WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo said Wednesday that limiting government protection to depository institutions or slashing the size of banks would do little to address problems posed by companies considered "too big to fail."
His comments to the Exchequer Club came a day after Mervyn King, the governor of the Bank of England, said governments should protect only the vanilla aspects of banking, carve out riskier trading activities and shrink the size of mammoth companies.
Tarullo did not directly discuss King's comments but noted problems with the ideas he advanced. For one, he argued, complex trading activities were not the sole cause of the financial crisis.
"Some very large institutions got themselves into a good deal of trouble through risky lending alone," he said. "Moreover, as we have seen in the experience of Bear Stearns and Lehman, firms without commercial banking operations can now also pose a 'too big to fail' threat."
As for downsizing systemically important institutions, Tarullo said, the task would be far more difficult than the breakup of AT&T during the 1980s.
"Indeed, to my knowledge, no one has offered anything like standards for undertaking this task, much less a blueprint for how it might be accomplished," he said. "This is, in other words, more a provocative idea than a proposal."
Instead, Tarullo encouraged regulators to employ a combination of approaches to keep the largest financial companies in check. For one, regulators should use capital requirements to head off risky business activities. He said regulators worldwide have agreed to tougher capital charges for trading and securitization exposures and continue to work on ensuring institutions' quality of capital.
Complementing the push for better capital, Tarullo agreed that systemically important companies should be subject to an additional charge, an idea included in the Obama administration's regulatory reform plan.
"Ideally, this requirement should be calibrated so as to begin to bite gradually as a firm's systemic importance increased, so as to avoid the need for identifying which firms are considered too big to fail," he said.
Echoing the administration's reform plan, Tarullo said any company with systemic importance — not just commercial banks — should be subject to heightened oversight. "Action by Congress is needed to ensure that other firms posing such a risk — now or in the future — can be brought within the perimeter of regulation," he said.
Taking questions from the audience, Tarullo acknowledged that some large banks have only grown further during the financial crisis, thanks to purchases of their weaker competitors.
"That underscores the importance of … measures to contain the systemic risk and too-big-to-fail problems at the outset during more normal periods," he said.
As much as lawmakers and the public may gnash their teeth over the bailouts during the current crisis, Tarullo essentially said that the problem of too big to fail cannot be extinguished.
"No matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention," he said. "Once a government has obviously extended the reach of its safety net, moral hazard problems are compounded, as market actors may expect similarly situated firms to be rescued in the future."
