What If Size Matters Less? The Case for a New Financial Regulation Gains Ground

What if the U.S. government took the attitude that complexity — and not merely size — is what makes a bank dangerous in times of crisis? This subtle concept lies at the heart of a rare piece of legislation on financial services that’s won bipartisan support, and could relax the fraught politics of regulatory relief for smaller banks in the next Congress.

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Financial Regulation

For much of the past 6 years, Washington has cleaved the banking world into two, not-entirely-sensible halves: community banks and Wall Street. Congress and administrative agencies have also fostered this dichotomy by the definitions they’ve embraced in law and regulation.

Are you a bank with a balance sheet under $10 billion in assets? You’re a community bank. Over $50 billion? You could be the cause of the next financial crisis. Over $250 billion? You’re a behemoth, subject to all sorts of special rules.

“Our system places too many institutions in regulatory boxes that are inappropriate given their risk profiles and business models,” said Rep. Blaine Luetkemeyer, a Missouri Republican who has sponsored legislation that would introduce a new regulatory paradigm.

New Financial Regulation – Alternative Regulatory Paradigm

An alternative — in 6 years really the only alternative that’s gotten serious attention — would be to ease regulations on banks that might be larger than $10 billion or even $50 billion in assets as long as they have simple structures that could be dealt with in a crisis. Substantively, it would represent a new form of regulation, and politically, it could unlock a broader easing of bank regulations in the future, if Congress has the patience for a re-think in 2017.

“There’s value there if you can hold their attention span long enough,” said one banking lobbyist. “That’s the challenge.”

Politically, the change would represent a triumph for regional banks like SunTrust, Fifth Third and Capital One, who have struggled to avoid the stigma under which Wall Street has labored in recent years. Substantively, they would be regulated more like community banks, which largely escaped the blame for the 2008 financial crisis.

A new basis for regulating banks would start with the premise that what got the United States into a quandary in 2008, when banks were teetering on the edge of the precipice after Lehman Brothers filed for bankruptcy, wasn’t as much about size as it was about complexity.

New Financial Regulation – Bank Resolutions Work

Bank failures are something that federal agencies, notably the Federal Deposit Insurance Corporation, have lots of experience in handling. On a Friday night, they’ll announce an insolvent bank has been closed and sold — it’s happened at least 4 times this year — and customers don’t experience much more beyond a change in the letterhead on their correspondence, and on a website.

The FDIC can handle this process, known as resolution, because that company is usually a single, chartered bank operating in a few states with liabilities that are mostly customer deposits, and mostly assets that are real estate or small-business loans. (Examples in 2016: North Milwaukee State Bank of Milwaukee, Wisconsin or First CornerStone Bank of King of Prussia, Pennsylvania.) So a purchasing bank can easily understand the bank’s value, while regulators can be sure that they are fulfilling their mandate of protecting depositors.

That wasn’t the case with Lehman Brothers at all in 2008. It had at least 209 subsidiaries scattered across national boundaries, and extremely complex assets — financial instruments like derivatives, collateralized debt obligations and claims on other banks — whose value was hard to know.

New Financial Regulation – Mind-Boggling Complexity

Even if federal regulators had had the legal authority to conduct an FDIC-like resolution, a point in some dispute, it would have been hard to know where to start, especially under crisis circumstances.

In today’s banking landscape, the complexity found on Wall Street boggles the mind. JPMorgan Chase has over 3,000 subsidiaries across the world, and all manner of assets and liabilities. It’s the largest U.S. bank with about $2.4 trillion in assets, and a soup-to-nuts financial operation.

When Congress has written banking legislation, it has distinguished between these two groups of banks with numbers. With $10 billion or less in assets, a bank isn’t directly supervised by the new consumer agency it created, and pays lower dues for deposit insurance. With over $50 billion assets, banks have to go through a lengthy process with the Federal Reserve over how they would be resolved if facing insolvency.

“Not that it’s the best approach but it’s cleaner and simpler when you’re trying to advance legislation,” said Paul Merski, chief economist with the Independent Community Bankers of America, which represents smaller banks.

New Financial Regulation – Rare Bipartisan Support

The Luektemeyer bill takes a different approach. Rather than setting a hard $50 billion threshold, it directs federal regulators to consider a bank’s scope, complexity and connections in the United States and abroad before forcing it to draw up plans for insolvency or test whether it can withstand a crisis. Put simply, a bank that’s simple in structure and operation, would get a pass.

The bill is a rarity for a political reason as well. At least 20 Democrats have signed on as co-sponsors, something that’s never happened on such a substantive piece of financial regulatory legislation since Dodd-Frank was passed in 2010.

In the heat of a presidential campaign, simplicity tends to triumph, and that’s the case with Democratic presidential nominee Hillary Clinton, who’s echoed the traditional approach in her policy propositions.

Clinton has pitched plans to “reduce unnecessary regulation” on smaller community banks and credit unions, while taking aim at “big Wall Street banks.”

This dichotomy — and the whole approach of Congress and the regulators — leaves out large but less controversial regional institutions like PNC, SunTrust or Fifth Third, which don’t fall neatly into either category. Fifth Third, for example, a Cincinnati-based bank, has about $142 billion in assets, but about 95 percent of its business is done under two bank charters.

New Financial Regulation – Holistic Threat Assessment

Matt Well, a spokesman for the Regional Bank Coalition, explained the case in military terms:

“If the Pentagon were to conduct a threat assessment to determine risks posed by foreign countries, they would likely take a holistic view that considers factors – such as size of a country’s army, whether it has nuclear or biological weapons, the disposition of its government and so forth, rather than simply looking at the landmass of the country alone,” Well said in an email. “Using an arbitrary asset threshold as the sole means to evaluate risk would be akin to the Pentagon determining Canada is a bigger threat to the U.S. than North Korea.”

Marcus Stanley, policy director for Americans for Financial Reform, an umbrella group for consumer advocates, labor unions and civil rights organizations, argued that it’s misleading to suggest the $50 billion threshold is a great burden.

Banks above this number face oversight from the Fed that is “pretty sensitive to the complexity of your operations and your model,” he said. In short, even though they both have assets above $50 billion, regulators don’t treat JPMorgan and Fifth Third the same way.

“If you move this threshold, it

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