Tags: bank | community | regulatory | Fed

Community Banks Need to Have a Voice on Fed Board

Wednesday, 15 January 2014 10:57 AM EST

By Simon Johnson

There is a long-standing tradition that a community banker, or someone close to that sector, serves on the Board of Governors of the Federal Reserve System.

Elizabeth Duke, who ably represented this constituency, stepped down from the board in August. The Obama administration's proposed replacements on what has become the single most important regulatory body for United States and global finance have very different backgrounds. This is a problem for community banks and the broader economy.

The rising importance of the Fed's Board of Governors is an odd development in some ways. After all, the central bank's track record on regulatory matters before the financial crisis of 2007 and 2008 was nothing short of dismal. The tone set at the top, from Chairman Alan Greenspan, was "deregulation, deregulation, deregulation," allowing large financial institutions to become even bigger and to take larger risks, without appropriate internal or external control. And the Fed's staff internalized this point of view; it was rare for the bank to deny any request from the big "sophisticated" players on Wall Street.

When I asked someone who was involved in writing the Dodd-Frank financial regulation legislation of 2010 why the Fed ended up with more powers, his response was: There was no one else. I presume he meant that the other banking regulators were perceived as even more compromised, intellectually and politically. And there was no desire to create a new administrative body or to transfer more powers to the Treasury Department. (Personally, I would have given more powers to the Federal Deposit Insurance Corp.)

So the seven governors of the Fed board have become a kind of Supreme Court for finance. In particular, because they have ultimate responsibility for determining what constitutes a "systemic risk," they have a great deal of discretionary power to add scrutiny and compliance requirements. (The newly created Financial Stability Oversight Council can also play a role, but it is mostly a coordinator of disparate regulatory bodies; the intellectual leadership is concentrated at the Fed.)

A big and obvious question about financial regulation is whether it is targeted appropriately. In our rules-based society, regulations are written for particular types of assets, such as collateralized debt obligations, or particular legal entities, such as bank holding companies.

But the problems of financial instability are most dramatically manifest in larger financial companies, which can bring down the system. When smaller financial companies get into trouble, it can be costly to specific regions — think of the savings and loan crisis in the 1980s and its impact in Texas — but such problems will rarely, if ever, threaten to bring down global finance.

And the larger U.S. financial institutions — the "too big to fail" crowd — can mobilize enormous resources for political lobbying and efforts to influence the writing and implementation of rules.

Modern finance is complex, so the regulators need to have discretion. But this discretion, combined with the political muscle and access of companies such as JPMorgan Chase & Co. or Citigroup Inc., tends to deflect regulation away from them and toward smaller banks.

Many financial systems are much more concentrated than the United States' has been historically. This dispersion is a great advantage compared with what you see in Europe, for example. There are big barriers to entry in banking everywhere, but the United States previously had a vibrant community banking sector.

After the financial crisis and re-regulation, this sector is under pressure. Hundreds of these banks have gone out of business since 2007, leaving only about 7,000.

Of course, some of them made bad business decisions. But as Camden Fine, president of the Independent Community Bankers of America, points out, there has never been a problem with small banks going out of business. They have long been well-regulated, including through the FDIC. The problem is that our largest financial companies are immune from failure because of their scale and complexity, and this allows them myriad advantages, including in access to funding in good times and bad.

The big banks like more regulation for their smaller competitors, for whom compliance costs are more of a challenge. This tilts the playing field even more in the direction of the largest banks, which already enjoy the implicit subsidies conferred by their too big to fail status.

It also allows the big banks to hide behind the smaller banks when seeking regulatory relief on Capitol Hill.

The smart way to run our regulatory system would be to ensure that small banks are well-represented on the Fed board and to exempt them from rules explicitly designed to reduce the dangers posed by large banks. There is some understanding in Congress that this is the right approach, as seen, for example, in the Collins Amendment to Dodd-Frank and the proposed legislation by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La. Both approaches involve higher capital requirements for large banks.

But none of the three Fed board candidates proposed last week has a background in or connection to community banking. And the board's recent involvement in designing the latest version of the Volcker Rule, which includes an inadvertent negative impact on community banks, suggests there will be — at best — a lack of attention to the details of community banking.

We should expect the Board of Governors to make more decisions that will hurt community banking and push the financial system to become more concentrated, with dangerous political and economic consequences.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.")

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There is a long-standing tradition that a community banker, or someone close to that sector, serves on the Board of Governors of the Federal Reserve System.
Wednesday, 15 January 2014 10:57 AM
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