Now Fed governor Dan Tarullo thinks Congress should move to limit banks’ size by mandating a cap on their non-deposit liabilities. This is from a speech he gave on the topic in Philadelphia last week:

In addition to the virtue of simplicity, [capping non-deposit liabs.] has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm's dependence on funding from sources other than the stable base of deposits. 

Brilliant. Put aside for a moment the fact that the size and complexity of big banks, which addles Tarullo so, had nothing to do with causing the financial crisis. It wasn’t proprietary trading, or derivatives, or quant models that caused the problems. It was credit: too many lenders wrote too many sub-prime mortgages to the wrong people; once the tidal wave of defaults began, the whole system came crashing down. It’s that simple. If, prior to the crisis, the banking system consisted of many more of the smaller banks Tarullo prefers and fewer of the big ones he doesn’t, the crackup would have happened anyway. Tarullo’s proposal would have prevented precisely nothing.

What’s more, this notion he has of “tying the limitation on growth of financial firms to the growth of the national economy” would have a serious, and negative, macro effect. Credit creation—which is what financial firms do—drives economic growth, not the other way around. So if the government decides to artificially slow the growth in financial firms by enacting measures like the one Tarullo has in mind, it will also artificially slow growth in GDP. It’s not immediately clear why that would be a good idea. 

But I have a broader question. How is it that Dan Tarullo, a single Fed governor, is out on his own putting forth legislative proposals for how big banks should be regulated? The entire Fed is tasked with bank supervision, remember—not just those governors who decide to take an interest in the topic. That means that the entire Fed, especially including Chairman Bernanke, should develop a formal policy and proposals regarding how big banks should be. Reasonable people—and reasonable Fed governors—can have an honest debate on what those policy proposals should be. (Tarullo sure isn’t the only Fed governor pushing for size limits, by the way.) And if the Fed isn’t interested in carrying out its supervision mandate, the structure of bank regulation ought to be revised to get the Fed out of the supervision business. But this middle ground of a few governors free-lancing their own proposals isn’t helpful. If Congress is going legislate based on input from the Fed, it ought to act based on what the Fed as a whole has to say. In the meantime, one-off proposals by individual governors are distractions that don’t necessarily add a lot of value.  

What do you think? Let me know!