NEW YORK - Federal Reserve Governor Daniel Tarullo said Thursday that the Fed may need to consider the pros and cons of "economies of scale" in deciding such things as whether large financial institutions should be allowed to merge or acquire other firms.
The costs and benefits of bigness may also enter into other facets of the Fed's newly mandated responsibility for "macroprudential supervision," Tarullo said in remarks prepared for delivery to a conference on "Regulation of Systemic Risk," cosponsored by the Federal Reserve Board and the Journal of Money, Credit and Banking in Washington, D.C.
He recommended more research into how the economics of "industrial organization" relate to the economics of banking now that the Fed has been given the task of managing "systemic risk" by last year's Dodd-Frank Wall Street Reform and Consumer Protection Act.
Noting that the financial markets are dominated by large firms, Tarullo said the evidence for benefits from economies of scale are "limited and mixed."
"It is possible that a firm would need to be quite large and diversified to achieve these economies, but still not as large and diversified as some of today's firms have become," he said.
As one example of the kinds of things that need to be explored, Tarullo cited the "funding-cost advantages" of large financial firms -- the ability of big banks to borrow more cheaply than smaller banks.
"If funding-cost advantages in fact derive from market perceptions that a very large firm was too-big-to-fail, the phenomenon is really one of competitive advantage grounded in moral hazard, not one of true efficiencies," he said.
Tarullo said the Dodd-Frank Act puts a different spin on the Fed's role as arbiter of bank mergers and acquisitions.
"Of course, economies of scale and scope have always played a part in the analysis of the competitive effects of proposed mergers," he said. "But the Dodd-Frank Act now requires that we also consider whether a proposed merger would lead to greater or more concentrated risks to financial stability."
In evaluating the financial stability effects of a proposed merger of two medium-sized institutions, he said the Fed now "would need to assess the expansion of the acquiring institution's systemic footprint."
"Then, we would have to balance the potential increased costs across the system were the institution to fail against the potential benefits from either a lesser likelihood of failure or, with respect to essential financial functions, a greater capacity to step in and fill the gap if one of the firms' large competitors were to fail," he added.
Tarullo said that "while Congress instructed us to consider the extent to which a proposed acquisition would pose a greater risk to financial stability, it clearly did not instruct us to reject an acquisition simply because there would be any increase in such risks."
"Instead, it appears we have been instructed to add any increased systemic risk to the list of adverse effects that could result from the merger and then determine whether the benefits to the public of the acquisition outweigh these adverse effects," he said. "If, for example, there are few indications that scale or scope efficiencies would be gained, then anticipated adverse effects on systemic stability could be expected to have a greater impact on our ultimate decision."
"If, on the other hand, there are genuine scale or scope efficiencies to be realized, then a more complicated set of trade-offs may be needed," he added.
Tarullo also related the scale and scope of financial institutions to how the Fed might wield its new authority for "orderly liquidation" of systemically important institutions that are deemed in danger of becoming insolvent.
"At least some advocates of orderly liquidation regimes seem to favor resolution plans that silo activities as much as possible," he said. "However, in the presence of significant economies of scope, this approach might result in loss of efficient forms of organization. In these circumstances, resolution plans that seek to preserve the scope economies even as a firm is dismembered might result in better liquidation outcomes."
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