Experience and data are clear: The focus of regulatory reform should be on a bank’s business model, not its asset size.

Analysis of the U.S. banking industry’s financial footprint illustrates that fundamentally there are two distinct groups of banks operating in the United States: commercial banks and universal banks. Their differences are significant and should not be ignored as Congress works to recalibrate the regulatory regime.

True commercial banks, even the largest among them, confine their activities to the traditional commercial banking business model and have a dramatically smaller financial footprint. They also have, on average, 200 basis points more tangible equity capital funding their activities.

Universal banks, in addition to their sheer size, are global in reach and are highly interconnected. They engage in not only commercial banking but also investment banking and broker-dealer operations. They are the primary sellers of credit protection as reflected in their level of trading and derivatives liabilities, and they have substantial interaction with the capital markets through their fiduciary, global custody and safekeeping arrangements.

The financial footprint of universal banks illustrates that they are undoubtedly systemically important financial institutions deserving of enhanced prudential standards and oversight. The first chart here, for example, shows that universal banks have both on- and off-balance-sheet exposures that overshadow the rest of the industry. All but two of the universal banks at the top of the chart are global systemically important banks (G-SIBs). The top four each have individual footprints exceeding U.S. GDP of $18 trillion, as illustrated in the second chart.

Consider also the significant difference in the amount of trading between U.S. G-SIBs — or universal banks — and the largest commercial banks. G-SIBs have trading activities measuring 20.7% on average, while trading activities comprise only 1.3% of assets of the largest regional commercial banks. The large non-G-SIB regional commercial banks that do trade or have derivatives mainly do so to accommodate their existing loan customers or hedge their own risks, while the G-SIBs with their universal bank models are typically global market makers dealing in a cadre of financial contracts, many that are complex and opaque. Some of these G-SIBs on a standalone basis have trading activities equal to 40% or more of total assets.

Many of the Dodd-Frank Act regulations and enhanced prudential standards were rightly established to constrain the impact of universal banking on the public safety net and to address the concerns that the U.S. G-SIBs are "too big to fail" and "too complex to fail.” However, because the remaining institutions in the industry — with their simpler commercial bank business model — hold significantly less than 10% of their assets in trading activities and maintain tangible capital of approximately 8%, they are less of a systemic threat to the economy.

As I’ve long advocated, regulation should focus on the business model rather than arbitrary asset-size thresholds, and the distinct differences between commercial and universal banks, as illustrated by their financial footprint, call for such an approach.

To this end, the effort to adjust the regulatory reach of Dodd-Frank should include extending relief to regional banks that are principally engaged in traditional commercial banking activities. This can be done effectively by applying criteria that measure a bank’s engagement in activities outside the commercial bank business model, for example, the degree to which a bank engages in trading, its designation as a G-SIB, and the level of tangible equity it relies on to fund its balance sheet. As a backstop, the primary regulator could also have authority to designate a firm as a universal bank in the case it has expanded into noncommercial bank activities to such a degree that there is a need to address systemic risk concerns. If a commercial bank chooses to change its business model and adopt a universal bank profile, this would be identified through a clear change in trading activities and a change in the distribution of assets, both on and off the balance sheet, which are publicly reported.

A principle advantage of this activities-based approach is that it would eliminate the need for the asset-size thresholds. Regulatory requirements that are determined by size rather than activity have the effect of further encouraging consolidation and pressuring the larger regional commercial banks to adopt the universal bank model as they seek to most efficiently absorb related supervisory costs. Even if the current thresholds are raised as part of the regulatory reform effort, they will quickly become obsolete and this trend will continue.

Commercial banks and universal banks are different, and they should be regulated differently. Failing to provide regulatory relief to institutions desiring to maintain the commercial banking model jeopardizes the decentralized and competitive commercial banking system in the United States. This could have a deleterious long-term impact on the broader and regional economies, Main Street lending and the financial safety net. For these reasons the focus of regulatory reform should be on the business model, and not on asset size, so that both community and regional commercial banks are freer to compete.

Thomas M. Hoenig

Thomas M. Hoenig

Thomas M. Hoenig is vice chairman of the Federal Deposit Insurance Corp. He formerly was president of the Federal Reserve Bank of Kansas City and a member of the Federal Open Market Committee.

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