In his October 10, 2012 remarks at the University of Pennsylvania Law School, Federal Reserve Board Governor, Daniel K Tarullo, criticized Dodd-Frank sharply for missing the mark in a number of vital ways in its framework for ensuring financial stability. Tarullo called Dodd-Frank a sweeping piece of legislation pieced together in a crisis, based on some theories of financial stability that are in many respects undeveloped or uncontested, and incomplete in a number of systematically important risk areas. According to Tarullo, this lack of an overarching unifying concept of financial stability or an officially embraced consensus theory of how financial stability is undermined presents a major weakness in the reform effort and is a significant hurdle for regulators in implementing and enforcing the legislation. This poor theoretical foundation for financial stability leaves major gaps in the handling of the moral hazard associated with too-big-to-fail institutions, as well as other areas like shadow banking. Consequently, Tarullo believes that these gaps in Dodd-Frank leave room for further Congressional action, including imposing caps on the size of banks.
The concepts of financial stability and systematic risk appear throughout Dodd-Frank. In Tarullo's opinion, a key weakness in the Act, however, is that it creates a legal and institutional framework within which regulation is to be developed, but, with a couple of notable exceptions, it does not delineate the steps that should actually be taken to promote financial stability.
The law creates or strengthens numerous forms of regulatory authority that can be used to control numerous practices or circumstances associated with financial instability. Yet the statute itself provides only limited guidance to regulators on how to implement financial stability where it is established as a standard, or how to weigh it against economic growth and other considerations where it is used as an informing concept for a regulatory exercise or a factor to be considered in regulatory approvals. Moreover, one does not really find in the statute or in its legislative history an implicit theory of financial stability from which to infer answers to the regulatory questions just noted.
An absence of concrete systematic risk measures leaves a gap in financial stability regulations, particularly when it comes to bank mergers and size. According to Tarullo, even post crisis, US law permits the biggest banks to grow large enough that they increase “perceptions of at least some residual too-big-to-fail quality.” In his opinion, Congress should consider, among other things, capping the size of the largest financial institutions.
There is, then, a case to be made for specifying an upper bound. With the potentially important consequences of such an upper bound and of the need to balance different interests and social goals, it would be most appropriate for Congress to legislate on the subject.
The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis. In addition to the virtue of simplicity, this approach has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm's dependence on funding from sources other than the stable base of deposits.
Too much focus on curbing the moral hazard of large financial institutions obscures some other very important drivers of systematic risk. Tarullo points to a body of academic research that demonstrates that financial instability is endogenous to the financial system, and presents a picture of a financial system prone to instability for reasons in addition to, and quite independent of, classic too-big-to-fail concerns. Their various analyses suggest the possibility of destabilization even in a financial world with no dominant firms, but many medium-sized entities.
Tarullo identifies "shadow banking" as an area outside of classic too-big-to-fail concerns where a flawed understanding of systematic risk and financial stability may have handicapped Dodd-Frank's effectiveness, and indeed, may have slipped the net altogether. Tarullo applauds the Act's efforts to deal with OTC derivatives by mandating requirements for margining of over-the-counter derivatives, increased use of central clearing facilities for derivatives, and higher prudential standards for systemically important financial market utilities. However, these efforts do not go far enough.
But Dodd-Frank does not fashion a far-reaching system of regulatory authority for the shadow banking system to parallel the one it creates for systemically important institutions, or even to address fully the significant connections - through implicit support and other channels - between the shadow banking system and systemically important institutions. This is particularly noteworthy, as there is clearly some potential for enhanced capital, liquidity, and other prudential requirements for bank holding companies to cause more activity to migrate to the shadow banking system.
Notably, Tarullo reiterated his concerns with respect to the systematic risks posed by money market mutual funds, which he considers a vital part of the shadow banking system.
Money market funds remain a major part of the shadow banking system and a key potential systemic risk even in the post-crisis financial environment. The protective tools available to the rest of us do not fit the problem precisely and thus will not regulate at the least cost to the funds while still mitigating financial risk. My hope, of course, is that recent indications that other SEC commissioners are now willing to move forward with reforms will lead to the SEC adopting first-best measures in the near-term.
Mr. Tarullo sees removing the fixed net asset value exception, requiring a capital buffer that would staunch or buffer runs, or measures of similar effect as the the best hope for mitigating the risks posed to the system by runs on money market funds.
According to Mr. Tarullo, the somewhat extemporized character of Dodd-Frank has had several consequences for the development of financial stability regulation. Notwithstanding his criticisms of the legislation, he believes that cross-pollination of theoretical advances and institutionally grounded knowledge can achieve Congress's ultimate intent to create a workable comprehensive framework for controlling systematic risk. To that end, he called upon academics and regulators to work together.
Issues such as those I have discussed today can only profit from an academic perspective, informed by practical and institutional considerations.
From the standpoint of a regulator, the key challenge in these early stages is to be neither excessively self-confident about what we know about financial stability so as to produce unfortunate unintended consequences, nor excessively tentative so as to fail to take steps to counter the very real risks that do exist, in keeping with the aims stated by Congress.