen on the too-big-to-fail problem at her testimony to the U.S. Senate Banking Committee on Thursday. The incoming Fed chairwoman has been ambiguous on this topic so far, although she does seem open to doing more to combat too-big-to-fail. "Ending too-big-to-fail will require steadfast implementation over the next few years," Ms. Yellen said on June 2. "I am not convinced that the existing regulatory work plan … goes far enough."
Mr. Dudley's speech came to an ominous conclusion – that the biggest problem is Wall Street's culture. "There is evidence of deep-seated cultural and ethical failures at many large financial institutions," he said. "These [regulatory changes] may not solve [the] problem – the apparent lack of respect for law, regulation and the public trust."