Gary Cameron/ReutersDaniel K. Tarullo, a governor at the Federal Reserve, described a measure aimed at requiring the biggest banks to hold extra capital. Many might prefer to become smaller banks instead.A nagging sense seems to pervade the public’s mind that the nation’s biggest banks still pose a risk to the wider economy, despite all that has been done since the 2008 financial crisis.
It seems that disquiet persists even at the heart of the regulatory establishment. The latest call to action came on Friday from Daniel K. Tarullo, a governor at the Federal Reserve, an agency that plays a crucial role in shaping new banking rules.
In a speech before the Peterson Institute for International Economics in Washington, he described a tough, new measure that could be squarely aimed at large Wall Street firms like Goldman Sachs and JPMorgan Chase.
Mr. Tarullo may have chosen an opportune time to make his case.
His speech comes amid increasing calls to do more to deal with the so-called too-big-to-fail issue. This holds that some financial institutions are so big that, if they were to collapse, they would damage the rest of the financial system, and weigh on the economy.
Mr. Tarullo said much had been done to make the financial system safer, through the two main overhauls that came after the crisis. Those are the Dodd-Frank Act, passed by Congress in 2010, and the internationally agreed bank regulations known as Basel III. In particular, these initiatives have made banks hold more capital, a part of a bank’s balance sheet that can serve as a buffer against losses. Before the crash of 2008, banks had insufficient capital, which stoked the fears that swept the global financial system. Taxpayers had to step in and provide new capital as part of efforts to restore confidence.
Still, Mr. Tarullo sees remaining areas of concern. He focused on the markets where Wall Street banks borrow huge sums of money for short periods. They use their borrowings in these so-called wholesale markets to then buy assets. But in times of stress, like 2008, these markets can dry up. Deprived of their lifeblood, banks rush to sell off the assets they bought with their wholesale borrowings, which can set off a wider collapse.
“Relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs,” he said in the speech.
To make the system safer, Mr. Tarullo floated an idea that could affect banks that make heavy use of wholesale markets. His idea is to require such banks to hold extra capital. How much extra would depend on how flush a bank’s balance sheet is. Such a program is more aimed at the major Wall Street institutions, while leaving regional lenders and even large consumer-oriented banks like Wells Fargo largely unscathed.
Under the current rules, large banks have to hold a pool of assets they can theoretically sell quickly to cover any outflows that occur in a turbulent period in the markets. Under Mr. Tarullo’s idea, the larger this pool, the less extra capital they would have to hold to cover the risk present in wholesale markets.
In reality, however, banks would probably do less wholesale borrowing to avoid the tougher capital requirements. In turn, that might prompt them to shrink their overall size, and therefore, not be so big as to require a government bailout if they failed.
“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, both in general and as they affect the ‘too big to fail’ problem,” Mr. Tarullo said.
The speech, which called for other changes to toughen regulation, follows a recently introduced bill that took aim at large banks.
The legislation, from Senator Sherrod Brown, a Democrat from Ohio, and Senator David Vitter, a Republican from Louisiana, would subject the biggest banks to much higher capital requirements than smaller banks. If the bill is passed, many large banks would probably choose to divest themselves of assets to shrink to a size where they would not be required to hold higher amounts of capital.
The bill has already generated fierce objections from the financial industry. Its critics said the capital increases would force banks to cut back on their lending, and they argued that large banks provide unique benefits to the economy.
Political analysts have said that the Brown-Vitter bill has little chance of passing, but the measure has reignited a conversation about what to do about banks whose failure could weaken the broader financial system.
Regulators like the Federal Reserve, however, do not have to wait for Congress to pass legislation to introduce new measures. The Dodd-Frank Act gave regulators substantial freedom to impose measures to strengthen the system on their own.
Mr. Tarullo mentioned that leeway in this speech on Friday. The Fed could use that authority to push forward on the measure to raise capital requirements for firms that make big use of wholesale debt markets. And it could impose another notable measure mentioned by Mr. Tarullo.
It involves something called the leverage ratio. This measures capital as a percentage of assets. It differs from other regulatory capital ratios in that it doesn’t adjust the assets for their perceived riskiness. Some analysts say they believe the “risk-based” approach is flawed and can lead a bank to hold too little capital.
They say the leverage ratio is a safer measure of capital because it doesn’t treat some assets as less risky than others. Mr. Tarullo said the Fed might set a higher leverage ratio.
Despite this call, some analysts said that Mr. Tarullo did not appear to be advocating for the much higher capital levels envisioned in the Brown-Vitter bill. The legislation requires banks with over $500 billion to have capital that is equivalent to 15 percent of their assets.
“He’s definitely not calling for a 15 percent leverage ratio like Brown-Vitter,” said Patrick Sims, a director at Hamilton Place Strategies, a policy firm that has aired objections to some of the contents in the senators’ bill.