The Tarullo-King Gap

On Wednesday, Dan Tarullo, a governor of the Federal Reserve and distinguished law school professor, dismissed breaking up big banks as “more a provocative idea than a proposal” and instead put almost all his eggs in the “creation by Congress of a special resolution procedure for systemically important financial firms”. He stressed: “We are hopeful that Congress will, in its legislative response to the crisis, include a resolution mechanism and an extension of regulation to all systemically important financial institutions” (full speech).

This put him strikingly at odds with Mervyn King, governor of the Bank of England, who said Tuesday night, quite bluntly,

“There are those who claim that such proposals [involving breaking up the largest banks] are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”

Tarullo’s speech actually framed today’s problem just right: “I would suggest … that the reform process cannot be judged a success unless it substantially reduces systemic risk generally and, in particular, the too-big-to-fail problem.” This is consistent with the tone of King’s remarks (even if less pointed than what Neal Barofsky said).

Tarullo also made some astute comments on how “too big to fail” emerged in its current specific form in the US and threatens us in a general form always.

“First, no matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention. Second, once a government has obviously extended the reach of its safety net, moral hazard problems are compounded, as market actors may expect similarly situated firms to be rescued in the future.” ….

“The fact that the largest financial firms will account for a significantly larger share of total industry assets after the crisis than they did before can only add to the uneasiness of those worried about the too-big-to-fail phenomenon. It is notable that current law provides very little in the way of structural means to limit systemic risk and the too-big-to-fail problem.”….

“I only urge that we all keep the too-big-to-fail problem front and center as the regulatory reform effort moves forward.”

But the “resolution authority” idea the Obama administration is pushing (and Tarullo endorsed) is a theoretical construct that would have no discernible practical effect. Charles Calomiris hit that particular nail on the head Tuesday in the WSJ – in his second paragraph, he explains that bank failures are hard to handle because

“there is no orderly means for transferring control of assets and operations, including the completion of complex transactions with many counterparties perhaps in scores of countries via thousands of affiliates” (emphasis added).

The Bank of England will tell you, for example, that their experience with BCCI – a bank that was closed nearly two decades ago – pointed clearly to the need for cross-border agreement between regulators on exactly how to handle bank failure.

But talk to any dozen or so central bank officials, and they will confirm that we do not have and are not close to having such cross-border agreements. And there is no sign that the G20 has this issue in its sights.

Still, the Tarullo-King gap – which loomed so large on Wednesday – finds potential closure in the Fed’s proposed “guidance” (read: orders) on executive compensation, announced Thursday. (WSJ; FT versions).

The proposal is obviously flawed, particularly in the quaint notion that there are only 28 financial institutions that can damage the system through excessive risk-taking (has the Fed really forgotten LTCM?) And the stock market yawned deeply on the announcement – presumably believing that the Fed cannot currently organize a regulatory tightening along any dimensions.

But the proposal is actually quite brilliant and – given the logic of our politics, including Mr. Bernanke’s impending re-confirmation hearing – is likely to have real impact.

For the first time, the appropriate regulators have recognized that excessive risk-taking generates a large negative externality, i.e., a spillover that has pernicious effects on the rest of the economy, and that this can be dealt with in a reasonable manner.

Attacking compensation is not the only way (nor ultimately the likely best way) to address this externality, but it does get everyone thinking along the right lines.

And the bottom line is clear: if your financial institution is big relative to the system, you will be at a systematic disadvantage relative to the smaller firms due to the way pay is regulated; “talent” (or, if you prefer, excessive risk-takers) will move from large firms to small.

My read of the Fed’s current intentions is that they do not intend the differential tax on size to be too great, so dangerously big firms could still survive. But once Capitol Hill understands the opportunity created by these compensation rules, all things are possible – think about the transparency and accountability implications for the Fed and the banks in question.

And remember two things: the midterm elections at the end of next year still lack an obvious and appealing theme, and the big banks are completely unable to cut back voluntarily on their compensation practices, their lobbying, or their egregious public behavior and obnoxious remarks (e.g., the latest AIG example).

The Fed’s press release quotes Dan Tarullo as saying,

“In customizing the implementation of our compensation principles to the specific activities and risks of banking organizations, we advance our goal of an effective, efficient regulatory system.”

My translation: Now it gets interesting.

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