Tarullo prudently prepares May 5, 2013 at 5:13 pm

FED governor Daniel Tarullo gave an interesting speech recently; interesting because he is clearly trying to set out a regulatory agenda while uncomfortably aware that legislators, if anything like Brown Vitter is passed, might pull the rug out from under him. He therefore has to tread delicately. That doesn’t stop him from pushing the FED’s line, but they are gentle nudges.

His first real point is that liquidity reform has not made much progress:

we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs… But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions.

He has to admit that little has been done about too big to fail as it hasn’t, and the Senate has noticed

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way… But questions remain as to whether all this is enough to contain the problem.

Indeed. He gives the standard spiel on more capital and/or liquidity risk regulation, as in Basel III. But then it gets interesting:

a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs.

Or, for that matter, a tax on them. Either would do.

Look at this for a lovely piece of politics. Tarullo says, as he would, that the FED should be allowed to complete its current agenda. But then he pays deference to the law makers:

the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks–whatever their merits and demerits–embody basic policy decisions that are properly the province of Congress

That leads him to trying to head the B-V posse off at the pass:

One approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

Is this just trying to kick the can down the road? Tarullo must know his chances of getting higher standards agreed in Basel are low. Equally he knows that unilateral action in the US will damage the competitiveness of US banks (while making them safer, of course). If he can’t persuade the Brown-Vitter crew to back off, and he can’t get Basel to agree to similar standards, he will have to doff his cap and do what the law requires. I would suggest, though, that that doesn’t mean that he will like it.

2 Responses to “Tarullo prudently prepares”

  1. I read the speech the same way. I’d keep in mnd the Fed’s long-term goal here: not to EXPLICITLYbreak up the bg banks, but to create the incentives for banks to shrink.

    To that end, they are actually aligned with the Amati crew. And they are in a box because of the BIS papers that assert higher capitalization does not have deleterious effects on the broader economy. And Modigliani-Miller.

  2. Carter

    I agree with your analysis. Admati and Hellwig’s problem, though, is that the preconditions of MM don’t hold (notably the tax treatment of equity vs. debt) so there is no theoretical reason for it to hold. There’s plenty of practical evidence that it doesn’t, too. So for me the ‘more equity won’t be that expensive’ argument is at best unproven and at worst intellectually dishonest.