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Bullard: Reg Reform Needs to Address Nonbank Sector

The presidents of the Federal Reserve banks used to be largely seen and not heard. Not anymore. Many of the 12 are outspoken critics of the financial reform bill working its way through Congress, and James B. Bullard of the St. Louis Fed is no exception.

In an interview, Bullard said the reform effort should take better aim at lenders outside the banking system, and he isn't buying the argument that the country needs large banks to finance companies with global operations.

Bullard joined the St. Louis Fed in 1990 and was deputy director of research for monetary analysis when he took over from William Poole as president two years ago.

You've said the regulatory reform legislation doesn't do enough to rein in the shadow banking system. Which companies are you talking about? Aren't most large financial firms bank holding companies now?
JAMES B. BULLARD: It's true that during the crisis some previously nonbanks converted over to bank holding companies. Even for those I think only a small fraction of their business is actually what we would call traditional commercial banking. Plus you have big insurers and you've got hybrid institutions like GE Capital and others. During the crisis, these institutions turned out to be susceptible to run-like phenomena and that created a lot of problems for the economy, and I am not really seeing us addressing that.

What is the solution?
BULLARD: I am not sure I have a great solution to it, but I wish people would be thinking about it more than they are. … There is one major change that we could make that makes a lot of sense and would help a lot, which is to change the tax code in a way that discourages short-term debt finance if you think short-term debt finance is what's really causing all these problems.

Are you really saying the regulatory reform bill doesn't address the interconnectedness of financial firms, how dependent they are on each other?
BULLARD: I know that has been a concern of some people, but I haven't really seen that borne out by data or even theories.

You need convincing after Lehman Brothers?
BULLARD: Bear Stearns was No. 47 on the list of S&P 500 financial firms at the beginning of the crisis, and as soon as you did something for Bear Stearns, that meant everyone on the list above Bear Stearns was evidently considered "too big to fail." … People will just say casually that there is too much interconnectedness, but what is it exactly and what kind of metrics do we have on that kind of thing and how does that work in some kind of coherent framework where you could trace it out and see how it worked?

What is your position on the Volcker Rule?
BULLARD: I think it makes sense to put some restrictions on the activities of institutions that are accepting government assistance in the form of deposit insurance. … I think it makes sense to put some limits on the types of risk that they can take. I think it's not so easy to see how that is actually going to work in practice, but it does make some sense if you are going to accept deposit insurance.

The bill would create a systemic-risk council, but you've said lawmakers aren't going far enough to ensure that the council takes action when risks to the system are spotted. What should Congress do?
BULLARD: If the systemic-risk council had existed in the past I think it's unlikely that it would have actually taken any action to mitigate the risks that might have been on the horizon, and I haven't seen very much in the legislation that is going to guarantee action. The reason you have an institution that's like the Federal Reserve that is quasi-independent is to take what might appear to be unpopular actions in the short term because you get better long-run policy. That's kind of what raising interest rates is like. It's that kind of decision. And so the systemic-risk decision would be something similar. You see excesses developing somewhere in the economy and you want to take action.

But policymakers saw the housing bubble and did nothing about it.
BULLARD: You need to give this decision to a quasi-independent body that is a step away from the political situation so they have enough independence and enough cover to be able to make that decision in the name of better long-run policy even though it won't be popular in the short run.

Should that body be the Fed?
BULLARD: That's exactly what the Federal Reserve does. It takes away the punch bowl just as the party gets going. But if you didn't want it to be the Federal Reserve then you need to create some other entity that has that kind of status.

Do you think the largest institutions should be broken up?
BULLARD: A lot of these institutions look like they are probably too big to manage. And even from their own perspective, they would probably benefit from being smaller.

But don't the global companies based in the U.S. need banks with global reach?
BULLARD: I don't buy that. I think you can put deals together with smaller institutions.

Will the regulations spurred by the reform bill make it tough to make a profit as a bank?
BULLARD: If you load up the banking sector with a lot of new regulations you will push a lot of activity out to the nonbank sector. That is exactly what has been going on over the last couple of decades. It's really what got us into trouble. I am very concerned that we are just going down the same path again. You have non-deposit-taking institutions that are inventing new ways to take new risks and stepping just one step outside the regulatory structure, and these new institutions then will come back to haunt us.

If you are Chris Dodd writing this bill, how do you prevent that from happening?
BULLARD: You have to think in terms of regulating the financial landscape, not in terms of how I am going to regulate my local bank. I am not sure there has been enough thinking in that direction during this whole process.

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