Fed's Tarullo Raises Doubts on Glass-Steagall Revival

WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo voiced concern Tuesday about a potential move to reestablish Glass-Steagall, a Depression-era law that separated investment and commercial banking.

Tarullo said such a division would result in "substantial costs" by limiting the types of services that banks currently offer. It might also inadvertently hurt smaller-sized institutions that provide capital market services to small businesses.

"The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options — from lines of credit to public equity offerings — depending on a client's needs and market conditions," Tarullo said in a speech at the Brookings Institute.

Other proposals, including a cap on a bank's non-deposit liabilities or a requirement to hold minimum levels of long-term debt, might be better options to help regulators limit a megabank's risk to the financial system. During a question and answer session following his speech, Tarullo hastened to add he was not endorsing any particular approach.

Tarullo has previously suggested the idea of capping a bank's non-deposit liabilities as a fraction of U.S. gross domestic product. He also called on Congress to place a limit on the size of the largest U.S. banks.

Although the Dodd-Frank Act gave regulators significant new tools to deal with megabanks, many policymakers, including Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig, have suggested the financial reform law did not go far enough.

While Tarullo has not gone as far as Hoenig, who has called for a big bank breakup, the Fed governor's suggestion of a size limitation is potentially significant because it acknowledges that policymakers must do more to deal with the issue.

Tarullo said capping non-deposit liabilities would eliminate an overt reliance on such funding, which has proven susceptible to "dramatic runs." Additionally, such an approach would reduce a certain amount of risk given that non-deposit liabilities among U.S. financial firms tend to be highly correlated.

Moreover, even if doing so placed constraints on the size and composition of a firm's balance sheet, it would still allow some "flexibility" in how a bank would choose to meet that threshold.

"A firm could shrink its balance sheet by shedding less profitable assets of its choosing," said Tarullo. "It could also shift its funding model more toward deposits assuming, of course, it does not exceed applicable deposit caps."

Even so, there are critical questions that need to be answered, despite the proposals having "conceptual appeal." For example, policymakers have yet to figure out what the appropriate percentage of GDP that would constitute a cap. Determining a limit would be based on several factors, including the capacity of the U.S. economy and financial system to absorb the losses resulting from the failure of a firm, Tarullo said.

Other questions, he said, pertain to the scale and scope of the economics related to non-deposit funding and how second- and third-tier institutions might respond as the largest banks reposition or shed part of their balance sheets.

Separately, another approach under consideration is to require large financial firms to hold minimum levels of long-term debt as a way to facilitate the orderly resolution of such banks, Tarullo said.

"A minimum long-term debt requirement could lend greater confidence that the combination of equity owners and long-term debt holders would be sufficient to bear all losses at the firm, thereby counteracting the moral hazard associated with taxpayer bailouts while avoiding disorderly failures," said Tarullo.

Requiring banks to hold a minimum level of long-term debt would allow regulators to transfer operating subsidiaries of a failed firm to a bridge entity, while leaving behind in a receivership equity and sufficient long-term debt to absorb the original firm's losses. Such an approach, he said, is consistent with the Federal Deposit Insurance Corp.'s preference for a "single-entry" strategy in dealing with the resolution of systemically important firm.

Tarullo acknowledged that there would be some costs attached to such a requirement for the largest, most complex banks, but it would be an intentional one.

"If there is a modest effect on industry structure, it would be an intended — rather than unintended or undesirable — consequence of the regulation," said Tarullo.