Bloomberg News

Tarullo Says Fed Should Oppose Mergers That Increase Risk

June 03, 2011

(Updates with comment from analyst in eighth paragraph.)

June 3 (Bloomberg) -- Federal Reserve Governor Daniel Tarullo said regulators should use capital surcharges to discourage mergers by large banks that would increase risk without yielding significant public benefits.

Tarullo signaled that the Fed aims to use tougher capital standards correlated to the size of a firm to curb risks posed by “systemically important financial institutions,” or “SIFIs.”

“There is little evidence that the size, complexity, and reach of some of today’s SIFIs are necessary in order to realize achievable economies of scale,” Tarullo, the Fed governor responsible for supervision and regulation, said in a speech at the Peterson Institute for International Economics today in Washington. “The regulatory structure for SIFIs should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant.”

The world’s largest banks face one of the biggest revisions of capital, liquidity and risk management requirements by regulators responding to public opposition to government bailouts. The Dodd-Frank Act in the U.S. mandates that the Fed establish heightened standards for banks with assets over $50 billion. In addition, global regulators are hammering out accords in Basel, Switzerland, that would more than double the minimum common equity requirement for banks.

The KBW Bank Index was down 0.36 to 47.76 at 3:48 p.m. New York time.

Capital Requirements

The Fed is developing a metric for banks with more than $50 billion in assets that gradually increases capital requirements according to measures of systemic importance including size, Tarullo said.

“The ideal approach would be a continuous function, by which the percentage rate of the additional requirement would vary precisely with the measure of a firm’s systemic importance,” Tarullo said. “An alternative would be a tiered structure, by which firms are divided into several groups on the basis of the systemic metric.”

Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington, called the speech “emphatic and unforgiving.”

“Higher amounts of mandated equity result in a lower return on equity” as banks carry less leverage, she said. “Regulators argue that this will produce a more stable return. But that remains to be seen.”

Additional Surcharge

Under international proposals known as Basel III, 15 to 26 of the biggest global banks will also likely face an additional surcharge because regulators don’t believe they have an effective cross-border resolution scheme, according to a memo from the Global Financial Markets Association obtained by Bloomberg News.

“The complexities of cross-border resolution of such firms, to which I alluded earlier, apply equally to foreign- based institutions,” Tarullo said. “For these reasons, we have advocated in the Basel Committee for enhanced capital standards for globally important SIFIs.”

Most analysts are working with an assumption that so-called global SIFIs will face a surcharge of 3 percent additional capital under Basel III, Shaw Petrou said.

Tarullo, responding to questions after the speech, said regulators including the Fed need to ensure their supervisory standards are clear.

“The metric for systemic risk needs to be transparent,” he said.

New Regulations

Jamie Dimon, chairman and chief executive officer of JPMorgan Chase & Co., warned yesterday that a wave of new regulations and capital requirements will distort markets.

“You’re going to end up with 10 percent capital for banks like us,” Dimon said at the Sanford C. Bernstein & Co. investor conference in New York. “It will have ramifications on what people pay for credit, what banks hold on balance sheets.”

In his speech, Tarullo rejected this objection, saying it was “conceptually incomplete, if not flawed, even when applied to generally applicable capital requirements.”

If the additional requirements make some lending unprofitable for larger banks it could then “be assumed by smaller banks that do not pose similar systemic risk and thus have lower capital requirements,” he said.

Disputed Notion

Tarullo also disputed the notion that the Fed’s actions were “punishment” of large firms, saying there is “little if any research” showing that the largest firms need their size in order to achieve economies of scope and scale.

Identifying the largest firms won’t increase moral hazard, Tarullo said, because “moral hazard is already undermining market discipline on firms that are perceived too-big-to-fail.”

Global regulators shouldn’t allow too-big-to-fail banks to use contingent convertible bonds to meet additional capital requirements, Tarullo said.

So-called CoCo bonds, which convert into a bank’s ordinary shares if a specific trigger event occurs, are being considered for a capital surcharge on big banks by the Basel Committee on Banking Supervision. Tarullo said “it wasn’t clear” how they could be “structured so as to convert in a timely, reliable fashion.”

“There is considerable risk that once some form of hybrid is permitted, a slippery slope effect ensues, whereby national regulators approve increasingly diluted forms of capital under political pressures,” he said.

Foot the Bill

Some regulators are exploring the use of CoCos to protect taxpayers from having to foot the bill for future bank rescues. Switzerland proposed that the country’s two largest banks, UBS AG and Credit Suisse Group AG, could use CoCos to satisfy part of a capital surcharge imposed at the national level.

“It’s not set in stone whether it’s going to be common equity, CoCos, or if a combination will be allowed,” Lars Frisell, chief economist of the Swedish Financial Supervisory Authority and a member of the Basel committee, said in an interview last month in Stockholm.

--Editors: James Tyson, Christopher Wellisz

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Joshua Zumbrun in Washington at jzumbrun@bloomberg.net; Ben Moshinsky in London at bmoshinsky@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net


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