As a community banker, I do not share concerns about the impact addressing the threat of "too big to fail" financial firms once and for all will have on our industry. In fact, downsizing and restructuring these systemically dangerous institutions is essential to removing their government-subsidized competitive advantages and restoring America's free market economic system. The fact is this: Community bankers should be more worried about what will happen to our industry if we don't act.
Right now there are two entirely different banking industries and two separate levels of risk. When you look at all the facts it's easy to see that 99.4% of the industry — I'm talking about community banks here — are clearly getting the raw end of the deal simply because they aren't able to operate in a truly free market system.
Excessive concentration in the banking industry and the "too big to fail" doctrine has led directly to systemic risks that jeopardize the safety and soundness of financial institutions across the nation. When incentivized risk-taking comes back to bite "too big to fail" firms, the federal government steps in with a taxpayer-funded rescue while community banks and Main Street communities suffer the economic consequences. And, when a community bank is deemed to be no longer a concern due to the economic wreckage, regulators intervene far differently than they do on Wall Street.
The "too big to fail" advantage extends beyond taxpayer backstops when Wall Street has gotten in over its head. Federal Deposit Insurance Corp. data show that while megabanks have the lowest credit quality in the banking industry, they also have the lowest cost of funding. Meanwhile, smaller community banks have both the best credit quality and the highest cost of funds. Obviously, the heavy hand of "too big to fail" is overpowering the invisible hand of free-market forces. Ensuring that no financial institution enjoys the benefit of being deemed "too big to fail" will help ensure that community banks operate on a level, market-based playing field.
Finally, truly addressing the "too big to fail" threat will help free community banks from the oppressive regulatory environment that we face every day. Much of the overwhelming paperwork burdens and regulatory red tape we endure is due to the reckless practices and misconduct of the megabanks and their tens of thousands of shadow banking subsidiaries. While these large financial firms can afford the legal teams necessary to meet the regulatory obligations they have spawned, community banks are left to redirect resources that could be used to help their communities prosper.
For community bankers, the answer to the "too big to fail" crisis is not more regulation. Innumerable regulations have already been enacted to deal with the problem. These regulations fall disproportionately hard on community banks, yet the megabanks continue to grow and our nation's financial resources continue to consolidate. Only by actually downsizing and restructuring "too big to fail" institutions— by limiting the systemic risk created by the sheer size and interconnectedness of the institutions that put our financial system and economy at risk — can we eliminate unfair competitive advantages, unleash our free markets and allow community banks to compete in the financial landscape.
Maintaining the status quo would only result in community banks' continued subjugation by the megabanks that enjoy privileged status in Washington. For the community bankers like me who want our industry to survive and thrive, we must stand together as one to break up the "too big to fail" stranglehold and ensure a future for Main Street community banking and the communities we are privileged to serve.
Regulators are hanging their hat on risk models and stress-testing by the banks to ensure banks are not headed for trouble. Unfortunately stress-testing and models being used have never been back-tested and provide a false sense of security. One example to highlight the point is shown by Basel II capital standard being entirely ineffective in protecting banks from serious hardship during the most recent financial crisis.
Models are not shared with the industry, nor are they shared with other bank regulatory agencies. They remain a secret black box. Examination ratings remain a secret as well to all but the subject bank.
A number of empirical studies show that leverage capital to assets is the best predictor to determine whether bank will hold up during a major crisis. Also, the larger the leverage capital, the better secured is the bank which should translate to better examination ratings, and lower FDIC deposit insurance assessments.
While regulations are growing in leaps and bounds, the financial industry, which includes banks and shadow banks is outpacing regulations quite handily. Regulators, as a result, become less effective over time because they cannot keep pace with a more rapidly changing industry.
Since regulations and regulators become less effective, the only way to prevent TBTF and bank failures is to increase the capital of all banks. Due to the heightened complexity of the large banks and the additional resources (regulatory examinations, monitoring and FDIC insurance protection) large banks should be required to have higher leverage capital ratios on a graduated scale based on asset size. The higher capital, if appropriately high enough, should exert pressure for the large banks to shrink to a more reasonable size.