Efforts to End Too Big to Fail on 'Right Track': Fed's Powell

WASHINGTON — Federal Reserve Board Gov. Jerome Powell said efforts by regulators to eliminate "too big to fail" could take years to complete, but said the agencies must be given a chance to make them work.

"It seems to me that efforts by U.S. and global regulators to fight 'too big to fail' are generally on the right track," Powell said in a prepared speech before the Institute of International Bankers conference. "The 'too big to fail' reform project is massive in scope. In my view, it holds real promise. But the project will take years to complete. Success is not assured."

Tougher regulation through higher capital and liquidity standards, stress tests and recovery planning will help to reduce the likelihood of failure of the largest most complex banks, he said.

Secondly, he cited the Federal Deposit Insurance Corp.'s orderly liquidation authority, which will help mitigate the potentially catastrophic consequences if a bank does fail.

At the heart of the debate is whether the current regulatory reform effort goes far enough. Some lawmakers, including Sens. Sherrod Brown and David Vitter, have called for a break up of the largest firms. Others like Sen. Elizabeth Warren, D-Mass., have worried that the market continues to treat big banks differently because of a perception they will be bailed out if they get into trouble.

Powell agreed that market perception was a critical problem.

"The market needs to believe--and it needs to be the case--that every private financial institution can fail and be resolved under our laws without imposing undue costs on society," said Powell.

But he disagreed with critics of Dodd-Frank who argue that the new resolution authorities will end up enshrining taxpayer bailouts, a position embraced by many House Republicans.

"I do not believe that it does," said Powell. "OLA requires by its terms that the losses of any financial company placed into FDIC receivership be borne by the private sector stockholders and creditors of the firm. Single point of entry can work without exposing taxpayers to loss."

He also rejected other policy prescriptions, including those calling for a reinstatement of the 1930's Depression-era Glass-Steagall law, which separated commercial banks from investment banks.

Resurrecting such a law "seems neither directly related to the causes of the financial crisis, nor likely to held end too big to fail," said Powell.

The systemic runs that led to the financial crisis started at traditional investment banks, like Bear Sterns and Lehman Brothers, he said. Losses at those commercial banks were a consequence of bad credit underwriting and the failure of risk management systems to keep up with innovation and the rapid growth of securitization.

As for potential further action to limit the size of banks or their systemic footprint, Powell said such proposals "require, and deserve, careful analysis."

He said there are already two provisions under Dodd-Frank that impose size caps on U.S. banking firms. The first limits acquisitions of financial institutions by any bank holding company that controls more than 10% of the total insured deposits in the U.S. The second prohibits acquisitions by any financial firm that controls more than 10% of total liabilities of financial firms in the U.S.

Dodd-Frank also added a new requirement that banking regulators consider the "risk to the stability of the U.S. banking or financial system" in evaluating any proposed merger or acquisition by a bank holding company.

"The simplest forms of this idea would put a further absolute limit on the amount of balance sheet assets or liabilities, or on the risk-weighted assets of a financial firm," said Powell. "Capping the size or systemic footprint of each financial firm would limit the adverse systemic effects of the failure of any single firm. Smaller, simpler financial firms should be easier to manage and supervise in life, and easier to resolve in death."

Powell also endorsed an idea first floated by Fed Gov. Daniel Tarullo to impose a cap on large U.S. banking firm's short-term non-deposit liabilities as a fraction of U.S. Gross Domestic Product.

"This form of proposal would allow such a firm to continue to increase assets and diversify its activities to achieve potentially available economies of scale and scope, so long as the firm finances expansion through more stable forms of funding," said Powell.

Speaking at the same conference, Mary Miller, Treasury undersecretary for domestic finance, said the Financial Stability Oversight Council is closing in on another much-discussed aspect of Dodd-Frank: identifying systemically important nonbanks. Miller said she hopes the FSOC will vote on the designations for the first set of companies in the next few months.

The FSOC is "in the final stages of evaluating an initial set of nonbank financial companies for potential designation, which will subject them to enhanced prudential standards and supervision by the Federal Reserve, closing an important regulatory gap," she said. "This is not a power the Council wields cavalierly."

— Rachel Witkowski contributed to this article.

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