WASHINGTON — Congress should consider placing a limit on the size of the largest banks to put an end to the "too big to fail" problem, Federal Reserve Board Gov. Daniel Tarullo said Wednesday.

During a speech at the University of Pennsylvania Law School, Tarullo suggested one possible method: limiting the non-deposit liabilities of financial firms to a specific percentage of gross domestic product.

"In addition to the virtue of simplicity, this approach has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm's dependence on funding from sources other than the stable base of deposits," Tarullo said.

Tarullo's comments add yet more momentum to the drive for a more radical solution to deal with the problem of "too big to fail."

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

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

"To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow," Tarullo said. "There is, then, a case to be made for specifying an upper bound."

Tarullo warned, however, that there would be challenges to implementing his proposal, including determining what the "applicable percentage of GDP" should be.

"The answer would depend on a judgment as to how much of an impact the economy could absorb," said Tarullo. "It would also entail a judgment as to how large and complex a firm needs to be in order to achieve significant economies of scale and scope that carry social benefit."

Additionally, policymakers would need to consider "whether to exclude a firm's calculated liabilities only insured deposits and which asset base to use in calculating non-deposit liabilities."

Tarullo suggested that based on answers by lawmakers, policymakers could use a transition period and compliance margins.

"Even good answers to all these questions would produce a policy instrument that could seem excessively blunt to some," said Tarullo. "But this is a debate well worth having."

During his speech, Tarullo also suggested that regulators should deny any acquisition by a firm that is in the top half of companies deemed systemically important to the global economy. Firms at the lower end might have "slightly less robust, but still significant presumption against acquisitions," he said.

The Basel Committee has already designated more than two dozen firms as globally significant, including eight U.S. banks.

Tarullo's remarks on a potential size limitation came as he raised challenges in implementing Dodd-Frank's mandate to foster and preserve "financial stability," primarily because Congress gave the agencies little guidance on how to proceed.

"Dodd-Frank creates a legal and institutional framework within which financial stability regulation is to be developed but, with a couple of notable exceptions; it does not delineate the steps that should actually be taken to promote financial stability," Tarullo said.

The 2010 reform law asks regulators to consider financial stability when considering proposed mergers, the designation of systemically important companies and setting appropriate capital requirements. But it does not define the concept.

"The statute itself provides only limited guidance to regulators on how to implement financial stability where it is established as a standard, or how to weight it against economic growth and other considerations where it is used as an informing concept for a regulatory exercise or a factor to be considered in regulatory approvals," said Tarullo. "Moreover, one does not really find in the statute or in its legislative history an implicit theory of financial stability from which to infer answers to the regulatory questions just noted."

For example, the Financial Stability Oversight Council is required to use a potential threat to financial stability as a factor — along with scope, size, scale, and interconnectedness — when designating firms as systemically important. Dodd-Frank also added financial stability as a factor the central bank must consider when evaluating proposed mergers or acquisition by a bank or bank holding company.

For Tarullo, that raises a number of concerns.

"There is no legacy of administrative or judicial analysis of the financial stability effects of mergers," said Tarullo. "We literally had to start from scratch."

He noted that there could be cases where a merger would decrease the chances of financial distress at a firm, but elevate the potential for risk in the financial system.

Alternatively, an acquisition may hurt a firm but wind up helping the system temporarily, such as JPMorgan Chase & Co's pick-up of Bear Stearns and Washington Mutual during the midst of the financial crisis. Tarullo argued that while such a move could provide some near-term stabilization, it would come at the cost of "greater moral hazard and risks to the financial stability over the medium term."

Regulators must also provide some guidance to firms about what financial stability entails, Tarullo said.

"For all the attention paid to financial stability analysis in the last few years, it is still — relatively speaking — a fledging enterprise," said Tarullo. "Even if we hypothesize a viable working theory of financial stability that commands a rough consensus, translating that theory into administrable standards and processes is a task that will take years."

During the speech, Tarullo also raised further concerns about the need to press ahead with reforms on the money market mutual fund industry.

Treasury Secretary Tim Geithner sent a letter to the members of the FSOC recently urging them to use their authority to consider an alternative means to wrestle with this issue. The move was prompted after Mary Shapiro, chairman of the Securities and Exchange Commission, failed to gain consensus among the agency's board to move forward with her set of reforms on the funds.

But Tarullo said using the FSOC's powers is not an ideal solution.

Tarullo said any of the options open to the FSOC is "decidedly a second-best alternative as compared to a change in SEC rules to remove the fixed net asset value exception, to require a capital buffer that would staunch or buffer runs, or measures of similar effect."

"The protective tools available to the rest of us do not fit the problem precisely and thus will not regulate at the least cost to the funds while still mitigating financial risk," said Tarullo.

His hope is that the SEC will move ahead with reforms, which "will lead to the SEC adopting first-best measures in the near term."

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