Aug. 9 (Bloomberg) -- The Federal Reserve governor leading the central bank’s effort to tighten financial regulation has a decision to make as its governing board is reshaped: Should he stay or should he go?
Overshadowed by speculation about the next Fed chairman is the question of how that appointment will affect the work of Daniel Tarullo, the Fed governor in charge of bank supervision. While Tarullo hasn’t disclosed his plans, he is in the middle of work on pending rules that may take at least two years to complete. The 60-year-old Georgetown University law professor declined through Fed spokeswoman Barbara Hagenbaugh to comment.
President Barack Obama will appoint a chairman and at least two governors to the Federal Reserve Board over the next few months. Obama’s commitment to regulatory overhaul makes it unlikely any of his nominees would stand in the way of completing the task, said H. Rodgin Cohen, a partner at the New York law firm Sullivan & Cromwell LLP.
“I just can’t imagine the president appointing a chairman or another governor who isn’t broadly consistent with where we are in the regulatory environment today,” said Cohen, whose clients include the largest banks in the U.S.
Ben S. Bernanke’s second term as chairman expires in January, and two members are leaving the board: Elizabeth Duke, who will resign Aug. 31, and Sarah Bloom Raskin, whom Obama plans to nominate to be deputy Treasury secretary. Duke’s departure will make Tarullo the longest-serving member of the board after Bernanke.
As replacements fill the three vacancies, Tarullo’s current efforts on regulation are unlikely to be deterred, former Fed regulators and economists say. With several rule makings under way, members of Congress in both parties are demanding that the Fed accelerate its implementation of the Dodd-Frank Act.
“They’re taking too long,” said Senator Sherrod Brown, an Ohio Democrat who is head of a Senate Banking Committee panel with oversight authority over the Fed’s performance on supervision and regulation.
“Tarullo’s been a good adviser,” Brown said in an interview. “He’s right on most of these regulatory issues.”
Senator Mike Crapo of Idaho, the Banking Committee’s ranking Republican, pressed Tarullo at a hearing last month on a timeline for completing new bank-capital rules and said he was interested in the “additional steps” regulators were considering to buffer the risks of the largest banks.
Adding to the momentum is recognition among central bankers that financial stability is a prerequisite for effective monetary policy, said former Fed Governor Laurence Meyer.
“If the financial system is impaired, it is going to make it very difficult for monetary policy to carry out its traditional role,” said Meyer, now a senior managing director at Macroeconomic Advisers LLC. “Supervision and regulation is the first line of defense.”
Obama has mentioned former Treasury Secretary Lawrence Summers, Fed Vice Chairman Janet Yellen and former Vice Chairman Donald Kohn as potential successors to Bernanke. If Yellen isn’t chosen to succeed Bernanke and elects to remain at the Fed, her term as vice chairman expires in October 2014.
“All of the candidates said to be in consideration seem likely to support the current trajectory of regulation,” said Patrick Parkinson, a managing director at bank adviser Promontory Financial Group in Washington and the former head of the Division of Banking Supervision and Regulation at the Fed Board.
Summers, as Treasury secretary from July 1999 until January 2001, oversaw the repeal of laws separating banking and brokerage and said markets were better regulators than government.
“It is the private sector, not the public sector, that is in the best position to provide effective supervision,” he said in a November 2000 speech.
The financial crisis discredited that approach, and as the consensus changed so did Summers. As a White House adviser in 2009, he expressed dismay at the economic and human cost of the crisis, and said it was time for “a fundamental change in the way those institutions are regulated.”
A speech by Yellen this year shows a full endorsement of the regulatory program now under way.
Reducing the likelihood that the largest banks will once again need taxpayer-funded bailouts “will require steadfast implementation by global regulators over the next few years,” and may require “a steeper capital surcharge curve or some other mechanism for requiring that additional capital be held by firms,” Yellen said in a June 2 speech in Shanghai.
Kohn, who was Fed vice chairman during the financial crisis, is currently a member of the Bank of England’s Financial Policy Committee, a new, independent unit charged with removing or reducing systemic risk.
Tarullo’s term runs until 2022 and his continuing service on the board would help assure completion of the regulatory overhaul. Tarullo and Bernanke used the financial crisis to pull some of the Fed’s supervisory power back to the Board of Governors and institute some of the biggest changes in oversight in the central bank’s 100-year history. Now, the annual stress tests of the largest banks are largely organized by board staff with input from the reserve banks.
Tarullo formed the Large Institution Supervision Coordinating Committee, a group of regulators, economists, lawyers, payment systems experts and reserve-bank supervisors. The group meets in Washington to coordinate their review and analysis of trends emerging in the largest banks. Bernanke and Tarullo also formed the Office of Financial Stability Policy and Research, a new Washington division charged with spotting systemic risk.
“You are going to see much more focus on the largest institutions,” said Deborah Bailey, former deputy director of the Division of Banking Supervision and Regulation at the Fed Board and now a managing director at Deloitte & Touche LLP. “You are seeing a lot of focus on risk management and governance around risk management.”
Tarullo’s influence extends beyond the Fed. He attends meetings of the Financial Stability Oversight Council principals, a group of regulators that meet on systemic risk.
This year he was appointed chairman of the Standing Committee on Supervisory and Regulatory Cooperation at the Financial Stability Board, a group of regulators that meets to align policy. That seat puts Tarullo in a position to defend the Fed’s internationally unpopular decision to force large foreign banks to form holding companies in the U.S. and fall under stricter Fed oversight.
At an open Fed board meeting held July 2 in Washington, Tarullo discussed four initiatives that his team and other agencies were working on, three of which would be out this year.
Days later, in the first of these, the Fed, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. proposed a leverage ratio of 6 percent for deposit and lending units, twice the world standard. For holding companies, the ratio would be pegged 2 percentage points above the international minimum of 3 percent. A leverage ratio measures how much capital stands behind a bank’s assets to absorb losses.
Tarullo also said the Fed will issue a proposal on the amounts of equity and long-term debt the biggest banks should maintain to facilitate their resolution in case of failure. Also this year, the Fed may issue a proposal on capital surcharges for the largest systemically important banks, he said. Finally, he said, the board staff is working on a proposal for a capital tax on large firms that are too reliant on short-term, wholesale funding.
Interrupting an entrenched regulatory process like this could be difficult given its complexity, Tarullo’s mastery of the subject and the bipartisan urgency in Congress for a plan that prevents large banks from coming back to taxpayers for a bailout.
“There is a tremendous amount of momentum behind these reforms and a lot of pressure to get Dodd-Frank implemented,” said John Dearie, executive vice president at the Financial Services Forum in Washington and a former member of the New York Fed staff.
Edward Kane, a professor of finance at Boston College who has written about incentives involving the federal safety net for much of his career, said the real challenge for the next chairman will be making sure the banks and financial institutions are compliant with the rules Congress and regulators have put in place. Some of those rules will create more rather than less risk, he said.
Higher capital standards, for example, increase risk-taking because firms seek to sustain high returns for shareholders. The bigger the downside exposure, the greater their implicit reliance on a bailout or rescue. “When it comes to controlling regulation-induced risk-taking, regulators are outcoached, outgunned, and always playing from behind,” Kane wrote in an essay in January.
“Regulation isn’t just rules, it is enforcement,” he said in an interview.
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