NEW YORK – Financial system reform must address not only the systemic risks, but also the too-big-to-fail dilemma, Federal Reserve Board Governor Daniel K. Tarullo said today.
“The roots of the present crisis--and thus of the current form of the too-big-to-fail problems--reach much deeper than the breakdown of private risk management and shortcomings of government regulation during the first part of this decade,” Tarullo said in a speech before the Exchequer Club, Washington, D.C., today, according to prepared text released by the Fed. “Its origins lie in 30 years of change in the organization of financial firms and markets that squeezed the traditional business model of commercial banking. The regulatory system accommodated the growth of capital market alternatives to traditional financing by relaxing many restrictions on the type and geographic scope of bank activities, and virtually all restrictions on affiliations between banks and non-bank financial firms. The result was a financial services industry dominated by one set of very large financial holding companies centered on a large commercial bank and another set of very large financial institutions not subject to prudential regulation.”
Tarullos said, that while the problem of too-big-to-fail is a moral hazard, and moral hazards cannot be eliminated, they can be contained so “the social costs associated with the consequences of the misaligned incentives do not exceed the benefits associated with the operation of the institutions or markets in which the moral hazard exists.”
By offering a regulatory response, policymakers “would enhance the safety and soundness of large financial institutions and thereby reduce the likelihood of severe financial distress that could raise the prospect of systemic effects,” Tarullo said.
There should be three parts to such a response: “First, the shortcomings of the regulations that failed to protect the stability of the firms and the financial system need to be rectified. Regulatory capital requirements can balance the incentive to excessive risk-taking that may arise when there is believed to be government support for a firm, or at least some of its liabilities”; second there should be “a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard”; and “any firm whose failure could have serious systemic consequences ought to be subject to regulatory requirements.”
He added, “This regulatory agenda has much to be said for it and should, I believe, be vigorously pursued. But I doubt that rules directed at the conduct of financial firms will be an adequate response to the too-big-to-fail problem. In the first place, there is some danger that simply piling on a series of administrative reforms and restrictions intended to constrain the behavior of firms would have unnecessarily adverse consequences for the availability of credit on risk-sensible terms for consumers and businesses alike. The interaction of regulatory changes needs to be thought through. Also, the financial crisis should itself inject a considerable dose of humility into regulators’ assessment of the efficacy of even well-considered regulations. Rules directed at the behavior of large firms must be complemented with reforms directed at the behavior of their investors and counterparties.”
