WASHINGTON Federal Reserve Board Gov. Daniel Tarullo said Friday that short-term wholesale funding continues to pose a risk to the largest banks and that fixing such "structural vulnerabilities" is a top priority to protect the financial system.
In a broad policy speech, he argued that an additional capital buffer on the biggest banks should be put into place and said that it must be a stand-alone requirement that is not beholden to economic conditions.
"One reason I place a high priority on initiatives to address the vulnerability created by short-term wholesale funding is that the development of these and other structural measures does not depend so heavily on identifying when credit growth or asset prices in one or more sectors of the economy have become unsustainable," Tarullo said.
The central banker has repeatedly called for further reforms on short-term wholesale funding given the risk of potential fire sales, as were seen during the 2008 financial crisis.
"Although the amounts of short-term wholesale funding have come down from their precrisis peaks, this structural vulnerability remains, particularly in funding channels that can be grouped under the heading of securities financing transactions," he said.
He also made the case that while a liquidity requirement, known as the liquidity coverage ratio, would be an "important step" in helping to shore up banking firms' liquidity, additional measures were needed to address vulnerabilities with short-term wholesale funding.
Tarullo said U.S. regulators would be releasing a proposal to adopt the Basel III measure "soon."
"The task of determining how much additional capital is needed to reduce the probability of a systemically important firm's failure to more acceptable levels is not a straightforward one," Tarullo said.
He again criticized as inadequate the Basel Committee on Banking Supervision's approach to the capital surcharge: placing an additional buffer on globally active banks, including eight U.S. firms.
"The 1-2½ percent amounts negotiated within the Basel Committee are at the low end of that range, reflecting a good deal of caution frankly, more caution than I think would have been desirable, even given the uncertainties," Tarullo said.
He also criticized the so-called countercyclical capital buffer, which is intended to shore up capital during good times but which lenders can also use in periods of stress. "It is uncertain just how useful this tool will be," Tarullo said. "In addition to some of the limitations affecting use of all-time varying instruments, such as judging when leverage or asset prices have become excessive, it is quite blunt."
Critics of the buffer say it raises a number of significant issues, including its reliability in measuring excess; who should be making the decisions; the speed at which such measures can take effect; and the precise calibration that will be used. Ideally the calibration would promote credit while also reducing excesses in the system.
Tarullo warned that even in periods of stress, banks may be adamant about maintaining their own capital requirements given the reaction of investors and markets.
"Even if supervisors were to announce a relaxation in regulatory requirements, in stressed economic conditions, investors and counterparties may well look unfavorably on reductions in capital levels (even from higher levels) or relaxation of underwriting standards at any one firm, notwithstanding the potential benefits for the economy as a whole were all large firms to follow suit," Tarullo said.
For now, U.S. regulators have not taken any significant steps to implement the buffer, which is not due to take effect until 2016.
U.S. regulators plan to continually update their annual stress-testing exercise for the largest financial institutions, Tarullo said.
"Stress tests must be modified as to avoid incentivizing firms to correlate their asset holdings or adopt correlated hedging strategies," he said.
Recently the Fed changed its shock scenario in 2011 to account for stress from the euro zone and the potential for sharp moves in interest rates in 2012 in order to avoid the risk of underestimating potential losses.
"We will continue to modify the market shock regularly to incorporate salient risks that were not necessarily present in 2008 and to ensure that firms cannot artificially improve their performance on the test through holding significant amounts of certain assets that happened to perform well in that period," Tarullo said.