Use Tiered Regulation to Preserve Small Banks, Keep Big Ones in Line

As the Dodd-Frank Act approaches its fifth anniversary, it is increasingly clear that the statute will not solve the "too big to fail" problem created by megabanks. The four biggest banks have grown rapidly since the mid-1980s and now control almost half of the industry's assets. Meanwhile, the number of community banks has fallen by more than half since the mid-1980s, and they currently hold less than a fifth of the banking industry's assets.

During the most recent financial crisis, the federal government encouraged consolidation in the banking industry by providing massive amounts of financial assistance and regulatory forbearance to the largest banks. By contrast, federal officials gave little help to community banks and subjected them to strict supervision and enforcement policies. Federal regulators allowed only one large depository institution (Washington Mutual) to fail. But they stood by while more than 500 community banks failed after 2007.

In the debates over Dodd-Frank, Wall Street and its allies on Capitol Hill defeated proposals that would have required megabanks to break up or to pay risk-based premiums to prefund the Orderly Liquidation Fund. Since the statute's passage, Wall Street and its allies have succeeded in repealing, blocking or undermining a number of Dodd-Frank reforms.

Meanwhile, community banks must comply with costly new regulatory burdens imposed by the landmark 2010 law, especially with respect to mortgage lending. All of these developments threaten the viability of community banks, which provide essential services to small businesses, consumers and local economies. As the community banking sector shrinks, our economy continues to struggle, since many small businesses cannot obtain the credit they need to sustain and expand their operations.

There is a clear solution to the foregoing problems.  Congress should establish a new two-tiered system of banking regulation to correct the perverse effects of our current regime.  A two-tiered system would encourage community banks and smaller regional banks to maintain their relationship-based business model.  It would also reduce the risks posed by megabanks to our financial system and national economy

Under my proposal, first-tier "relationship" banks would continue to accept deposits, make loans, exercise fiduciary powers and engage in other closely related activities. First-tier banks would retain their current supervisory arrangements and would also keep their existing deposit insurance. Congress and regulators would reduce compliance burdens on first-tier banks in order to accommodate their proven business model of providing personalized customer service and relationship loans.

First-tier relationship banks would also be allowed to offer investment and insurance products as agents. But they would be barred from affiliating with companies that engage in securities underwriting or dealing, insurance underwriting or derivatives dealing. First-tier banks could buy derivatives only for bona fide hedging purposes.

The second tier of "nontraditional" banking organizations (including megabanks and other financial conglomerates) could continue to engage in securities, derivatives, insurance and other capital markets activities through nonbank subsidiaries. However, second-tier conglomerates would be prohibited from making private-equity investments or dealing in physical commodities. Those activities create unacceptable risks to our financial system and also threaten to expand the federal safety net to embrace speculative commercial ventures that are far removed from the business of banking.

Second-tier conglomerates would be required to conduct their deposit-taking activities within "narrow banks." Narrow banks could offer FDIC-insured deposit accounts, but they could not accept uninsured deposits. The assets of narrow banks would be limited to cash and highly marketable, short-term debt securities. As a practical matter, narrow banks would operate as FDIC-insured money market mutual funds.

Narrow banks would be prohibited from making loans or other transfers of funds to their affiliates, except for the payment of lawful dividends to their parent holding companies. Narrow banks would also be prohibited from buying or selling derivatives, except for the purpose of hedging their own risks.

The foregoing restrictions would prevent financial conglomerates from using FDIC-insured deposits to subsidize their capital markets activities. Instead, conglomerates would be expected to finance their capital markets activities through market-based sources, in keeping with established principles of market discipline.

To further reduce TBTF subsidies, second-tier megabanks and other systemically important financial institutions designated under Title I of Dodd-Frank should pay risk-based premiums to prefund the Orderly Liquidation Fund. A prefunded liquidation fund would force megabanks and other SIFIs to internalize the systemic risks created by their complex and far-flung activities. It would also help to protect the FDIC and taxpayers from suffering losses when SIFIs fail.

Second-tier megabanks and other SIFIs should also pay at least half of their compensation to senior executives and key employees in the form of contingent convertible bonds (CoCos), which convert into equity when a company fails. In addition, those insiders should not be allowed to sell their CoCos until several years after their employment ends.

Insiders would know that they would automatically lose the value of their CoCos if their company failed, without the need for any clawback. Significant holdings of CoCos would therefore encourage senior executives and key employees of megabanks and other SIFIs to follow prudent, long-term business strategies that would be more closely aligned with the interests of the FDIC and taxpayers.

The "narrow bank" concept is consistent with "ring-fencing" legislation recently enacted by the United Kingdom for its largest banks. If the U.S. and the U.K. establish a harmonious regulatory scheme for SIFIs, they would place significant pressure on other major financial centers — including the European Union, which is currently considering comparable legislation — to adopt a similar approach.

A two-tiered system of regulation could restore a more balanced, diverse and resilient banking industry in this country. Community banks have compiled a superior record of meeting the needs of their customers while serving the long-term interests of their stakeholders and local economies. In contrast, megabanks have shown a strong and persistent tendency to pursue short-term, speculative strategies that produce boom-and-bust cycles and impose tremendous costs on our financial system and our national economy.

By affirming the value of the relationship banking model, my proposal would promote the continued success of community banks and smaller regional banks. And by removing TBTF subsidies for megabanks and other SIFIs, my proposal would create strong incentives for megabanks to spin off risky activities and adopt more conservative and sensible business policies.

Arthur Wilmarth is a professor at George Washington University Law School. His reform proposals will be discussed at greater length in a forthcoming article in the Michigan State Law Review.