The Fed Shifts Ground on Big Banks

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz professor of entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

It’s all change at the Federal Reserve Board of Governors. Janet Yellen was confirmed as the new chief this week, and we should expect a major shift in the composition of the board over the next 12 months. Ben Bernanke is leaving, Elizabeth Duke has already resigned, and Sarah Bloom Raskin is moving to the Treasury Department — so there will soon presumably be three new appointments out of seven total positions. (Jerome Powell’s term will expire next month, but he may well be reappointed.)

Over the past half-decade the Bernanke Fed was primarily concerned with staving off disaster and then getting an economic recovery going. Ms. Yellen’s Fed obviously inherits the continuation of the latter task, but it also needs to complete crucial financial-sector reforms — and, perhaps most important, to decide on its attitude toward large banks. On this critical issue, there are signs of a potential shift in thinking at the top.

Under Alan Greenspan, the Fed went easy on the largest banks — light regulation was the name of the game.  And under Mr. Bernanke, while it became clear that some of these banks had managed themselves into great difficulties, there was also concern not to rock the boat too much by pushing for big changes. The Dodd-Frank reform legislation was hardly carried out with alacrity by the Fed.

Of late, however, there are definite indications of changes in thinking at the most senior levels of the Federal Reserve System.  It is entirely possible that under Ms. Yellen’s direction, the Fed will move further in a sensible direction — meaning that it will seek to limit the damage that very large, complex financial institutions can inflict on the rest of the economy.

If the Fed does move more decisively in that direction, historians will most likely trace the move to a speech in October 2012 in which Daniel K. Tarullo, a Fed governor, first clearly articulated the potential case for limiting the size of our largest banks, measured in terms of their nondeposit liabilities as a percent of gross domestic product.  (He made similar points in a speech at the Brookings Institution in December 2012 and in testimony before the Senate Banking Committee in February 2013.)

Mr. Tarullo was the first top Fed official to recognize clearly and discuss publicly the implicit subsidies that large banks continue to receive. He also drew the implication that bank size should be limited, given that subsidies expand as the bank gets bigger:

To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and regulations, there may be funding advantages for the firm, which reinforces the impulse to grow. There is, then, a case to be made for specifying an upper bound.

Here “upper bound” means the “systemic footprint” of banks or, put more simply, their size.

The implication is that we should not allow the largest bank holding companies to grow further, although Mr. Tarullo apparently wants to pass the buck back to Congress.

In these circumstances, however, with the potentially important consequences of such an upper bound and of the need to balance different interests and social goals, it would be most appropriate for Congress to legislate on the subject. If it chooses to do so, there would be merit in its adopting a simpler policy instrument, rather than relying on indirect, incomplete policy measures such as administrative calculation of potentially complex financial stability footprints. The idea along these lines that seems to have the most promise would limit the nondeposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis.

We can hope that in 2014 there will be growing support for legislation along exactly these lines — in bills proposed by Senator Sherrod Brown, Democrat of Ohio, and by Senator Brown with Senator David Vitter, Republican of Louisiana.  (See the proposed SAFE Banking Act and TBTF Act.)

And on Wednesday, at a hearing of the Senate Banking Committee’s subcommittee on financial institutions at which Senator Brown presided, I heard concern from across the political spectrum — including from Senator Elizabeth Warren, Democrat of Massachusetts, and Senator Patrick J. Toomey, Republican of Pennsylvania — that complete fulfillment of Dodd-Frank along current lines will not end the problem of “too big to fail.” Compared with early discussions on limiting bank size, in which I took part four years ago, there is definite indication that a bipartisan coalition on Capitol Hill can develop around this issue — and respond, for example, with capital requirements that rise steeply for the largest banks (the Brown-Vitter TBTF proposal).

But the Federal Reserve could and should help articulate the case for such legislation with greater clarity — building on the points that Mr. Tarullo has already made.

It would also be most helpful if a vice chairman for supervision could now be appointed to the Federal Reserve Board. The creation of this position is a requirement of the Dodd-Frank act that, rather inexplicably, remains completely unaddressed by the Obama administration.

Giving this job to Mr. Tarullo would make a great deal of sense, particularly as he seems increasingly likely to push forward with the ideas on limiting the scale of megabanks, along the lines that he has already floated. I’m optimistic that Mr. Tarullo could work closely with the emerging coalition of bipartisan senators willing to push further to reduce the dangers associated with global megabanks.