Tarullo Sees Big Banks With Fed Rule Protecting Taxpayer

Federal Reserve Governor Daniel Tarullo is pushing an agenda to regulate banks beyond the restraints in the Dodd-Frank Act, including making them fund more of their assets using long-term borrowing.

The Fed and the Federal Deposit Insurance Corp. are holding preliminary discussions on a rule that would require holding companies for the largest U.S. banks to maintain a minimum amount of long-term debt that would aid in winding them down in case they fail, FDIC spokesman Andrew Gray said.

As the Fed governor in charge of bank supervision, Tarullo leads the central bank’s effort to implement the 2010 Dodd-Frank Act and is now pressing beyond it to limit the kind of systemic risks that required taxpayer-funded bailouts in the 2008-2009 financial crisis. Tarullo, 60, became President Barack Obama’s first appointee to the Fed in January 2009 after previously serving as an aide to President Bill Clinton.

“Tarullo is very intent on fixing what in his views are flaws in the supervisory process,” said Deborah Bailey, managing director at Deloitte LLP in New York and a former deputy director in the supervision and regulation division at the Fed. “The Fed was given more explicit authority under Dodd-Frank to oversee financially systemic institutions, and, as a result, they are on the hook” if another large bank fails.

Tarullo’s agenda for reducing risk also includes strengthening supervision of so-called shadow banking that falls outside traditional regulation and limiting the risk that the biggest banks once again become too big to fail through mergers and more complexity.

Long-Term Borrowing

The push to get banks to use more long-term borrowing is aimed at creating a class of stakeholders that could step in to shoulder losses in case of a failure and reduce the need for taxpayer funding.

Banks typically fund their longer-term assets with short-term debt, making a profit on the interest-rate difference between the two. In a bank failure, stockholders are typically wiped out, and short-term debt can evaporate quickly as creditors refuse to renew commercial paper and short-term notes.

Requiring banks to rely more on long-term debt means the issuers of such debt would become stakeholders at the holding company level, whose bonds regulators could convert into equity in a failure. That might reduce or eliminate the need for taxpayer funding, which Dodd-Frank prohibits. Yields on long-term bank bonds would also provide regulators with a market gauge of bank stress.

Risk Awareness

“It eliminates the government as the backup and makes everybody in the capital line a little more cognizant of risk because you could be wiped out or moved down the capital structure in a pinch,” said R. Scott Siefers, managing director at Sandler O’Neill & Partners LP in New York.

Regulators have rarely determined the capital structure for private banks, he said. “We are living in a completely new world.”

Tarullo said in a Dec. 4 speech in Washington that a minimum long-term debt rule “could lend greater confidence that the combination of equity owners and long-term debt holders would be sufficient to bear all losses at the firm.”

Bank capital structure is just one area Tarullo is sizing up for possible rule-making. The Fed last month published a proposal that would require stricter oversight of foreign banks with large U.S. operations. Fed officials have also urged more oversight of shadow banking, where financial institutions from banks, to real estate investment trusts to finance companies use lightly regulated money markets to fund long-term assets. Tarullo is also exploring how to measure the costs and benefits posed by the merger of large banks.

Activist Agenda

“Post crisis, the Fed has a new more activist agenda,” said Margaret Tahyar, a partner at the law firm Davis Polk & Wardwell in New York. “It’s a complete paradigm shift.”

Tarullo called in a June 12 speech for more oversight of shadow banking, an area he said has only been “obliquely addressed despite the fact that the most acute phase of the crisis was precipitated by a run on that system.”

With shadow banking usually outside of Fed oversight, regulation falls to other agencies and the Financial Stability Oversight Council, a group of regulators charged with preventing another financial crisis. Tarullo sits with Fed Chairman Ben S. Bernanke and Treasury Secretary Timothy F. Geithner at FSOC meetings, even though he isn’t a voting member of the group.

Fragile Component

Tarullo said last June that the financial crisis exposed money-market mutual funds as a fragile component of the funding system. When the $62.5 billion Reserve Primary Fund broke the $1 net asset value in September 2008 after writing off debt issued by Lehman Brothers Holdings Inc., “the illusion that money funds were effectively as safe as insured bank accounts was shattered,” Tarullo said.

The Fed is also concerned about what some analysts call systemic herds, or groups of companies such as mortgage real estate investment trusts, that hold in total hundreds of billions of dollars of the same kind of assets, a senior U.S. regulator said. Fire sales of assets could result if creditors pull back.

Mortgage Securities

REITs, which are not regulated by the Fed, held $368.2 billion of government-backed mortgage securities as of Sept. 30, funded with $319.7 billion of typically short-term repurchase agreement borrowing, according to Fed data. Since 2008, their assets have grown from $89.6 billion and their liabilities have risen from $79.3 billion.

Tarullo has also proposed outright limits on bank size. He called on Congress in October to constrain the non-deposit liabilities of financial firms to a specific percentage of U.S. gross domestic product. He also said the U.S. will follow the Basel Committee’s recommendation and develop capital surcharges for eight large systemically important U.S. banks, led by Citigroup Inc., JPMorgan Chase & Co., Bank of America Corp. and Goldman Sachs Group Inc.

The Basel Committee’s measure imposes another charge if banks grow bigger. Tarullo said on Oct. 10 in Philadelphia that he would “urge a strong, though not irrebuttable, presumption of denial for any acquisition by any firm that falls in the higher end of the list of global systemically important banks developed by the Basel Committee.”

The Fed doesn’t explicitly cap bank size. Still Tarullo has given no indication he wants to see the biggest U.S. banks grow bigger. He wants first to clarify the risks posed by big banks to financial stability and public perceptions that the institutions are too big to fail.

“Really big deals are going to be extremely difficult if not doomed,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington, a consulting firm on regulation whose clients include the world’s largest banks.

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