A Two-Tiered System of Regulation is Needed to Preserve the Viability of Community Banks and Reduce the Risks of Megabanks

123 Pages Posted: 5 Nov 2014 Last revised: 15 Jul 2015

See all articles by Arthur E. Wilmarth

Arthur E. Wilmarth

George Washington University Law School

Date Written: January 15, 2015


The financial crisis of 2007-2009 and its aftermath have accelerated a consolidation trend that has transformed the U.S. banking system during the past three decades. During that period, the number of community banks and their share of the banking industry’s assets have fallen by more than half, while the largest banks have captured much of the industry’s assets. In responding to the financial crisis, the federal government encouraged further consolidation by adopting extraordinary assistance programs and forbearance measures designed to ensure the survival of the biggest institutions. In contrast, federal officials gave little help to community banks and subjected them to strict supervision and enforcement policies. Federal regulators allowed only one large depository institution (Washington Mutual) to fail, but they stood by while more than 450 community banks failed between 2008 and 2012. Similarly, the Federal Reserve’s monetary policy since the outbreak of the crisis benefited megabanks while suppressing the earnings of community banks.

In addition to the fact that community banks received very limited assistance during the financial crisis, they must now comply with costly new regulatory burdens imposed by the Dodd-Frank Act. These developments threaten the viability of community banks, which provide essential services to small businesses, consumers and local economies. At the same time, Dodd-Frank does not provide an adequate solution to the growing risks posed by megabanks to our national and global economies. Dodd-Frank has not ended the “too big to fail” (TBTF) status of megabanks. In addition, big banks and their political allies have succeeded in weakening the implementation of even the relatively mild reforms called for by Dodd-Frank.

A new two-tiered system of regulation is urgently needed to correct the perverse effects of our current regulatory regime. My proposal would reduce regulatory burdens on community banks and encourage them to maintain their traditional business model of relationship-based intermediation. My proposal would also seek to remove the TBTF subsidy for megabanks and other systemically important financial institutions (SIFIs). SIFIs would be required to conduct their deposit-taking activities within “narrow banks,” which would be barred from transferring their safety net subsidies to nonbank affiliates. SIFIs would also be required to pay risk-based premiums to pre-fund the Orderly Liquidation Fund, in order to shield taxpayers from the future costs of resolving failed SIFIs.

By removing the TBTF subsidy, my proposal would enable financial markets and regulators to exercise more effective discipline over our largest financial institutions. In addition, SIFIs would be obliged to pay at least half of their compensation for senior executives and key employees in the form of contingent convertible debt (CoCos). CoCos would help to align the personal incentives of executives and other key employees of SIFIs with the interests of creditors, the FDIC and taxpayers.

My proposed two-tiered system of regulation would help to restore a more balanced, diverse and resilient banking industry. Community banks have compiled a superior record of meeting the needs of their customers while maintaining a stable business model that serves the longer-term interests of their stakeholders and communities. In contrast, megabanks have shown a strong and persistent tendency to pursue short-term, high-risk strategies that produce boom-and-bust cycles and impose tremendous costs on our economy and taxpayers. If the TBTF subsidy for megabanks were removed, those banks would have strong incentives to spin off risky activities and adopt more conservative and transparent business policies.

Keywords: bailouts, community banks, contingent convertible debt, Dodd-Frank Act, financial conglomerates, Orderly Liquidation Authority, relationship lending, systemically important financial institutions, tiered regulation, too big to fail, universal banks

JEL Classification: E44, E53, E58, G18, G20, G21, G24, G28, K20, K23

Suggested Citation

Wilmarth, Arthur E., A Two-Tiered System of Regulation is Needed to Preserve the Viability of Community Banks and Reduce the Risks of Megabanks (January 15, 2015). 2015 Michigan State Law Review, pp. 249-370, , GWU Law School Public Law Research Paper No. 2014-53, GWU Legal Studies Research Paper No. 2014-53, Available at SSRN: https://ssrn.com/abstract=2518690

Arthur E. Wilmarth (Contact Author)

George Washington University Law School ( email )

2000 H Street, N.W.
Washington, DC 20052
United States

HOME PAGE: http://https://www.law.gwu.edu/arthur-e-wilmarth-jr

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