One-size-fits-all bank regulation is really one-size-fits-none

As The Hill has reported Wednesday, the Federal Reserve released a framework for matching the regulation of 29 large banking companies with their individual risk profiles.

The Fed will accept public comments on this complex, 124-page proposal until Jan. 22.

Perhaps given that the release occurred on Halloween, the Fed’s proposal generated frightening talk about the risks this regulatory initiative poses to the safety of large banks and the overall financial system, as well as the health of the entire economy.

Fed Governor Lael Brainard, an Obama appointee, voted against the proposal, arguing “it went beyond Congress’s intent and exposed the financial system to unnecessary risk.”

Dennis Kelleher, president of the pro-reform group Better Markets, asserted that “deregulating some of the largest banks in the country will make the financial system less safe, less stable and less protected from another crash.”

A more insightful comment, though, came from Greg Baer, head of the Bank Policy Institute, when he stated that the proposed regulatory framework “does not do enough to tailor regulations based on banks’ risk profiles.”

Baer’s criticism reflects the fundamental challenge, and problem, of banking regulation: No matter how much Congress and the regulators attempt to refine banking regulation and tailor it to reflect the ever-changing risk profiles of individual banks, banking regulation still reflects the one-size-must-fit-all characteristic of all regulations.

Worse, complex financial regulations often have unintended consequences when individual regulations work at cross-purposes, while bank managements try to game the regulations to purse specific business strategies and profit objectives.

An appendix to the proposal graphically illustrates the challenge of regulating large, complex financial institutions. Each of the 29 companies pursues its own business strategy within a unique geographical footprint, but the banks are slotted into one of five regulatory buckets, based primarily on total assets. One company, Northern Trust, even gets its own bucket!

Anyone at all familiar with the eight largest companies classified as global systemically important bank holding companies (GSIBs) understands the extent to which they differ from each other in myriad ways.  Consequently, the regulatory mechanisms needed to keep each company operating in a safe manner must be tailored to that company. In other words, one size fits none well.