The Exchange

Dallas Fed: Small Banks Key to Financial Stability

The Exchange

The Federal Reserve Bank of Dallas is pressing the U.S. to emphasize local banking to get traditional lending practices restored and the nation back on proper financial footing, while repeating calls for splitting apart or containing the size of "too-big-to-fail" firms.

A multipart series from the bank advocates the idea that community banks, or those with no more than $10 billion in assets, were better off in terms of loan quality than the global banking giants during the financial crisis and that they now should be encouraged to flourish rather than be encumbered by unneeded regulations.

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Dallas Fed President Richard Fisher
"Financial stability rests on a level playing field that rewards sound judgment and integrity and penalizes excessive risk and complexity financed by taxpayer dollars," Dallas Fed President Richard Fisher -- who has on more than one occasion criticized the system by which enormous financial institutions have been deemed so critical to commerce that they can't be allowed to go under -- said in prepared remarks. "Government must retain its role as the financial system's watchdog, but it should render no institution immune to market discipline."

One of the pieces in the series argues that local banks make better decisions on loans because they can truly get to know the businesses in their area. The smaller firms "tap direct knowledge of customers, going beyond the credit scores, financial statements or other quantitative assessments on which their larger competitors depend."

The series also takes aim at financial bailouts and reforms, including Dodd-Frank, saying regulations have been put in place that preserve and benefit the big banks yet make it overly difficult for smaller lenders to compete and employ the knowledge that will help their operations and their customers.

Another piece proposes that protections such as account insurance coverage and banks' access to Federal Reserve loans should apply only to financial practices that are necessary for commercial banks. In theory, the Dallas Fed says, limiting the available safety measures would lead to fixes driven by the marketplace, punishing banks if they take too much risk or become too complicated. However, this market-based approach might not happen quickly enough, meaning legislative action could be needed in some areas, such as limiting how large banks can get, the series says.

While the issue of immensity has come up repeatedly since the collapse of financials like Lehman Brothers started the banking panic in the fall of 2008, neither lawmakers nor bankers have shown an overwhelming interest in mandating a ceiling. That needs to change, the series says.

"[Too-big-to-fail] banks pose a clear and present danger," Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, writes. "They’ve grown large and dominant through favorable government policies. Leveling the playing field will give smaller institutions a fair shake and enhance financial and economic stability."

The recommendations from the Dallas Fed were published a day after Fisher gave a speech urging the break-up of too-big-to-fail banks into smaller units, an idea he's supported before, with part of the rationale being to keep them to "a size, complexity and scope that allows both regulatory and market discipline to restrain excessive risk taking."

Fisher's comments contain data showing that of the 5,600 commercial banks operating in the U.S., all but around 100 are community banks. Because of the size of these community banks, together they account for only 12% of overall assets in the system. Meanwhile, the 12 megabanks with assets of $250 billion to $2.3 trillion, names like JPMorgan Chase (JPM), Goldman Sachs (GS) and Citigroup (C), control some 69% of the assets.

The proposal to downsize the largest members of the group could be done with minor changes to the law and wouldn't require significant government involvement, Fisher contended.

"It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking," he said. "Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support."

You tell us -- should the too-big-to-fail banks be broken up? Will they be? What do you think of the proposals to emphasize community banking?

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