Fed's Tarullo Calls for Second Look at Bank Regulations

CHICAGO — Federal Reserve Board Gov. Daniel Tarullo said Thursday that regulators should consider modifying — or completely eliminating — outdated regulatory requirements that are no longer appropriate given other recent reforms to the system.

Tarullo, who heads bank supervision at the Fed, specifically endorsed scrapping Basel II's internal ratings-based approach to risk-weighted capital requirements, which is applied to all U.S. bank holding companies with at least $250 billion in assets.

"I believe we should consider discarding the IRB approach to risk-weighted capital requirements," said Tarullo, in prepared remarks at the annual Federal Reserve of Chicago bank regulatory conference.

He said the Fed's annual stress tests are a far better supervisory tool for setting minimum capital requirements for the largest bank holding companies, along with a new set of standards mandated by the Dodd-Frank Act.

"With the Collins Amendment providing a standardized, statutory floor for risk-based capital; the enhanced supplementary leverage ratio providing a stronger back-up capital measure; and the stress tests providing a better risk-sensitive measure that incorporates a macroprudential dimension, the IRB approach has little useful role to play," he said.

Still necessary, however, are sound quantitative risk management practices, which could be supervised through the yearly stress test exercises, he said.

Some observers, however, cast some doubt whether the Fed's stress test sufficiently address potential risks by withdrawing from the IRB-approach.

"There could be interesting consequences," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc., who also presented a paper at the conference. While she agreed that there are complexity issues and flaws in the Basel II approach, the flipside is there a risk from "walking away from some lessons we learned."

In his remarks, Tarullo laid out his rationale for disbanding the global standard, arguing that the decade-old effort to align risk weightings more closely to sophisticated quantitative risk-assessment techniques in the financial industry is "problematic."

"The combined complexity and opacity of risk weights generated by each banking organization for purposes of its regulatory capital requirement create manifold risks of gaming, mistakes, and monitoring difficulty," said Tarullo.

The Fed governor went further to criticize the current IRB-approach's "short, backward-looking basis" for calculating risks weights, which makes it "excessively pro-cyclical and insufficiently sensitive to tail risk."

Tarullo also recognized that the IRB-approach was an international standard first established in 2004. He suggested all countries part of the Basel Committee should move to adopt a standardized risk-weighted and supervisory stress testing requirements for all globally active banks.

While the effort could be complicated, it would not be any harder than the problems of consistency and transparency that arose under Basel II, he said.

"There is no reason to believe that the task of creating an oversight and review framework for supervisory stress testing would be any more difficult," said Tarullo.

The Fed governor also suggested making some adjustments to better tailor its requirements to a wide variety of institutions — large and small — in order to minimize the trickle-down effect caused by tougher regulations.

Supervisors have actively taken steps to avoid unnecessary regulatory costs for community banks, but that effort could be furthered by excluding smaller banks from particular requirements, like executive compensation and the Volcker Rule, which bans banks from taking risky bets with taxpayer money, said Tarullo.

"Even where regulatory frameworks try to place a lesser burden on smaller banks, there may be some risk of 'supervisory trickle down,' whereby supervisors informally, and perhaps not wholly intentionally, create compliance expectations for smaller banks that resemble expectations created for larger institutions," said Tarullo.

Barney Frank, former chairman of the House Financial Services Committee and co-author of the regulatory reform bill, said many of his former colleagues on Capitol Hill would be "very sympathetic" to exempting community banks from specific rules intended for the largest financial institutions.

"The assumption we made," Frank said reflecting on the drafting of the 2010 reform law, "was because these things were not applicable to smaller banks, they would not be a burden. But establishing they are not applicable takes work."

Tarullo went even further to suggest doubling the threshold at which a bank is considered systemically important from the $50 billion level established by the regulatory reform law.

"If the line were redrawn to a higher figure, we might explore simpler methods for promoting macroprudential aims with respect to banks above $10 billion in assets but below the new threshold," said Tarullo.

Changing the threshold, however, would likely require an act of Congress, and Tarullo didn't offer any suggestions of his own of how it could be accomplished otherwise.

"He stated the problem very well, but he didn't really give us any solution about what would be done in changing the thresholds," said Edward Kane, a professor at Boston College.

Still, Terry Jorde, senior executive vice president and chief of staff of the Independent Community Bankers of America, said she was "encouraged" by Tarullo's comments.

"There's a recognition that there's a different business model among different banking organizations and it's appropriate to regulate based on what the business model is and the systemic risk it brings to the national economy," said Jorde, at the conference.