May 3 (Bloomberg) -- Federal Reserve Governor Daniel Tarullo said regulators should impose higher requirements for capital and liquidity at banks that pose the greatest risk to the financial system, and should consider measures to link the two.
“While there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters,” Tarullo said in remarks prepared for delivery today in Washington. An “interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements.”
Regulators should focus on the risks still posed by banks and other financial companies that rely on short-term market funding because they can be subject to runs in a crisis, Tarullo said. He said that existing capital rules for banks and broker-dealers don’t fully reflect the risks that come from such funding, and proposed that a higher capital charge could be imposed to reduce the risks.
Tarullo, the Fed governor in charge of financial regulation and bank oversight, is expanding the central bank’s efforts to strengthen the financial system and prevent a repeat of the 2007-2008 financial crisis that precipitated the longest recession since the Great Depression.
Regulators should consider a requirement that large financial institutions hold long-term debt that can be converted to equity, Tarullo said in his speech at the Peterson Institute for International Economics.
“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,” Tarullo said. He said that applies “both in general and as they affect the too-big-to-fail problem.”
The financial system still remains vulnerable to the risk that short-term funding could be withdrawn and financial institutions would face the type of liquidity crisis that led to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc. in 2008.
Among the proposals Tarullo outlined was to make capital and liquidity more closely linked, so that firms with stable deposit funding may not need as much capital as firms that rely more heavily on short-term financing.
“This approach is worth exploring, precisely because it rests upon the link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vulnerable today,” Tarullo said.
“Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strengthening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied,” according to Tarullo.
The Fed governor said that the current regulatory reform agenda aimed at strengthening the largest banks so that regulators would not resort to bail outs in a financial crisis was insufficient.
“Completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent,” Tarullo said. Regulators have “the authority, and the obligation, to apply regulations of increasing stringency to large banking organizations in order to mitigate risks to financial stability.”
Top U.S. bank regulators and lawmakers are pushing for action to limit the risk that the government again winds up financing the rescue of one or more of the nation’s biggest financial institutions.
Dallas Fed President Richard Fisher and Senator Sherrod Brown are among those who share the view that the 2010 Dodd-Frank Act failed to curb the growth of large banks after promising in its preamble to “end too big to fail.”
Tarullo said there is “clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency.”
Such an approach is known as a bail-in. A bail-in is a form of bank rescue that makes debt investors and stockholders absorb losses instead of taxpayers. In some cases, debt may be converted to stock to help recapitalize the bank.
Bail-ins have drawn favor in the U.S. and Europe after taxpayers were forced to bear the risk of bailing out firms such as American International Group Inc. and Royal Bank of Scotland Group Plc while senior bondholders weren’t asked to take losses. Bail-ins have been used in Cyprus, Denmark and Ireland.
Fed Governor Jerome Powell said in March that the central bank and Federal Deposit Insurance Corp. are “considering the pros and cons” of setting a floor for the amount of long-term unsecured debt to absorb losses and capitalize a bridge holding company for banks that fail.
Tarullo has said before that he wants a minimum long-term debt requirement for large firms. U.S. regulators are discussing such a rule with the view that it would help buffer against bailouts as debt holdings could be converted into equity in a bank failure.
He also said today that leverage ratios agreed to as part of the international banking standards known as Basel III “may have been set too low.”
In response to audience questions, he said that the Basel III regulations are “moving along” and that most of the substantial issues “have been talked through.”
He said the regulations may be completed “within the course of the next couple months.”
President Barack Obama’s first appointment to the Fed, Tarullo, 60, helped create the Large Institution Supervision Coordinating Committee, a group of senior Fed bank supervisors, economists, payment experts and quantitative analysts that looks for risks that may be clustering in several of the largest financial institutions at once.
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