Fed Governor Offers a Way to Limit Bank Size

Since the financial crisis, academics, politicians and even former bank chieftains have called for the nation's banking behemoths to be broken up or shrunk - calls that appear to have fallen largely on deaf ears among Washington's policy makers.

Now, a powerful insider has suggested a simple tool that could place a tight limit on the size of individual banks. Daniel K. Tarullo, a Federal Reserve governor who oversees bank regulation, said in a speech last week that an important part of a bank's balance sheet could be capped at a set percentage of the nation's gross domestic product.

That a regulator at the Fed - the most powerful of the banking industry's overseers - would say that such a structural overhaul of the financial system might be considered, was a sign that the policy debate over what to do about “too big to fail” might be shifting.

Mr. Tarullo's “statements mark a significant - perhaps even dramatic - shift in thinking at the central ban k,” Simon Johnson wrote in a recent column for Bloomberg News. Mr. Johnson, a professor at the Massachusetts Institute of Technology, has been a leading voice in the movement to limit the size of large banks.

It's not just that the Fed governor's words provided comfort to supporters of breaking up the banks. They also come at a moment in the debate over the Dodd-Frank Act, when both Republicans and Democrats might be able find common ground.

Mitt Romney and other Republicans have criticized Dodd-Frank, contending that it is overly complex and protects “too big to fail” institutions. Some Republicans looking to repeal Dodd-Frank say they still want to constrain large banks. Their concern is that the law may lead the market to believe that the government protects large banks. In turn, investors might then provide cheap loans to the biggest banks, fueling even more growth in the banks' balance sheets. As a result, some Republicans may warm to the simple cap o n bank size outlined in Mr. Tarullo's speech.

“I am completely open to the proposal because of my similar concern about the growing size of institutions that are too big to fail,” said Senator David Vitter, a Republican of Louisiana. “Beyond this specific proposal, there is a growing nonpartisan consensus to do a lot more to limit the size of the megabanks.”

Any shift at the Federal Reserve would be notable. The central bank, mindful of the stability of the financial system, has avoided giving strong backing to measures that could have a direct impact on bank size.

Mr. Tarullo did not give an unequivocal, personal backing to a cap on size of banks. But he said that if size were to become a big issue, Congress should take it up, so the effects of a cap could be debated. Mr. Tarullo then detailed a type of cap that he said seemed to have “the most promise.”

His proposed limit would focus on something called “nondeposit liabilities.” Thes e are the borrowings that banks do to finance themselves, excluding deposits.

For example, at the end of June, JPMorgan Chase had $1.24 trillion of nondeposit liabilities, a figure that excludes deposits in the United States, but includes international deposits.

That $1.24 trillion is equivalent to 8 percent of G.D.P. Any legislation would have to decide whether to set a percentage that would immediately force a bank like JPMorgan to shrink. If it were set at 5 percent, JPMorgan would have to shed the excess borrowings, which in turn would lead it to cut its overall size.

Senator Sherrod Brown, Democrat of Ohio, introduced legislation earlier this year that proposed the cap be set at 2 percent of G.D.P., which would force several of the largest banks, including Citigroup, Bank of America and Goldman Sachs, to shrink aggressively. (That bill has not advanced.)

Alternatively, the cap could be set at a percentage of G.D.P. that allows banks to stay at cl ose to their current size. In that case, it would just constrain future growth.

Dodd-Frank has a provision that sets out to limit the relative size of banks. It stipulates that banks cannot have liabilities that exceed 10 percent of the total financial system's liabilities. But this may not cap bank growth if the whole system is ballooning, as happened in the last decade. From 1999 to 2007, the Goldman Sachs balance sheet grew by 346 percent. But it would have increased by only 48 percent if its growth had been strictly tied to G.D.P. growth in that period.

The cap has its critics.

One drawback is that it might deter banks from issuing longer-term debt, which can act as a stable source of financing in a crisis. Hal S. Scott, a professor in Harvard Law School, said it would be preferable to limit short-term borrowings by banks, since that is more vulnerable to bank runs.

Others say that the economy needs both large and small banks and growth could be h armed by efforts to dictate bank size.

“The costs to society would outweigh the benefits,” said Phillip L. Swagel, a professor at the School of Public Policy at the University of Maryland. “But I realize that the idea of setting limits on large banks is gaining popularity across the political spectrum.”

Others fear that an inordinate focus on one tool to deal with financial stability could backfire. They think that the multifaceted approach of Dodd-Frank is better at catching and moderating the risks in the banking system.

“I think it's a mistake to think there's some sort of silver bullet here,” said Michael S. Barr, professor at the University of Michigan Law School. Mr. Barr worked on Dodd-Frank as an assistant secretary at the Treasury Department. He also says he thinks that going back right now and undoing parts of Dodd-Frank would most likely only dilute the overhaul.

“If Congress took up reform, it would only be in the direction o f weakening it, not strengthening it,” he said.