Fed's Tarullo Rejects Big-Bank Worries Over Capital Surcharge

WASHINGTON — A top Federal Reserve Board official on Friday defended an international plan to levy an additional capital charge on the largest financial institutions.

In a speech before the Peter G. Peterson Institute for International Economists, Fed Gov. Daniel Tarullo disputed criticisms that the capital surcharge would hurt the economy.

"Some of these objections actually strengthen the case by revealing certain misplaced assumptions about the financial system that are embedded in the arguments of those who oppose a meaningful additional requirement," Tarullo said.

International regulators have proposed a new set of capital standards for all institutions, which would require them to hold a common equity ratio of at least 7% by 2019. But they have also warned they plan to add a capital surcharge for the largest banks that pose a threat to the economy.

So far, the size of the surcharge has not been determined, but the Basel Committee on Banking Supervision is expected to release its proposal on the issue in the next few months, fueling anxiety among banks about what regulators are planning. The Fed is also separately working on its own rule about enhanced prudential standards for such systemically important institutions, Tarullo said.

"The parallelism of international and domestic processes should facilitate the goal of congruence," he said.

But banks have argued a capital surcharge goes too far and would force them to reduce their balance sheets significantly, because they won't be able to earn the rate of return demanded by investors — hurting the economy in the process.

"This argument is conceptually incomplete, if not flawed, even when applied to generally applicable capital requirements," Tarullo said. "To the extent that equity investors demand higher rates of return from financial firms than non-financial firms, it is largely because financial firms are so much more highly leveraged. Thus, the risk of loss is greater."

For those who argue that an additional charge would make lending unprofitable, he said, smaller banks, which do not pose a systemic risk and have lower capital requirements, could fill the gap.

"To be sure, they may not be [a] perfect substitution, particularly not in the short term," Tarullo said. But that is one reason that regulators are "contemplating a fairly generous transition period to the [systemically important financial institution] capital regime."

Tarullo said it was "shortsighted" for institutions to argue a capital surcharge is a "punishment" for their size and interconnectedness.

"A SIFI capital requirement would not prohibit the size and interconnectedness of today's firms," he said. "Rather, it would incentivize firms to maintain those dimensions only if there are risk-adjusted returns for activities that require this scale."

Tarullo outright dismissed claims that by creating metrics to identify systemically important firms it would increase, rather than lower, the risk of moral hazard. Critics have said it will solidify the perception of "too big to fail" banks.

"Moral hazard is already undermining market discipline on firms that are perceived to be 'too big to fail.' Higher capital standards will help offset the existing funding advantage for SIFIs," Tarullo said.

He also disagreed with assertions that a surcharge is no longer needed given other requirements under Basel III and the Dodd-Frank Act.

"Capital regulation is the supplest and most dynamic tool we have to keep pace with the shifting sources of risk taken by financial firms," Tarullo said. Such standards would be "complementary rather than as substitutes."