03/30/2012 03:39 pm ET Updated May 30, 2012

The Dallas Fed and Too-Big-to-Fail

Jesse Eisinger at ProPublica, among others, has taken note of the annual report from the Dallas Federal Reserve that goes after the big banks. The title of that essay, by the Dallas Fed's head of research Harvey Rosenblum, is pretty blunt: "Choosing the Road to Prosperity: Why We Must End Too Big to Fail -- Now."

This is not a new topic at the Dallas Fed, where president Richard Fisher, a former Brown Brothers Harriman & Co. banker, U.S. Trade representative and unsuccessful Democratic candidate for the Senate from Texas, has argued for breaking up the big banks in speeches going back at least to 2009. In his introduction to the piece, Fisher, echoing Rosenblum, argues not only that too-big-to-fail banks were at the center of the financial crisis, but "significantly hamper the Federal Reserve's ability to conduct monetary policy" and continue "to play an important role in prolonging our economic malaise." Both Fisher and Rosenblum blame that much-abused piece of legislation, the Dodd-Frank Act, for not breaking up the banks. They make none of the usual defenses of the big banks: that it's too difficult or too costly to take them apart, that they provide services (including liquidity) that smaller banks can't, that they would put the U.S. at a competitive disadvantage globally.

They're also, not surprisingly, pretty kind to the Fed.

Rosenblum's argument, like so many targeted at the crisis, begins by describing what happened. He focuses on what he calls "people issues": complacency (long-lasting good times and moral hazard), complicity (credit raters, interconnections), exuberance and concentration. Under these banners, he manages to squeeze most of what we now accept as causes: easy money, deregulation, financial innovation, overheating real estate, the growth of off-balance sheet entities and, of course, an increasing concentration of banking assets -- that is, big banks.

Rosenblum treads carefully here. He drops in praise for the Fed as an effective mechanism for limiting recessions and he tiptoes past the failures of bank regulation, in which the Fed played a major role, by admitting "the public sector grew complacent and relaxed the financial system's constraints, explicitly in law" -- hello, Glass-Steagall? -- "and implicitly in enforcement." He directly blames the Fed for keeping interest rates too low for too long -- hello, Alan Greenspan? But generally, Rosenblum casts blame widely: "Hindsight leaves us wondering what financial gurus and policymakers could have been thinking." One group he passes over is shareholders, who clearly encouraged much of the risk-taking and consolidation. Including shareholders takes this critique more deeply into governance issues and the underlying structure of the banking system.

I'd also like to know what Rosenblum was thinking in those pre-crisis years. This isn't meant to be sarcastic: He apparently did have a clue. The Dallas Fed was worried about housing in 2006, and Rosenblum co-wrote a piece for the bank's Economic Letter in December 2007 titled "From Complacency to Crisis: Financial Risk Taking in the Early 21st Century," which touched on many of the salient causes, from SIVs to credit default swaps and conduits. It wasn't really early, but it wasn't late either.

All this takes us to his critique of TBTF banks. Rosenblum says these very large banks are a threat for two big reasons: First, they impair the efficient operation of the Fed's monetary policy because their balance sheets are weighed down with toxic assets; and second, they're a future threat to stability. His real target here is Dodd-Frank, which, he argues, not only has created great uncertainty and long delays, but given its complexity, spawns "an obstacle to transparency" and a field day for lobbyists. Rosenblum worries that the prudential decision to mandate higher bank capital ratios will disproportionately hit smaller banks, which lack the market subsidy that comes with TBTF status. As for the legislation's attempt to eliminate TBTF as a problem -- so-called resolution authority -- Rosenblum is not hopeful.

Big banks often follow parallel business strategies and hold similar assets. In hard times, odds are that several big financial institutions will get into trouble at the same time. Liquid assets are a lot less liquid if these institutions try to sell them at the same time. A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF -- too many to fail, as happened in 2008.

Rosenblum's conclusion is sound byte-ish: "For all its bluster, Dodd-Frank leaves TBTF entrenched." That may well be true, but for all his passion, Rosenblum does not deal with how this massive carving up of the largest banks would unfold and what the consequences might be. He does not wrestle with any of the related complexities: the post-Glass-Steagall mixing of investment and commercial banking; proprietary trading; the tangled question of how big is too big; or the even more bewildering matter of how interconnected is too interconnected. He does not tackle globalization. Rosenblum seems to take it on faith that an economy of predominately smaller banks would be more effective economically, never discussing the reality of widespread disintermediation that led to bank deregulation and consolidation in the first place.

A financial system composed of more banks, numerous enough to ensure competition in funding businesses and households but none of them big enough to put the entire economy in jeopardy, will give the United States a better chance of navigating through future financial potholes and precipices. As this more level playing field emerges, it will begin to restore our nation's faith in the system of market capitalism.

Can you navigate a precipice? Can you have a level field with potholes and precipices?

There is an historical context here that may well be important. The voices raised about TBTF are widespread if not powerful enough to make a difference -- yet. But the cries against the big banks -- traditionally the big Eastern banks -- have a long history in the uniquely decentralized U.S. banking system. Perhaps their most fertile homeland is -- Texas, home of Fisher's Dallas Fed. The politics here are interesting. The roots of this anti-big-bank philosophy goes back to the predominately rural populists of the late 19th century who viewed the economic struggle as a matter of capital (banks) versus land (mostly farms and ranches), rural versus urban, West versus East, small versus large (and, more interesting yet, silver versus gold).

That attitude toward plutocratic bankers deepened in the Great Depression, when so many farms went under. (So did a lot of banks, but who feels sorry for plutocrats, mini or maxi?) Much of the New Deal was shaped by this attitude, with Texan Sam Rayburn, the powerful Democratic Speaker of the House, a major legislative power broker. In the post-war years, another Texan, Wright Patman, ruled the House Banking Committee from 1963 to 1975. Patman, a New Deal Democrat, was unremittingly hostile to larger banks, including the central bank.

A final historical fragment that may or may not belong: Texas historically was a unit banking state, meaning banks could have only one branch; this was the veritable embodiment of the decentralized bank model. The state, like many others, also forbade interstate banking, protecting vulnerable local banks against larger, flusher and more predatory outsiders. Those interstate barriers only fell after the thrift and banking crisis of the late '80s took hold in Texas, forcing the banks to seek out-of-state saviors. New York money center Chemical Bank arrived in Texas in 1987 to buy Houston's Texas Commerce Bank after Texas and New York agreed to mutual reduction of barriers. In years ahead, Texas had to watch more outsiders -- the federal Resolution Trust Corp., Bank One, NationsBank and financiers like Ron Perelman and Lewis Ranieri -- roll in to take over much of its banking system, making ever greater fortunes to boot. Chemical and Bank One eventually became part of J.P. Morgan Chase & Co.

Texas survived and again prospered, but in politicians like Rick Perry and Ron Paul it still displays a broad populist streak that includes enthusiastically bashing the Fed. Fisher and Rosenblum are not Perry, Patman or Paul. But the tradition of banking decentralization persists. All of which raises two questions that neither Fisher nor Rosenblum answer: How will the rest of the country fare without larger banks? And are we all Texans now?

Robert Teitelman is editor in chief of The Deal magazine.