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Dodd-Frank Falls Short on TBTF

By: Bill Poquette

Serious questions were raised by two Federal Reserve Bank presidents recently whether enough is being done to prevent another financial crisis threatening survival of the nation’s too big to fail banks.

“We have made some progress on the TBTF problem,” said William C. Dudley, CEO of the New York Fed, “particularly in reducing the likelihood that a large, complex firm will reach the point of distress at which society faces serious costs. But we have a considerable ways to go to finish the job and reduce to tolerable levels the social costs associated with such failures.”

Dudley does not currently favor breaking up or limiting the size of the biggest firms, as some Fed officials and others have suggested. “My own view is that while this could yet prove necessary, it is premature,” he said, “to give up on the current approach: changing the incentives facing large and complex firms, forcing them to become more resilient and making the financial system more robust to their failure.”

Too big to fail is an “unacceptable regime,” Dudley concluded in his remarks at a Clearing House conference in New York City. “The good news is there are many efforts under way to address this problem. The bad news is that some of these these efforts are just in their nascent stages. It is important that as the crisis recedes in memory, that these efforts not flag — this is a project that needs to be seen to a successful conclusion and then sustained on a permanent basis.”

Esther L. George, CEO of the Kansas City bank, questioned whether the “misaligned incentives” that led to the crisis have been corrected. “Quite clearly, a major issue in the United States and many other countries during the crisis was the public assistance and protection that was given to banks deemed too big to fail,” she said. “We cannot expect to have a sound financial system if the key players in it are not held fully responsible for the choices they make,” she told global supervisors at a meeting in Panama City, Panama.

“Enhanced supervision and the related steps many of us are taking now are unlikely to work well as long as major institutions still have incentive to take on added risk,” she added. Strong leverage ratios are essential, in her view, but along with them, “we must have the correct supervisory focus, particularly since we have not followed some of the lessons of the previous crisis.”

George is especially concerned that the importance of traditional supervisory tools — microprudential supervision, careful examiner assessments of credit and other banking risks and evaluations of the quality of bank management — will be forgotten. “Today we are focused on enhanced supervision of the systemically important financial institutions, stress tests, macroprudential supervision and many other reforms,” she said. “These steps will not get us very far if we don’t first address the incentive problems in our financial institutions, insist on better bank management wherever needed and emphasize our traditional supervisory framework.”

It is clear from the two Fed presidents’ remarks that there is no magic bullet in the Dodd-Frank Act for dealing with too-big-to-fail institutions. While their approaches to this issue differ in certain respects, attention should be paid by policymakers and regulators writing new rules.

Bill Poquette is editor-in-chief of BankNews.

Copyright (c) December 2012 by BankNews Media