Fed Ready to Raise Capital Standards If TBTF Remains Unsolved

WASHINGTON — Top Federal Reserve Board officials appear to have reached a consensus on how to deal with the "too big to fail" dilemma: wait for the current reform process to play out, but be ready to significantly increase capital standards if the problem remains unsolved.

Fed Chairman Ben Bernanke became the most recent central banker to call for such an approach, saying in a speech to the Chicago Fed conference last week that tougher capital requirements, not size caps, were the solution to "too big to fail."

"Rather than arbitrarily saying the banks can be no larger than such and such a size, for example, I would argue that what we need to do is make sure that larger institutions have to have more and better quality capital," said Bernanke.

Lawmakers are also focused on capital requirements as the solution. Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., introduced a bill last month that would require banks with more than $500 billion of assets to hold a 15% capital ratio, as well as scrap proposed Basel III standards and require bank subsidiaries to capitalize separately.

But Fed officials are forcibly pushing back against the need for such legislation by emphasizing that they have both the authority and the political will to raise capital standards on their own if megabanks continue to receive a funding advantage due to their perceived status.

"They're feeling heat from various fronts from the left and the right, and Brown-Vitter is a very powerful coming together of that critique in a sensible, articulate way that could become legislation," said Simon Johnson, an economist at the Massachusetts Institute of Technology. "When you have intelligent pressure applied intelligently from Capitol Hill, the regulators have to pay attention."

One industry source, speaking on condition of anonymity, agreed.

"All of this stepped up rhetoric on the part of the Fed is that this is signaling on the part of the Fed to Congress, 'We get it and we've got it. We're on the job. We understand how important capital is. You don't need to legislate. We're going to do our jobs,' " the source said.

Lawmakers' key argument is that the Dodd-Frank Act did not go far enough to eliminate the market's perception that some institutions are backed by the government.

But Bernanke and other Fed officials have repeatedly stressed that the Dodd-Frank Act and the Basel III package of capital and liquidity rules have not been fully implemented and must be given time to work. They have made it clear that the Fed is willing to revisit the issue once those reforms are complete.

"We will see if we are comfortable at that point, when that is all done, if we believe that the 'too big to fail' problem has been solved," said Bernanke. "If not, certainly one direction that we could go forward would be in my view, one constructive direction and a number of my board colleagues have talked about this, is through the capital direction."

Bernanke has tried to make the argument that additional regulations like robust capital, liquidity requirements and stress testing will incentivize the banks to reduce their size, complexity and interconnectedness.

The chairman's remarks appeared to remove any doubt that regulators stand ready to raise capital requirements, if needed, at a later point, some observers said.

"He could have closed the door to all of this talk about additional capital requirements by simply saying Basel III hasn't even been fully implemented yet and it would be irresponsible on what do next until regulators finish the process," said Jaret Seiberg, a policy analyst at Guggenheim Securities. "By keeping the door open, he's now created the expectation that regulators will act."

Others were less certain of how fast the Fed would move given the provisional nature of the chairman's remarks.

"I did not get the sense from him, as I did get the sense from [Fed Gov. Daniel] Tarullo's recent speech, that Bernanke himself was of the view that additional capital beyond what's already been announced whether in the context of Dodd-Frank or in the context of Basel III was imminent," said the industry source.

Part of the reason for that may be how far along regulators are in implementing Dodd-Frank and a hesitancy shared by both regulators and the banking industry to add more rules until the dust has settled on the new regulatory landscape.

"There are a lot of regulations in place," said Tony Fratto, a partner at Hamilton Place Strategies and a former top White House and Treasury official in the Bush administration. "It's not the cleanest system. Not everyone agrees with every regulation being put in place, but they're all having an impact on the industry. So before we go pushing new ideas, layering new ideas on top of what's already out there, can we at least take a little bit of time to see what these reforms and institutions that are being put into place are doing?"

Other Fed board members have made similar remarks as Bernanke. Tarullo, the official responsible for bank supervision, and Gov. Jeremy Stein, have separately called for going beyond Basel III capital requirements if needed.

"While I agree we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions," Stein said during a speech at the International Monetary Fund's annual spring meeting in April.

Stein said regulators could gradually increase a proposed capital surcharge on the largest globally active banks over time. For example, the proposed surcharge, which ranges from 1% to 2.5%, could potentially serve as a starting point. If, after some time, the surcharges do little to change the size and complexity of the largest banks, it could be concluded that the "implicit tax was too small, and should be ratcheted up," he said.

Johnson, who is also a co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, said such an approach would be a mistake.

"The idea that there is a dial on capital and you're going to tweak it on a quarterly basis and tweak it differently for different assets, how does that work for business planning or for having any kind of regulatory clarity?" said Johnson. "They'll get enormous push back on that and some of that will be justified. You're going to have a very hard time treating this like you would monetary policy instruments."

Tarullo has suggested that regulators might ask institutions to hold higher capital and more liquidity to ensure that banks are not susceptible to damaging runs in the wholesale funding market. He said that regulators could consider placing a "regulatory charge or other measure" on all uses of short-term wholesale funding, which would not be based on the type of transaction or whether the borrower was a regulated institution.

Bernanke left the door open even further by suggesting that the Fed could supplement its Basel III capital rules with an additional surcharge on the largest banks, while also noting that U.S. regulators had "some discretion" in how high they could set a leverage ratio. Fed officials, he said, are also considering requiring bank holding companies to hold a certain amount of unsecured senior debt in the event of a resolution.

While new capital standards under Basel III are generally regarded as a floor, not a ceiling, by supervisors, some observers warned against regulators taking an approach that would wind up overemphasizing capital as if it is a magic solution to the "too big to fail" problem.

"We're certainly of the view that banks have to be to well capitalized. But there are downsides to excessive capitalization," said John Dearie, executive vice president for policy at the Financial Services Forum. "Capital is not a silver bullet and should not be myopically focused on with the effect of obstructing banks' ability to do their job in the economy, which is to lend and take risks and fuel growth and job creation."

Others, like Johnson, disagreed with Bernanke's reluctance to embrace a size cap on the largest banks, calling it a "bit extreme."

"To say no size caps at all, it's very out-on-the-limb there," Johnson said. "You have to worry about big banks can get in your economy. That's a lesson we should learn from the European experience. If you don't have to rely on megabanks relative to the size of your economy, then you shouldn't. It's an unnecessary macroeconomic risk."