The Mission Regulators Forgot: Ending TBTF

Former presidential wannabe Mitt Romney may not have made banking reform the centerpiece of his 2012 campaign, but in one shining moment he did utter a profound piece of wisdom. During Romney's first debate with President Obama, he scored a technical knockout by saying that the Dodd-Frank Act was "the biggest kiss that's being given to New York banks." Romney was referring, of course, to the giant subsidy that continues to flow to Wall Street banks, notwithstanding the monumental law.

When it comes to financial reform, no one will accuse the Obama administration of going big. His appointees at the Federal Reserve and the Treasury Department understand this andfall in line withhis timid, lead-from-behind strategy every day. And his halting approach to financial reform is embodied in the actions of the Financial Stability Oversight Council.

The singular bold stroke of the Dodd-Frank Act was the law's clear instruction to the FSOC to promote market discipline "by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the Government will shield them from losses in the event of failure" (emphasis mine).

Did the council seize this clear mandate and run with it? Hardly. Instead it has acted as if the language does not even appear in the statute.

The FSOC has repeatedly mischaracterized its own mission. For example, in its recent notice seeking comment on asset management and systemic risk, the council said its mission was merely "to promote market discipline," full stop. It completely ignored the law's instruction to promote market discipline by erasing the perception that a few elite banks are too big to fail.

Lest you think this was just an oversight, consider the FSOC's annual report for 2014. The report turns a blind eye to this vital statutory requirement and in its place lauds the FSOC's regulatory efforts to "reduce" the perception of TBTF status.

The Fed has compounded this critical error. Last week, Fed Governor DanielTarullo spoke of "countering too-big-to fail perceptions" during the Office of Financial Research and FSOC conference on macroprudential regulation. Not once did he mention the goal of eliminating those perceptions. This was consistent with his remarks in another recent speech in which he again distorted mandate of the Dodd-Frank Act by saying, "Finally, the regulatory system should aim to offset the perception of too-big-to-fail status."

"Offsetting," "countering" and "reducing" are not nearly the same thing as eliminating the perception of TBTF status. The regulators' posture is one of peaceful coexistence with TBTF, where the very thing that should be erased is dressed up to look more presentable.

The law requires the FSOC to eliminate TBTFs, not to cosset them.

It is essential that the council and the Fed come to grips with the stated statutory goal. Marginal adjustments to capital, liquidity and resolution rules are necessary. But they are insufficient to address the underlying problem and carry out the intent of the law.

Without a shred of evidence to prove his point, Tarullo told the FSOC last week that maybe, just maybe, the TBTFs that have to keep higher capital levels as punishment for their size will consider downsizing themselves voluntarily. That way, they would fall into a lower risk bucket or become TBTF no more.

This is wishful thinking on the part of Tarullo. Moreover, it prompts the question of what regulators propose to do if big banks fail to take the capital transition time to resize themselves. Is there a Plan B?

That said, Tarullo may be on to something. The problem is that both he and the FSOC are confused about whether to use the capital buffer as a tool to eliminate the TBTF problem or as a cushion to protect us against the next bank crisis. If they read the law, the choice is clear. They should force the very few truly TBTF banks to accumulate capital without an arbitrary ceiling. Instead, the biggest banks should build up capital until it hurts — that is, until they actually decide to resize. Now that would be consistent with the law!

This week, big-bank trade groups wrote to the Financial Stability Board whining about higher capital requirements. Of course, it wasn't for themselves that they were complaining. It was on behalf those unfortunates who would be denied credit because of the capital rules.

This is nonsense. The FSB, FSOC and the Fed should reject these crocodile tears and grasp their essential mission.

Who knows whether Romney would have put an end to the government's long embrace with Wall Street. It is highly unlikely that a Clinton II administration will be any bolder, populated as the Obama administration is with legions of Clinton I alumni. Perhaps one of the myriad candidates from the Grand Old Party will be bold enough to spurn Wall Street's open checkbook and pick up Mr. Romney's mantle. Or perhaps Sen. Elizabeth Warren will fight the battle — a possibility that underscores the nonpartisan nature of this issue.

This just might be a winning issue to take to the voters in 2016. After all, voters perceive quite clearly that taxpayers are on the hook as long as TBTF remains.

Cornelius Hurley is the director of the Boston University Center for Finance, Law & Policy. Follow him on Twitter at @ckhurley.