WASHINGTON — Federal Reserve Board Gov. Jeremy Stein said Wednesday regulators should continue to implement current regulatory reform efforts designed to eliminate "too big to fail," but take further steps to strengthen capital requirements if needed.
"While I agree we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions," Stein said at a speech at the International Monetary Fund's annual Spring Meeting.
Stein joined the chorus of regulators who have been weighing in on the public debate over whether "too big to fail" has been eliminated under the Dodd-Frank Act, but disagreed with those who argue that the current path is not working.
"We've made considerable progress with respect to SIFIs[systemically important financial institutions] since the financial crisis," said Stein. "And we're not yet at a point where we should be satisfied."
Fed officials, including Chairman Ben Bernanke, have pointed to higher capital requirements, new liquidity rules, stress testing and resolution authority as tools that will help to reduce the possibility of a failure by a systemically important financial institution.
Critics of the regulatory reform law have suggested different approaches to tackle "too big to fail" such as a size cap for individual banks or a return to Glass Steagall, a Depression-era law that separates commercial and investment banking.
But Stein ruled out those ideas.
Rather, he noted there were two areas worth considering. The first is a gradual increase in the proposed capital surcharge applied to the largest globally active banks over time while the second is a requirement that holding companies maintain a substantial amount of senior debt to facilitate a resolution under Dodd-Frank.
Stein said that recent changes to capital regulation could serve as informative experiment for regulators. For example, the proposed surcharges on the globally systemically important banks, which range from 1% to 2.5%, could potentially serve as a starting point.
If, after some time, the surcharges do little to change the size and complexity of the largest banks, it could be concluded that the "implicit tax was too small, and should be ratcheted up," he said.
"In principle, this turning-up-the-dials approach feels to me like the right way to go: It retains the flexibility that makes price-based regulation attractive, while mitigating the risk that the implicit tax rate will be set too low," said Stein. "Of course, I recognize that its gradualist nature presents practical challenges, not least of which is sustaining a level of regulatory commitment and resolve sufficient to keep the dials turning so long as this is the right thing to do."
Increasing capital requirements — as opposed to placing a size cap on the megabanks — creates an incentive for banks to shrink, but also gives them the opportunity to "balance this incentive against the scale benefits that they realize by staying big," said Stein.
"Price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decisions on their own understanding of the synergies — or lack thereof — in their respective businesses," said Stein.
He also agreed with Fed Gov. Jerome Powell's endorsement of the Federal Deposit Insurance Corp.'s so-called "single point of entry" approach to resolution as a promising one.
"The Federal Reserve continues to work with the FDIC on the many difficult implementation challenges that remain, but I believe this approach gets the first-order economics right and ultimately has a good chance to be effective," said Stein.
Separately, Stein emphasized the potential role corporate governance can play in addressing the "too big to fail" problem.
Even if regulators are able to do everything right with capital regulation, management will still need to be required — at some point in the future — to selectively shed assets.
A number of studies, he said, have shown how difficult it is for managers to voluntarily downsize their firms, even when the market is sending a clear signal that downsizing would be in the interest of shareholders.
"Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board," said Stein. "As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy."