Regulation Should Influence Risk-Taking at Firms: Fed's Tarullo

WASHINGTON — Federal Reserve Gov. Daniel Tarullo on Monday said a slew of new regulations imposed on the biggest U.S. financial institutions should influence how banks make risky bets.

While prudential rules can reduce the types of risky activities that banks engage in, they can also, where permitted, "indirectly" influence corporate decision-making by requiring minimum capital requirements. The Dodd-Frank Act, meanwhile, required banks to maintain independent risk committees as well as added a number of measures to firms that pose a threat to financial stability.

In making his argument, Tarullo outlined three regulatory measures that help align corporate governance at banks with supervisors' objectives, while also suggesting that bank directors should be responsible for meeting regulatory goals as part of their fiduciary duty.

Long-Term Debt. There's more than just one reason for forcing some of the country's riskiest banks to adhere to a long-term-debt requirement. Not only would the measure help to increase financial institutions' loss absorbency by holding a certain amount of debt that can be easily converted to equity, it could help to realign incentives, Tarullo argues. "While the principal motivation of such a requirement is to help ensure that even a very large financial firm can be resolved in an orderly fashion without the injection of capital, identifying debt instruments as convertible to equity in a context where resolution is a credible option should make the price of those instruments especially sensitive to the relative risk of failure of those firms," said the Fed governor, who is responsible for bank supervision at the central bank. There have been a number of ideas floated so far, including deferring compensation and subjecting it to clawback and forfeiture; or aligning compensation packages with the liability side of a bank's balance sheet, he said. While some version of either of these approaches may come into fruition, the salient feature in either will have to promote prudential objectives across many risky decisions made within the firm. That's why Tarullo argues: "Requiring systemically important financial firms to issue a meaningful amount of long-term debt would indirectly influence corporate governance by introducing at-risk debt holders as a constituency whose concerns management must monitor and address."

Capital. While the Fed's decision to utilize its discretion to reject unfit capital plans by dozens of the largest banks in U.S. may have been vehemently opposed by the industry, regulators' use of those powers makes sense, Tarullo says. Bank regulators, he argues, are "not only permitted, but obliged," to set capital requirements for banks. Capping a firm's capital distribution is "no different from requiring a firm to build capital in the first place," he says. "Tying capital levels to corporate governance decisions about capital distributions simply recognizes that capital levels and capital distributions are two sides of the same coin."

Stress Testing. As banks' internal risk-management processes improve, so does regulators' ability to provide more timely responses. In short, it enhances the "supervisory line-of-sight into the safety and soundness of a firm," says Tarullo. It also allows regulators a point-of-entry for meeting objectives as supervisors. The Fed's annual stress test exercise and Comprehensive Capital Analysis and Review accomplish just that, says Tarullo. "Discrete regulatory measure, well-developed processes for determining risk appetite give supervisors better insight into risks specific to the activities and strategic decisions of each firm," Tarullo said. "As a result, supervisors should be better able to identify points at which a firm's risk-taking may diverge from that which is consistent with microprudential and macroprudential objectives."

Fiduciary Duties. Tarullo also opened the door to potentially changing the fiduciary duties of the boards of Fed-supervised banks to meet regulatory objectives. "Doing so might make the boards of financial firms responsive to the broader interests implicated by their risk-taking decisions even where regulatory and supervisory measures had not anticipated or addressed a particular issue," said Tarullo.