Fed's Tarullo Suggests Higher Capital as Fix for Wholesale Funding Risk

WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo said Friday that he was still concerned about ongoing risks from banks' potential overreliance on short-term wholesale funding, but suggested one possible remedy: higher capital requirements.

Tarullo, who is responsible for bank supervision and regulation at the Fed, has continued to press for further regulatory reforms when it comes to short-term wholesale funding, suggesting that without changes to the structure of such markets "victory" cannot be declared.

"We would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the 'too big to fail' problem," said Tarullo, in prepared remarks at the Peterson Institute for International Finance. "This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it."

The governor offered a number of prescriptions to the problem, hinting that regulators might ask institutions to hold higher capital and more liquidity to ensure banks are not susceptible to damaging runs in the wholesale funding market. He suggested that regulators could consider placing a "regulatory charge or other measure" on all uses of short-term wholesale funding. It should not be based on the type of transaction or whether the borrower was a regulated institution, he said.

One option would be to change minimum capital and liquidity requirements at all regulated firms to address outstanding risks related to large short-term wholesale funding books, as well as risks to financial stability.

"Higher, generally applicable capital charge applied to short-term wholesale funds might be a useful piece of a complementary set of macroprudential measures, though an indirect measure like a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding," said Tarullo.

But he said it's unclear whether the firms already regulated would occupy enough of the wholesale funding markets that the standards applied would be enough to address systemic risk.

Utilizing a comprehensive approach, Tarullo said, would address risks that are often tied to specific firms and prevent risk of regulatory arbitrage if certain unregulated firms continued to participate in wholesale funding markets.

"Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund," said Tarullo.

But Tarullo made clear that there were a number of challenges to such an approach, especially given that while bank regulators have the legal authority to supervise financial institutions, their power over other financial markets is questionable.

"Determining appropriately equivalent controls is a challenging task and, with respect to institutions not subject to prudential regulation, there may be questions as to where - if at all - current regulatory authority resides," said Tarullo.

He also said short-term wholesale funding is used in a number of way by a variety of market participants, making it more difficult to address the issue.

"There is the overarching problem of calibrating the regulation so as to mitigate the systemic risks associated with these funding markets, while not suppressing the mechanisms that have become important parts of the modern financial system in providing liquidity and lowering borrowing costs for both financial and non-financial firms," said Tarullo.

Another approach that has also received attention is a potential universal minimum margin requirement that would be applied directly to short-term wholesale funding.

"This kind of requirement could be an effective tool to limit procyclicality in securities financing and, thereby, to contain risks of runs and contagion," said Tarullo.

During a question and answer session following his speech, Tarullo endorsed this as his preferred approach, while still recognizing the number of issues that would need to be resolved.

"As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets," said Tarullo.

He also said there was a strong case to be made for "taking steps beyond any generally applicable measures that are eventually applied to short-term wholesale funding."

One idea would be "to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements." It would also end up supplementing the Basel capital surcharge on large institutions, which doesn't include use of short-term wholesale funding as one of the factor's in calculating a firm's systemic footprint.

Speaking separately on Basel III, he said regulators are committed to implementing it "as soon as possible."

Regulators released a proposal last June, but have indefinitely delayed finalizing the rules, saying they need more time to review thousands of comment letters submitted by industry members. They have hinted that a final package could be delivered in the spring, and Tarullo reiterated Friday that the rules are due out soon.

He said regulators would simplify the final rules to address concerns by the smaller banks, however he was not supportive of delaying the rules any further.

"Opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments," said Tarullo. "It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions."

Addressing additional reform efforts to end "too big to fail," Tarullo again reiterated the necessity to require large financial institutions to carry minimum amounts of long-term unsecured debt that could be easily converted to equity in the event of a resolution.

Additionally, he said regulators should consider taking a second look at the calibration of two existing capital requirements for the largest firms: the leverage ratio and risk-based capital surcharge.

Tarullo suggested that Basel III leverage ratio "may have been set too low." He said regulators could beef up the requirement under rules in Dodd-Frank pertaining to the largest financial institutions.

He also said it is best for U.S. regulators to implement the capital surcharge, rather than delay the process, but it might be useful for the Basel Committee to return to the calibration sooner rather than later.