August 9, 2022

To Cushion Against Losses, Fed Considers Raising Capital Requirements for Banks

The governor, Daniel K. Tarullo, said “systemically important financial institutions,” a category specified in the sweeping overhaul of financial regulation enacted last year, would be required to carry substantially higher levels of capital on their books. The levels would act as a cushion against losses, perhaps as much as twice the level specified in new international banking standards.

“The failure of a systemically important financial institution, especially in a period of stress, significantly increases the chances that other firms will fail,” Mr. Tarullo said. But because those firms have “no incentive to reduce the chances of such systemic losses,” higher capital requirements are necessary “to make those large, interconnected firms less prone to failure.”

Wall Street is bracing for guidelines as to how federal regulators will decide which companies fall under the “systemically important” designation. Mr. Tarullo’s remarks, before a group at the Peterson Institute for International Economics here, offered some of the first public details on how regulators are thinking about the rules. The law requires that banks, nonbank financial firms like hedge funds, insurance companies or other institutions that greatly affect the financial system, to be subject to an additional capital requirements to prevent a repeat of the 2008 financial crisis. The crisis was made worse by the interdependence of many of the largest financial outfits.

Mark A. Calabria, director of financial regulation studies for the Cato Institute, said that among the most interesting details provided by Mr. Tarullo on Friday was that the Fed was considering that the new capital requirements should be imposed on a sliding or tiered scale.

The new Dodd-Frank law requires that the new standards be applied to bank holding companies with more than $50 billion in assets. But Mr. Tarullo said that he thought there should not be a huge difference in the requirements for a bank with, say, $51 billion in assets and another with $48 billion.

“It seems like he was saying they do not want to draw a line in the sand,” Mr. Calabria said, “although the statute seems to require that.”

The possibility of greater capital requirements has caused some financial companies that are dominant in their niche to begin to argue publicly that they are not so “significant” after all.

BlackRock, the money manager that manages $3.5 trillion in assets, recently told the Fed that “for a number of reasons we do not believe that asset management firms should be designated” as systemically important.

Mr. Tarullo said that the Fed had considered several methods for determining if a company was systemically significant. But, he said, the one approach that “has had the most influence on our staff’s analysis” was what he called the “expected impact” approach, which was intended to equalize the impact on the financial system of the failure of a systemically important firm and a large firm without that designation.

If, for example, the blow to the financial system from the failure of a systemically important firm would be five times the impact of the failure of a nonsystemic firm, the larger company should have to hold enough additional capital to make its expected probability of failure one-fifth that of the smaller firm.

The more important firm, Mr. Tarullo said, should therefore hold capital equal to 20 percent to 100 percent more than the recently heightened banking requirements known as Basel III, which requires banks to maintain capital equal to 7 percent of assets. By that formula, systemically important financial companies might be required to hold capital of 8.4 percent to 14 percent of assets — a huge increase over the 2 percent that was the standard before the financial crisis.

Banks have argued that heavy new capital requirements will leave them less able to lend money to businesses, drying up credit and hurting the economy. But Mr. Tarullo argued that “lending could be assumed by smaller banks that do not pose similar systemic risk and thus have lower capital requirements.”

“There may not be perfect substitution, particularly not in the short term,” he said — a reason that regulators will allow for a long transition period to apply the new capital requirements.

Nevertheless, he said, “some checks on the scale of systemically important financial institutions are warranted to avoid a repeat of the financial crisis.”

Related to that, he said the capital requirements should be strict enough that companies are not encouraged to seek designation as systemically important because they think that they will then be “too big to fail.” The new regulations should discourage very big firms from getting much larger, “unless the benefits to society are clearly significant.”

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