How the Federal Reserve and Congress Have Failed the Banking System

Daniel Tarullo, a member of the Board of Governors of the Federal Reserve System, admitted, although he did not say it explicitly, that the Federal Reserve and the U. S. Congress has failed the smaller banks of America.

The smaller banks of America, those whose asset size is less than $250 billion, have not been doing well since the financial collapse that came in 2007 and have found that the regulatory requirements imposed on the system by the Dodd-Frank law that re-directed the banking system, have been a burden that is hard to bear.

These banks, Tarullo stated in a speech at Yale University on Monday, "with less that $250 billion in assets that don't conduct significant nonbank or international activity would be exempt from the 'qualitative' part of the Fed's annual (stress) tests."

The banks that Tarullo is talking about include all the banks in the banking system except for a handful of banks, the "too big to fail" banks. That is, the vast majority of banks in the banking system will be excluded from certain parts of the stress tests.

The most important group of banks excluded is the roughly 20 banks that fall between $50 billion and $250 billion in asset size. They are on the edge of the "large" banks, but now will not have to undergo the expenses and effort needed to complete the full extent of the test, which are quite substantial.

Two points need to be made here. First, the Dodd-Frank bill has proven to be very expensive and, relative to their size, quite oppressive for the smaller banks. From the very beginning, the smaller banks have complained about the expense of adhering to the regulations and preparing for the examinations.

Furthermore, the smaller banks are not as complex as are the larger banks and hence do not need to be investigated with the more sophisticated models used for the larger banks.

These expenses, along with the exceedingly low interest rates that Federal Reserve policy has maintained, have put a huge burden on the performance of these smaller banks.

This leads to the second point, the actual health of the smaller banks in the United States. The Great Recession took its toll on the banking system, but most of the attention was paid to the larger banks and their need to be bailed out.

Little attention was given to the smaller banks. Even after the economic recovery began there were questions about the health of many of the smaller banks. One of the reasons for the three rounds of quantitative easing on the part of the Federal Reserve was the concern over the health of the smaller banks in the banking system.

By providing so much liquidity, the Federal Reserve kept the banking system afloat so that the Federal Deposit Insurance Corp. could smoothly eliminate the less healthy banks by combining them with healthier banks rather than just closing them.

In this the Fed and the FDIC were very successful.

How successful? Well, as I wrote in my recent blog post, "Altogether, since the beginning of the current economic recovery, the commercial banking industry has lost a net of 1,591 institutions...almost 25% of the commercial banks in operation on June 30, 2009."

Overall, "Since just before the Great Recession began, the banking system has lost 2,059 commercial banks, or 28% of the institutions in operation on June 30, 2007."

The banking system is getting smaller in terms of the number of institutions that exist within the system. That is, most of the banks leaving the system were the "smaller banks." The "community banks."

The efforts Tarullo presents in his speech are more evidence that the smaller banks must be treated differently from the larger banks. The smaller banks are facing very severe pressures to survive on many fronts and the regulators -- and Congress -- must back off if the current structure of the banking system is to survive.

Here we are again, dealing with what economists call "unintended consequences." The Federal Reserve and the government contributed to the creation of the economic environment that preceded the Great Recession and have also created the economic environment that exists within the current recovery. This includes the regulatory legislation passed by Congress.

Now, it is dealing with the consequences, and the picture is not a pretty one.

The banking system is changing. Technology is bringing more and more changes to the banking system almost daily. FinTech is on the rise. The regulatory system, as it is now exists, is not functioning well. Something must change.

The Federal Reserve, the other financial regulators, and Congress cannot re-establish the former banking system. In this they have failed, and further attempts to turn the clock backwards will only exacerbate the problem.

Rather than band-aid the system, Tarullo and others need to accept their failure and move to build the system of the future. 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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