Fed Governor Examines Post-Crisis Financial Regulation

Governor Daniel K. Tarullo of the Board of Governors of the Federal Reserve System described a “shift of perspective” in regulation since the financial crisis. In a speech on the “New Pedagogy of Financial Regulation” at Columbia Law School, he examined the transition from banking regulation to financial regulation and its effects on policy and scholarship.

Governor Tarullo identified two gaps highlighted by the crisis. These included “the inadequate prudential regulation of the most systemically important financial institutions (‘SIFIs’) and the sometimes nonexistent prudential regulation of the many activities now denominated as ‘shadow banking.'” He opined further that as regulatory stringency is strengthened for larger banking organizations, a less demanding regime is needed “for smaller institutions whose contribution to systemic contagion would almost surely be somewhere between modest and inconsequential.”

Governor Tarullo addressed questions raised by a system-wide perspective on financial regulation. He stated that it would be useful to distinguish three possible targets of regulation: (i) financial institutions; (ii) financial business models; and (iii) financial transactions. He noted that this “taxonomy” would categorize regulation as targeted at a specific institution when it applies because of the particular characteristics of that institution, not simply because of its business model (or models). For example, “a transaction-based requirement . . . would be binding on anyone involved in such a transaction (with perhaps some de minimis exceptions), regardless of their status as a particular kind of financial intermediary.”

Further, he discussed the scope and allocation of government authority for financial regulation under the Dodd-Frank Act, which created the Financial Stability Oversight Council. To consider whether this “new configuration of authorities” proves optimal over time, he suggested looking at “factors of efficacy, expertise, and excessive concentrations of authority.”

Governor Tarullo stated that further academic examination would be helpful on:

  • measures and standards for evaluating systemic risk;
  • corporate governance in a prudentially regulated institution;
  • oversight of regulatory agencies;
  • the implications of technological innovation for financial services regulation; and
  • the organization of the international system for financial regulation.

Governor Tarullo urged academics to emphasize “the liability side of the balance sheets of financial institutions” and liquidity and funding issues, particularly in the context of systemic risk.

Lofchie Comment: Governor Tarullo’s assertion that all types of institutions engaged in the same activity should be subject to the same regulation seems commonsensical. Upon closer consideration, however, that conclusion is less obvious. For example, should it really be the case that a bank, a broker-dealer that is not affiliated with a bank, and an unregulated hedge fund be subject to the same requirements when entering into a repurchase transaction or a swap? Banks take in large amounts of deposits that they are free to lend back and that are guaranteed by the federal government; broker-dealers hold customer cash but cannot use it in their business in the same ways that banks do; hedge funds don’t custody assets or take deposits. Further, it is considered ok if a hedge fund goes insolvent and loses its shareholders’ money; private businesses sometimes do that.  Conversely, banks have access to the Federal Reserve window for borrowing, which is not true of other types of institutions. When all of these other factors are considered, it becomes a lot less commonsensical to assume, for example, that banks and hedge funds should be subject to the same regulation on the same transaction.

Governor Tarullo believes that the Federal Reserve Board should have considerably more power. See, e.g., Governor Tarullo Delivers Speech Regarding Shadow Banking and Systemic Risk Regulation; Federal Reserve Board Governor Tarullo Calls for Regulatory Approach to “Runnable Funding.” But it seems fair to ask: how much more power, to what ends and under whose control? As to broader questions, what is the role of private decision-making in an economy managed as Governor Tarullo imagines? What is the role of international regulators in regard to U.S. financial institutions?