Nov. 10 (Bloomberg) -- Federal Reserve Governor Daniel Tarullo said proposals to separate trading from deposit taking and lending at the biggest banks probably wouldn’t dispel the perception that some firms are too big to fail.

“Some very large institutions have in the past encountered serious difficulties through risky lending alone,” the central bank governor said in remarks yesterday to the Money Marketeers of New York University.

U.S. legislators are drafting the most sweeping overhaul of financial regulation since the Great Depression after risky mortgage lending triggered more than $1.6 trillion in credit losses and writedowns at large financial institutions. Lawmakers are also debating whether they should give the government powers to break up or limit the size of firms whose failure could put the entire financial system at risk.

Congress redrew financial regulation in 1999 with the Gramm-Leach-Bliley Act, repealing Depression-era laws that separated commercial and investment banking. The legislation gave rise to financial conglomerates involved in insurance, stock brokerage and commodity trading.

The Obama administration wants to boost the Fed’s ability to set stricter capital and liquidity standards at the biggest firms to curb systemic risk. Still, some economists say that big firms need to shrink.

Joseph Stiglitz, a Nobel laureate and Columbia University economist, former Fed Chairman Paul Volcker and Bank of England Governor Mervyn King have advocated limiting or splitting some trading activities from commercial banking to limit risk.

Break Up Firms

In Congress, Senator Bernie Sanders, a Vermont independent, is proposing legislation that would break up financial firms deemed too big to fail. Representative Paul Kanjorski, a Pennsylvania Democrat, is also preparing legislation that would limit the size of large financial organizations.

Tarullo “was lobbying on behalf of the Fed’s positions,” said Ray Stone, a managing director at Stone & McCarthy Research Associates in Princeton, New Jersey, who attended the speech. “It comes down to capital requirements and liquidity requirements. Those are their main tools on the regulatory front.”

Tarullo cited “massive failures” in risk management inside financial firms, and “serious deficiencies” in government regulation as causes of the crisis.

Pose Threat

“As shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to- fail threat,” he said. Lehman Brothers Holdings Inc. collapsed into bankruptcy in September 2008, and Bear Stearns Cos. was merged into JPMorgan Chase & Co. with Fed assistance.

“Too-big-to-fail perceptions weaken normal market disciplinary forces,” Tarullo said. Splitting apart commercial and investment banking activities “would seem unlikely to limit the too-big-to-fail problem to a significant degree.”

Volcker said in Sept. 30 remarks in Gothenburg, Sweden that banks don’t “have any real business in doing a lot of speculative trading.”

Tarullo said in response to an audience question that legislators will need to address the U.S. fiscal imbalance and Fed officials will be watching their efforts with “considerable interest.”

The U.S. is headed for a second straight year of budget deficits exceeding $1 trillion, and the country’s legal limit on debt may be reached next month.

Global Rally

U.S. stocks extended a global rally yesterday, sending the Dow Jones Industrial Average to a 13-month high after the Group of 20 nations agreed to maintain economic stimulus efforts. The Standard & Poor’s 500 Index climbed 2.2 percent yesterday, its steepest gain in more than a week, while gold futures for December delivery advanced to a record $1,111.70 an ounce.

Tarullo said an alternative to breaking apart banking and trading operations would be to limit the size of firms. Regulators would have to define how size increases systemic risk or perceptions of too-big-to-fail, a condition when investors and counterparties assume that the federal government must backstop a failing firm to save the overall financial system.

Tarullo said creating special charges for firms deemed systemically important, or developing rules that would require banks to build up capital in boom times, are concepts that have “substantial appeal” and may need further consideration.

Under a House proposal, the Fed would gain authority over the largest, most interconnected firms, while losing power to grant emergency bailout loans to individual companies.

Power to Tighten

The House bill would give the Fed power to tighten standards on capital, liquidity and leverage for companies posing a risk to the financial system. The Fed would gain authority to shrink financial firms that could destabilize markets and the economy, according to the legislation released by House Financial Services Chairman Barney Frank.

The draft bill would also curb the emergency powers the Fed used during the crisis to bail out American International Group Inc. and finance $29 billion in troubled Bear Stearns assets to facilitate the broker’s merger with JPMorgan Chase & Co.

Another proposal by Senate Banking Committee Chairman Christopher Dodd, a Democrat from Connecticut, would strip the central bank and Federal Deposit Insurance Corp. of supervisory powers, a person familiar with the matter said.

Dodd wants to eliminate the Office of the Comptroller of the Currency and the Office of Thrift Supervision and fold the Treasury Department units into the new bank regulator, according to the person, who spoke on condition of anonymity because the plan isn’t public. Dodd plans today to release a draft of his financial regulation overhaul.

-- With assistance from Alison Vekshin in Washington. Editors: James Tyson, John McCluskey

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Michael McKee in New York at mmckee@bloomberg.net.

Last Updated: November 10, 2009 00:01 EST