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Dallas Fed Advocates ‘Back-to-Basics’ for Banking Industry

Market Discipline Needed, Says Dallas Fed Special Report
For immediate release: January 17, 2013

DALLAS—A “back-to-basics” approach to banking that restores market discipline and allows the largest financial institutions to fail could help the nation realize financial stability, according to a special report from the Federal Reserve Bank of Dallas.

“Financial Stability: Traditional Banks Pave the Way” features a series of five essays by Dallas Fed financial experts focused on rethinking America’s banking system.

In an introductory letter, Dallas Fed president and CEO Richard W. Fisher says the “old and familiar virtues of traditional banking” may be key for a stable financial system in the United States.

“Financial stability rests on a level playing field that rewards sound judgment and integrity and penalizes excessive risk and complexity financed by taxpayer dollars,” Fisher writes.

In “Community Banks Withstand the Storm,” by Jeffery W. Gunther and Kelly Klemme, the authors find community banks—those with assets of $10 billion or less—weathered the financial crisis with relatively high loan quality compared with larger financial institutions.

“Locally owned banks establish long-term ties with businesses in their communities,” the authors state. “When making lending decisions, community banks tap direct knowledge of customers, going beyond the credit scores, financial statements or other quantitative assessments on which their larger competitors depend.”

In “A Lender for Tough Times,” Gunther and Klemme find community banks also provide a vital source of credit to small businesses, even during periods of turmoil such as the recent recession.

Community banks held less than 20 percent of U.S. banking assets as of June 30, 2012, but accounted for more than half of small business loans, according to the authors. From mid-2008 to 2010, a period of severe economic hardship, business lending from community banks held up relative to 2007 levels, while the biggest banks significantly reduced business lending.

In “Small Banks Squeezed,” Gunther and Klemme explain how community banks are struggling to maintain market share, partly because of financial-crisis policies benefiting too-big-to-fail (TBTF) banks and overregulation.

Massive public interventions during the crisis kept troubled TBTF financial institutions open, impeding redistribution of market share to smaller, healthier banks, the authors note. In addition, new regulations risk a “one-size-fits-all” approach.

In “Regulatory Burden Rising,” Christoffer Koch says that small banks—which have faced mounting regulatory complexity over the years—encounter new hurdles under provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act.

A community bank’s knowledge of a business, once sufficient for a loan, now may not satisfy regulators, Koch says. Also, new provisions relating to residential mortgages may be overly burdensome, even preventing community banks from using their knowledge of local real-estate markets.

“The country would be better served by a regulatory framework that more fully accounts for the operational differences between small and large banks,” Koch writes.

In “Leveling the Playing Field,” Harvey Rosenblum says market discipline must be returned to the banking industry.

The financial safety net—including Federal Deposit Insurance Corp. deposit insurance and access to the Fed’s lending facilities—should cover only those activities essential to commercial banks and their role in the payments system, Rosenblum argues.

“With a limited and proper safety net, some of the artificial advantages of size will fade and market discipline will reassert itself,” Rosenblum says. “Market discipline and its positive incentives could help reduce the size of the biggest banks by penalizing excessive risk taking and mind-numbing complexity.”

Still, market discipline could take too long to reduce the size of the biggest banks, and policy interventions, including a cap on bank size, might be needed to reach the point where large banks can fail without endangering the economy, Rosenblum states.

“TBTF banks pose a clear and present danger,” he 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.”

Gunther is vice president and Klemme is a financial industry analyst in the bank’s Financial Industry Studies Department. Koch is a research economist in the Research Department. Rosenblum is executive vice president and director of research.


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Alexander Johnson
Phone: (214) 922-5288