The Federal Reserve, mindful that some banks are still so big that their failure could weigh on the wider economy, said on Monday that it planned to increase the pressure on large financial firms to shrink.
Daniel K. Tarullo, the Fed governor who oversees regulatory policies, signaled the central bank’s intent in testimony that he is scheduled to give before the Senate Banking Committee on Tuesday. In particular, Mr. Tarullo said that the Fed would propose special capital requirements for the largest banks that will be even higher than those demanded under international banking regulations.
“We intend to improve the resiliency of these firms,” Mr. Tarullo said. “This measure might also create incentives for them to reduce their systemic footprint and risk profile.”
The speech sets out to update Congress on how much progress regulators have made with the Dodd-Frank Act, which was passed in 2010 to overhaul the financial system.
The part of his remarks that could unsettle large Wall Street firms has to do with capital. When regulators increase capital requirements, it forces banks to borrow less money to finance their lending and trading. The theory is that banks that rely less on borrowing are more stable because they are getting more of their financing from shareholder funds, which do not have to be repaid at short notice when turbulence hits.
But as a bank has more equity funding, it in theory becomes harder for it to earn a return on its shares that satisfies investors. The bank might therefore decide that, to reduce its equity funding, it needs to shrink its assets. And if the largest banks fall considerably in size, they would pose less of a threat to the wider economy if they collapsed.
But some large banks may not want to reduce their size. And they may assert that higher capital requirements will cause banks to cut back in ways that could impede the flow of credit.
International bank rules already envision that the largest banks have higher capital requirements than smaller ones. The basic requirement is that a bank’s capital must equal at least 7 percent of its assets, measured according to the risk of the assets. But the largest global banks’ capital will have to be between 8 and 9.5 percent of their risk-adjusted assets by the end of 2018, according to international rules.
In his speech, Mr. Tarullo said that the Fed wanted even higher capital surcharges for the biggest American banks. “Noticeably so for some firms,” he said.
JPMorgan Chase is one of the banks that will be required to hold an extra 2.5 percentage points of capital, or 9.5 percent in total, under the international rules. JPMorgan, however, is already at 9.8 percent. JPMorgan declined to comment on Mr. Tarullo’s speech.
Although big American banks should be able to meet the Fed’s new demands, they can be expected to voice their concerns. The Fed would propose the new capital surcharges as a formal rule and invite comments from the industry and the broader public.
Mr. Tarullo’s capital surcharge plan would particularly penalize firms with large Wall Street businesses that borrow a lot of money in short-term debt markets. These markets dried up in the financial crisis of 2008, threatening the life of many firms. As a result, the Fed is looking for ways to reduce banks’ reliance on this type of borrowing.
“We believe the case for including short-term wholesale funding in the surcharge calculation is compelling,” Mr. Tarullo said, “given that reliance on this type of funding can leave firms vulnerable to runs that threaten the firm’s solvency.”