On Topic: Tiered Regulation

Editor's note: The following are excerpts from a speech delivered May 8 in Chicago by Federal Reserve Board Gov. Daniel Tarullo..When I was teaching banking law, I noticed an interesting disconnect in the best casebooks in the field. An introductory chapter on the history and purposes of bank regulation suggested that the rationales for regulating banks might vary depending on the size, business model, and affiliations of a bank. Yet the remaining chapters of the casebooks treated bank regulation as a more or less unitary endeavor — with prudential rules applicable in about the same way to the activities and affiliations of all banking organizations..The reason for this disconnect was that pre-crisis regulations reflected what I have termed a unitary approach to banking regulation. The core of banking regulation could be explained with a relatively simple narrative. Deposit insurance and access to the Discount Window had been granted to depository institutions in order to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified everything from capital requirements to limitations on banks getting into nonbanking businesses..The financial crisis has confirmed that the pre-crisis regulatory structure reflected a view of the financial system that was at once too broad and too narrow. The prudential regulatory structure was too narrow in that it did not extend to firms and activities outside of banking organizations, even those that could pose a threat to financial stability..The turmoil that attended the collapse of several large nonbank financial institutions, and the extraordinary government measures necessary to contain that turmoil, changed into a consensus that prudential regulation should safeguard the financial system as a whole. This perspective was embraced by Congress in the Dodd-Frank Act..One regulatory innovation in Dodd-Frank was the creation of different categories of banking organizations — largely on the basis of total assets — to which different regulatory requirements are to apply. The Federal Reserve has created several categories for banks with $10 billion or more in assets, with $50 billion in assets, with either $250 billion in assets or $10 billion in foreign assets. Clearly, the unitary approach of the pre-crisis period has been abandoned. This is an important move in the right direction..The roughly 5,700 community banks constitute 98 percent of insured commercial banks in the United States, but hold just under 20 percent of the assets. Indeed, 90 percent of community banks are what supervisors classify as "small" community banks — those with less than $1 billion in assets. While these banks will suffer the fallout from systemic problems, they are unlikely to cause such problems..Community bankers often argue they are subject to a range of rules and requirements that are not really necessary given the relevant regulatory aim which is quite straightforward. Smaller community banks account for nearly a quarter of commercial and industrial lending, and nearly 40 percent of commercial real estate lending, to small- and medium-sized businesses. This means that the disappearance of community banks, particularly in rural areas, could augur a permanent fall off in this kind of credit..It would be worthwhile to have a policy discussion of statutes that might be amended explicitly to exclude community banks. In my view, two candidates would be the Volcker rule and the incentive compensation requirements in section 956 of Dodd-Frank. Indeed, relieving both banks and supervisors of the need to focus on formal compliance with a range of regulations less relevant to community bank practice would free them to focus on the actual problems that may exist at smaller banks.