Today, I testified before the Senate Banking Committee on the new regime for regulating large, complex financial institutions. If you don’t have the time to read the whole testimony, here are some key takeaways:
Large financial institutions can be good:
Indeed, there are important benefits to the U.S. economy from having financial institutions with large and diverse balance sheets that can best make liquid markets for large transactions and across a broad range of assets. Large banks are best able to help end-users deal with risks, and to serve large clients in trade finance, global lending, and cash management. Smaller banks also play a vital role in the U.S. financial system and in the economy. But it is a reality that large financial institutions are best able to undertake commercial transactions for large multinational clients that are a hallmark of the globalized economy.
Better oversight is better than breaking big banks up:
The Dodd-Frank Act takes a better approach, which is to strengthen regulation and oversight of large, complex financial institutions, including with features that will help regulators detect, avoid, and respond to future crises. The Financial Stability Oversight Council in particular will help avoid a repetition of the problems in which no regulator had clear responsibility for AIG.
The new regulatory regime in Dodd-Frank does not break up large financial institutions or reinstitute the Glass-Steagall separation of commercial and investment banking. This is appropriate. The repeal of Glass-Steagall is not well correlated with the failures in the crisis. Bear Stearns and Lehman Brothers, for example, both remained investment banks, while JPMorgan Chase combined investment banking and commercial banking but weathered the strains of the crisis. I would focus instead on the riskiness of firms’ particular assets and activities.
Raising capital standards leads to a tradeoff between stability and strength:
Increased capital and liquidity requirements on large financial institutions will provide a greater buffer for firms to absorb losses and weather market strains. But there will be an impact on financial intermediation and thus on the economy. Real-world banks react to binding capital requirements by making fewer loans, and increased capital requirements could drive lending activity once again into the less-regulated shadow banking system. Higher capital standards are useful, but they do not escape the tradeoff between stability and economic vitality.