WASHINGTON – Federal Reserve Gov. Daniel Tarullo strongly defended bank regulators' responses to the 2008 financial crisis and faulted competing Republican proposals to replace the Dodd-Frank Act with a simpler, single leverage requirement as shortsighted.

Speaking before a conference sponsored by the Federal Reserve Bank of Cleveland Friday afternoon, Tarullo, who heads the Fed board's Supervisory Committee, acknowledged that replacing the many facets of the Dodd-Frank regulatory structure with a single leverage ratio might have "surface appeal." But he warned that adopting such a plan would push banks into riskier assets.

That is precisely the kind of behavior that prudential regulation is meant to prevent, he said, and the only way to counter that effect would be to set the leverage ratio "considerably higher" – likely too high for financial intermediation to be profitable.

"The imposition of, say, a 10% leverage ratio on the current balance sheets of large banks would yield a very well-capitalized set of banks. But one needs to look at the dynamic effects of such a requirement," Tarullo said. "We should remember that it was because of the limitations of a stand-alone leverage ratio that risk-based capital requirements were introduced in the 1980s."

Tarullo's reference to a 10% ratio is significant since the Financial Choice Act – a bill authored by House Financial Services Committee Chairman Jeb Hensarling, R-Texas – would impose such a requirement on banks in return for easing many Dodd-Frank Act requirements.

But capital levels alone cannot make a bank or a financial system safe, Tarullo said – noting that other favors need to be considered, particularly liquidity and bank funding methodologies. Banks that have stable sources of funding and are less susceptible to runs are less likely to need to absorb their capital, he said.

"If a firm is not vulnerable to runs, it is far more likely to weather a financial storm without resorting to fire sales or cutting off customers from credit, and thus far less likely to wreak havoc on the financial system," Tarullo said.

Hensarling and other congressional Republicans have likewise been critical of Dodd-Frank’s resolution planning requirements — the so-called living wills – that require banks to detail precisely how they would be resolved in traditional bankruptcy and are therefore not “too big to fail.” Tarullo said that at the time of the crisis, that idea – along with much else in Dodd-Frank – was not particularly controversial, and indeed many of the ideas incorporated into Dodd-Frank were originally Republican ideas. 

"The Dodd-Frank Act contains measures that commanded fairly wide consensus," Tarullo said. "Furthermore, the origins of some features of the legislation rested as much or more with Republican than Democratic legislators, such as the … requirement for resolution plans."

Tarullo acknowledged that there are aspects of Dodd-Frank that should be reconsidered, particularly the $50 billion asset threshold for banks to be considered systemically important financial institutions – a threshold he said is too low, favoring perhaps a $100 billion threshold. The House passed a bill Thursday to remove that threshold and give regulators criteria to judge banks as systemically important.

Tarullo said there are still some things that Congress could do to further strengthen the system – updating the bankruptcy code, for example, which he said would "facilitate the resolution of large financial firms and, thereby, limit the number of instances" in which the government would have to take a firm over itself.

The Fed will also continue its work to strengthen the financial system, Tarullo said. The central bank will complete its proposed total loss-absorbing capacity rule "in the very short term," he said. And he warned that the U.S. branches of foreign banks may need to be more closely examined, since their capital adequacy "can be difficult for us to discern when the bank uses internal models to compute its required regulatory capital."

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