Fed's Tarullo: Big Banks in This Year's Dodd-Frank Sights

WASHINGTON — The Federal Reserve's point man for Dodd-Frank regulations will tell the Senate Banking Committee Thursday that this is the year the biggest banks get what's coming to them, a wide array of new rules that define capital requirements which make sure that if they falter, they will be put out of their misery in an orderly fashion that leaves taxpayers out of it.

Fed Gov. Daniel Tarullo, in prepared testimony made public Wednesday night, delivers a long to-do list that includes several regulatory projects the biggest banks have been fighting with lobbyist armies, including the so-called Volcker Rule.

The Fed has four priority projects this year, Tarullo said, among them "improving the resolvability of large banking firms," a euphemism for the way the biggest institutions could be gradually put to sleep if they get in trouble. If the process can be made credible, then no longer would markets give the big banks special consideration because of their too-big-to-fail guarantee of immortality. Those benefits are seen to include lower borrowing costs.

The Obama administration has additionally pushed a fee to be paid by the biggest banks to compensate for the extra danger their failure could pose for the entire financial system.

The other three main priorities are, he said, "continuing key Dodd-Frank and Basel III regulatory implementation work," further development of the "systematic supervision of large banking firms," and finally, formulating rules that reduce systemic risk in the shadow banking system.

Improved capital requirements "are central to promoting the resiliency of banking firms and the financial sector as a whole," Tarullo said. The financial crisis revealed "that the regulatory capital requirements for banking firms were not sufficiently robust." Since no single capital measure "adequately captures a banking firm's risks of credit and trading losses" the Fed has made "a good bit of progress" in "strengthening and updating traditional capital requirements, as well as devising some complementary measures for larger firms."

This year the Fed will be working on comprehensive single-counterparty credit limits that the Fed hopes will offset "any benefits that these firms may gain from being perceived as 'too big to fail.'"

In what bankers could find the most chilling part of the developing regulatory arsenal, Dodd-Frank's Orderly Liquidation Authority, Tarullo said the U.S. appears to be "ahead of its global peers" in working out ways to wind down the big, complicated bank firm that needs to be extinguished with as few systemic ripples as possible.

Under the plan worked out so far, he said, the FDIC creates a creditor-funded holding company to recapitalize the failing firm, as it continues to serve customers while its shareholders and unsecured creditors see their holdings wiped out by losses, the "culpable management" otherwise known as the top executives find themselves without jobs and the firms themselves — according to the current plan — pay for everything. They would do this, Tarullo said, by maintaining a minimum amount of long-term unsecured debt that would "lend greater confidence that the combination of equity owners and long-term debt holders would be sufficient to bear all losses."

Under this plan no longer would there be the moral hazard element, in which taxpayer bailouts are assured, he said.

The biggest non-banks, firms that are not as regulated as the banks, remain a "significant" threat to the financial system even though "some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared," Tarullo said.

"Many of the key issues related to shadow banking and their potential solutions are still being debated domestically and internationally," he said. "U.S. and global regulators need to take a hard, comprehensive look at the systemic risks present in wholesale short-term funding markets."

Regulators and the public need to be able to know more about shadow banking markets, "especially securities financing transactions," he said. "Additional measures should be taken to reduce the risk of runs on money market funds."

Another familiar target of the regulatory community, tri-party repurchase agreements, remains work in progress and the Fed is pressing "for further and faster action by the clearing banks and dealer affiliates of bank holding companies." He added, "Vulnerabilities in this market remain a concern."

"Considerable work remains," Tarullo concluded. "Our goal is to preserve financial stability at the least cost to credit availability and economic growth."

As some members of the Senate Finance Committee made clear Wednesday, in their questioning of Treasury secretary nominee Jack Lew in his confirmation hearing, a key congressional concern is that smaller banks not be lumped in with their much larger money center cousins, and have to bear the same regulatory burdens. Tarullo made a glancing reference to that concern, saying, "We have proposed varying the application of the Dodd-Frank Act's special prudential rules based on the relative size and complexity of regulated financial firms."

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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