As his eight year-long service to the country as a Governor on the Federal Reserve Board ends, Dan Tarullo gave a very important speech at Princeton University, offering a compelling and nuanced defense of critically important financial rules that are essential to protect America’s families, workers, savers and businesses. He also thoughtfully reviewed the key elements of the capital regime and stress test process that has been put in place since the crash, including some suggestions for thinking about modifications that might make sense in light of experienced and changed circumstances. Notably, he also directly rebutted what he politely referred to “as some ill-advised ideas circulating in current policy discussions.” Truthfully, he could have spoken for hours on the many, many “ill-advised ideas circulating in current policy discussions” and, although we wish he did, it would have substantially delayed his departure.
In stark contrast to so much cant and unsupported self-interested and/or ideological claims, Gov. Tarullo once again provided his views free of politics, spin and ideology. Instead, he based his remarks and analysis on facts, data and experience guided by one simple standard: what would most likely strengthen the stability of a financial system so that it supports durable economic growth and the lives and dreams of America’s families.
In an era where so many from the Oval Office and Congress to Wall Street and K Street have convenient and selective amnesia of recent history, Gov. Tarullo appropriately begins his remarks by recalling the dark and dire circumstances confronting policy makers and regulators during the financial crash. As proven time and again by a mountain of objective and indisputable data, he reminds us that the crash caused the worst economy since the Great Depression. The damage it caused is going to cost the US alone more than $20 trillion, which is more than $170,000 for every woman, man and child alive today in the country. And, of course, those numbers, however large, can never reflect the catastrophic human suffering caused by tens of millions of Americans thrown out of their jobs and homes.
He also reviewed the most consequential policy choices confronting legislators in 2009-2010: how to deal with the handful of largest, most complex, interconnected, leveraged and dangerous financial firms that were at the center of causing and spreading the financial crash and which required historically large taxpayer and government bailouts (referred to in shorthand as the “too big to fail” problem). One option was to structurally break up those firms, ensuring that none were too big to fail, or to enact new regulations/or tighten existing regulations of the practices and activities of those gigantic institutions to tame the problem.
Of course, we now all know that policy makers decided not to break up the banks and to enact a sweeping and comprehensive legislative overhaul of how too big to fail financial firms are regulated: the Dodd-Frank Act. He notes that, given this choice, “it is not surprising” that implementation of the law has been a major undertaking, that financial firms and others have sometimes felt overwhelmed and that there has been some overlap in regulations. He could have added that, of course, there were going to be substantial costs, that industry was going to fight like crazy for loopholes and that some of it was going to be frustrating to all as some of it inevitably would be learn-as-you-go.
But, his most important statement – forgotten or willfully denied by industry titans – should be repeated by everyone involved in this ongoing undertaking:
“This [‘not surprising’] outcome was, in effect, the price of the largest banks not being subject to direct structural solutions such as breakup.”
This is, also unsurprising, entirely missing from the endless complaining by the industry and its allies. They simply ignore their near-death experiences: first when the generosity of taxpayers bailed them out and prevented the bankruptcy of their firms and the wholesale destruction of their wealth (not to mention reputations, etc.) and, second, when their lawyers, lobbyists and political allies stopped the legislative movement to break them up post-crash. (They are almost certainly not likely to be so lucky next time. Hard not to see direct breakups for the firms and prison sentences for the executives after the next crash.)
Another key observation (albeit couched in typical Fed-speak understatement) that is objectively true, but repeatedly ignored or misleadingly spun by the industry (as we have also noted recently):
“Given the healthy increases in lending over the last several years and the record levels of commercial bank profits recorded in 2016, it would seem a substantial overreach to claim that the new regulatory system is broadly hamstringing either the banking industry or the economy.”
While Gov. Tarullo’s extensive remarks on capital regulation should be read with care, the frame for thinking about that should be this:
“A recent study … concludes that the tier 1 capital requirement that best [balances the benefits associated with reduced risk of financial crisis with the costs of banks funding with capital rather than debt] is somewhere between 13 percent and 26 percent …. By this assessment, current requirements for the largest US firms are toward the lower end of this range ….”
As we have pointed out in the past, prior Fed, FSB and other studies have indicated that the US capital hole created during the 2008 financial crash was around 20% and that was only after the trillions of dollars of federal government and taxpayers’ bailouts and rescue programs. That suggests that 20% capital should be the minimum required, almost precisely the midpoint of the newest study.
Gov. Tarullo’s related primary conclusion is indisputable:
“As proposals for regulatory change swirl about, it is crucial that the strong capital regime be maintained, especially as it applies to the most systemically important banks. Neither regulators nor legislators should agree to changes that would effectively weaken that regime, whether directly or indirectly. It would be tragic if the lessons of the financial crisis were forgotten so quickly.”
We will not review here Gov. Tarullo’s thoughts on how current financial regulations might be changed or modified other than to note he discusses the Volcker Rule, stress tests, Glass Steagall and numerous aspects of the capital regime. While we don’t agree with all of his observations and thoughts, they are all learned, nuanced, thought-provoking and experience-based, and merit careful consideration.
During his time at the Fed, Gov. Tarullo was at the center of virtually every US and international financial denate. When the Fed finalized its total loss absorbing capacity rule, Gov. Tarullo had been one of the forces behind it. He led the charge by the Fed to impose additional capital requirements for the largest Wall Street banks that exceed levels set by international regulators, meaning that these banks would have to set aside more cash and raise more money to withstand unexpected losses. In the early days of implementing Dodd-Frank, Gov. Tarullo was the lone voice at the Fed, urging it to set higher capital requirements and reduced leverage ratios for the big banks. Indeed, during that same period amid criticism from members of Congress that the White House appoint nominees to the Fed who would pursue financial regulation more actively, Gov. Tarullo was cited as the example it ought to follow.
In closing, we repeat here the view we stated when his retirement was announced in February:
Gov. Tarullo has been a model public servant: honorable, hardworking, totally dedicated and courageous in fighting for what is right and best to protect the American people, the financial system and our economy. The American people will forever be in his debt.