WASHINGTON — Federal Reserve Board Gov. Dan Tarullo's speech last week that the largest banks may have to hold even more capital than previously expected touched off a fierce debate: how much capital is enough?
Tarullo's intent may have been simply to shed light on the central bank's thinking as he headed to Frankfurt to negotiate with international regulators on new capital and liquidity requirements. But his remarks had the opposite effect, raising new fears about how much the Fed wants to raise capital requirements.
"He was throwing around numbers — 100% of Basel III," Hugh Carney, general counsel for the American Bankers Association, said of Tarullo's suggestion that the largest banks could face double the capital requirements of smaller institutions. "What does that mean? People get spooked by that."
At issue is a proposed capital surcharge for systemically important financial institutions, or SIFIs. Under proposed Basel III requirements, all banks would have to hold 4.5% of common equity by 2015, plus a 2.5% conservation buffer that would take effect in full in 2019.
Though international regulators had discussed an extra capital charge for the largest institutions, most analysts had expected it to be roughly 3%.
But Tarullo raised the prospect that regulators may go even higher, offering a range of 1.5% to 7% on top of the proposed Basel III capital requirements.
The biggest banks, then, would have to hold capital of 8.5% to 14%, not including an extra countercyclical charge regulators are devising that would force banks to build up capital in good economic times.
The mere mention of a possible 14% capital charge alarmed many observers.
"This is a ridiculously high and unwarranted capital level that could take the better part of a decade for the banks to grow into, and we certainly do not envision the banks raising common equity to get there, as it would be massively dilutive," wrote Christopher Mutascio, an analyst for Stifel Nicolaus.
Tarullo's comments made investors uneasy, with several banks' stock prices falling, and may have moved JPMorgan Chase & Co. Chairman and CEO Jamie Dimon to confront Fed Chairman Ben Bernanke at a public event in Atlanta this week about fears of overregulation.
Most observers said banks do not expect the 14% capital requirement to come to fruition.
"They don't really believe the 14% is likely, but I do think they believe it's going to be higher than 7%," said Greg Lyons, a partner at Debevoise & Plimpton LLP.
Industry representatives said Tarullo appeared to be making a point rather than seriously suggesting that Basel III capital requirements be doubled for large banks.
"Bankers were first thunderstruck. Then they started making a few calls, and what they basically think they learned was that the 14% wasn't real," said a banking lawyer, who requested anonymity. "It was being thrown out as sort of a warning sign to how far the Fed would go."
Whether that was Tarullo's intent is unclear, but some have interpreted his comments as an attempt by the Fed to justify a 3% additional capital SIFI surcharge, while still offering a compromise to the banks. People familiar with the matter said the Fed is still targeting a 3% surcharge for the biggest banks, which would raise their total capital requirements to 10%.
The issue likely will come up again at next week's House Financial Services Committee hearing, where Tarullo and others, including acting Comptroller of the Currency John Walsh and Federal Deposit Insurance Corp. Chairman Sheila Bair, are expected to testify on progress made on global coordination in implementing Basel III.
To be sure, even the Fed — while offering a soft endorsement of such a capital SIFI surcharge plan — has noted that there are other possible means to determine what the add-on could be.
It has also become apparent that regulators are likely to distinguish between the largest SIFIs and the smaller ones, which was one of the banking industry's chief initial concerns. The largest such institutions likely will face a higher surcharge than smaller ones.
A persistent question is how regulators will determine the capital surcharge. Unlike last year, when regulators reached the required 7% common equity ratio, there is no single obvious way to calibrate it.
Tarullo suggested that the surcharge calculation would be based on a number of assumptions, but he was not specific about them. "The assumptions make a huge difference, and the process so far has not been terribly transparent," the ABA's Carney said. "We don't know what the assumptions would be."
Bank observers said there is little public data to make such a calculation.
"You don't see anything empirical," said Ernest Patrikis, a lawyer at White & Case LLP. "These things are just not discussed. What is the rationale for the right amount of capital? The attitude is, 'We're not going to have big banks fail.' You have to take a step back and say, 'Oh, I always thought failure was America's way.' "
Banks had hoped that requirements of the Dodd-Frank Act, including those that would make it easier for regulators to take apart large banks in a crisis, would slow the push for an added capital surcharge.
"There had been the hope by the larger banks that all of these other requirements of Dodd-Frank, like the living wills, would reduce the need for these surcharges, and they would just prove to be overly burdensome relative to the benefit they provided," Lyons said. "That's disappointing to a lot of folks."
Tarullo emphasized in his speech that such a fee for the biggest banks would be regarded as "complementary rather than as substitutes."
That regulators are working at such a brisk pace to complete this process ahead of the Group of 20 summit this fall makes banks all the more uneasy.
"Why are they in such a rush? Basel III isn't taking effect until 2019, Europe is still debating reg reform and Asia hasn't started. And yet they want to rush out some global SIFI surcharge, which has no intellectual foundation," said a banking executive who spoke on condition of anonymity. "The rush doesn't make any sense."
