Fed’s Tarullo Says Efforts Needed to Curb Too-Big-to-Fail Risk

Federal Reserve Governor Daniel Tarullo said more efforts are needed to end the perception that the biggest banks are “too big to fail” and to reduce risks that could spread rapidly through the financial system.

The central bank’s stress tests of the largest banks will “evolve further over time” as challenges to the banking industry shift, Tarullo said in remarks prepared for testimony today to the Senate Banking Committee and obtained by Bloomberg News.

In this year’s tests, lenders including JPMorgan Chase & Co. and Citigroup Inc. will have to show they can survive the demise of a trading partner or a plunge in value of high-risk business loans.

Tarullo is the Fed governor in charge of bank supervision and regulation and President Barack Obama’s first appointee to the Board of Governors. In that role he is overseeing the most sweeping change in financial rules since the Great Depression as he implements the Dodd-Frank Act of 2010.

The Fed governor said the central bank will “fairly soon” issue a proposal on capital surcharges for the largest banks that pose risk to the financial system. Part of the goal of the added charge is to “offset any funding advantage” such firms may have because they are perceived to be too big to fail, he said.

Tarullo also said the central bank intends to incorporate “stricter treatment” of credit derivatives in a leverage ratio proposal that international regulators have agreed to.

He repeated his concerns about runs in so-called wholesale funding markets where banks and securities firms leverage their holdings with short-term, collateralized loans.

Unwind Rapidly

Unlike bank deposits, such funding arrangements can unwind rapidly in a crisis as creditors pull back. That in turn can lead to fire sales of assets as banks and brokers dump securities they can no longer finance.

Regulators are considering several ways to address the risk, such as requiring liquidity buffers against leveraged securities positions or a kind of capital tax for firms that use short-term financing extensively, Tarullo said. That would create an incentive for firms “to use more stable funding.”

“We are focused on reducing the probability of failure of systemic financial firms, improving the resolvability of systemic financial firms, and monitoring and mitigating emerging systemic risks,” he said.

Tarullo also said the Fed is working with banks to encourage robust defenses against attacks on their information systems.

“Cyber attacks on financial institutions and the data they house pose significant risks to the economy and to national security more broadly,” Tarullo said. “We believe there should be increased attention and coordination across the federal government to support the security of the nation’s financial infrastructure.”

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