BOSTON -- The spate of post-financial crisis rules intended to end the perception that the largest financial institutions are “too big to fail” may ultimately fall short, necessitating even more stringent approaches, a top Federal Reserve official warned Friday.
Daniel Tarullo, the Fed governor overseeing the central bank’s supervision efforts, suggested that regulators force the biggest banks to reduce their borrowings, increase the amount of equity capital they use to fund their assets and improve their liquidity -- all beyond the standards agreed upon internationally and expectations of U.S. banking executives.
Tarullo argued that current efforts to reduce the risk a big bank's failure would pose to the U.S. economy may fall short. They “would leave more too-big-to-fail risk than I think is prudent," he said.
Tarullo’s warning and recommendations come as policymakers and legislators in Washington debate further restrictions on the country’s biggest and most complex banks. They threaten to crimp profitability at five of the six largest U.S. banks by assets: JPMorgan Chase, Goldman Sachs, Citigroup, Morgan Stanley and Bank of America.
Recent bills in Congress, such as one introduced by Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.), would force large banks to either increase the amount of equity capital or reduce the amount of debt used to fund their assets, or break themselves up into several pieces. A growing number of current and former senior regulators who continue to worry about the dangers big banks pose to the financial system and broader economy are demanding the same.
The onslaught of regulatory threats to banks such as JPMorgan and Goldman Sachs suggests that officials will not relent in their efforts to strengthen bank balance sheets. Three years after passage of Dodd-Frank, the post-crisis law intended to make the financial system safer, the biggest banks' ability to generate highly-leveraged profits faces as great a threat as ever.
“Questions remain as to whether all this is enough to contain the problem,” Tarullo said.
He said much of the problem stems from big banks’ reliance on short-term non-deposit borrowings.
“We would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem,” Tarullo said. “This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.”
He outlined a host of potential remedies, some he has mentioned in the past and others that caught bankers and other policymakers by surprise.
One fix would be to ratchet up capital requirements to compensate for the increased risk posed by a bank’s reliance on creditors who lend on a short-term basis, funding that could evaporate at the first sign of trouble.
Another would be to require a greater percentage of a big bank’s assets to be funded by equity, rather than borrowed funds, a move that would better guard against unexpected losses.
A third would make it more expensive to be big, by further taxing size and complexity. An internationally agreed upon set of accords known as Basel III sets out capital surcharges for the largest and most complex banks. Tarullo suggested these could be made higher in order to compensate for the costs a big bank’s failure would impose on the economy.
Additionally, Tarullo suggested that large banks that faced significant liquidity risks -- the chance that they wouldn’t be able to fund operations if lenders quickly pulled their cash -- should be required to fund themselves with more equity, rather than with borrowed funds. A “material” amount of higher capital could incentivize banks to have liquidity positions “substantially stronger than minimum requirements,” he said.
Lastly, Tarullo repeated a suggestion that regulators require all market participants who rely on short-term funds to be forced to provide a minimum amount of collateral to their lenders in order to obtain borrowed cash. Doing so would lessen financial groups’ reliance on volatile funding, making the overall financial system safer. Leading regulators representing countries with major financial centers have long been exploring such a measure.
Year-end figures compiled by researchers at the Federal Reserve and Federal Reserve Bank of New York show that Goldman Sachs and Morgan Stanley rely on short-term funds for more than 60 percent of their assets, suggesting they’d be among the banks facing the greatest risk from the kinds of moves suggested by Tarullo.
About 30 percent of Citigroup, JPMorgan and Bank of America’s assets are funded by short-term cash. Wells Fargo, the country’s fourth-largest bank, uses short-term funds for less than 20 percent of its assets, Fed figures show.