PRINCETON, N.J. — In his final public remarks before stepping down from the agency, Fed Gov. Daniel Tarullo called Tuesday for several changes to the system, including dropping a key element of the stress tests and rethinking the Volcker Rule.

Speaking at Princeton University in what was billed as his farewell address before he officially leaves Wednesday, Tarullo — who has had an outsize influence on the direction of banking supervision at the Fed since joining it in 2009 — argued that the primary risks posed by the financial crisis have been substantially addressed.

“With a few exceptions, the approach we took from the fall of 2009 onward allowed the banks to use retained earnings to build their capital,” Tarullo said. “We also began development of the first quantitative liquidity regulations to be used in prudential regulation by the U.S. banking agencies. This initiative was, of course, a direct response to the liquidity squeezes encountered during the crisis itself.”

But Tarullo used much of his address to identify areas where policymakers could improve bank regulation, as well as offer some perspectives for the next crop of Fed officials and the administration to keep in mind as it reconsiders banking regulation. Following are takeaways from his remarks.

Fed Gov. Daniel Tarullo
The Volcker Rule was "too complicated" and needs to be addressed, said Fed Gov. Daniel Tarullo, who is stepping down Wednesday. Bloomberg News

Qualitative test in stress testing may no longer be useful

Tarullo said that existing approaches to stress testing of capital may need to be reconsidered. Among his proposed changes was scrapping the qualitative test for banks. Under the existing Comprehensive Capital Analysis and Review, banks can fail for failing to hit the quantitative targets, as well as for vaguer qualitative reasons.

That test, which the Fed has already suspended for all but the largest U.S. banks, may need to be phased out, he said, especially if a stress capital buffer regime is brought online. Tarullo further said that the CCAR may be folded into the Fed’s regular supervisory processes, a move that banks and some members of Congress have recently urged.

“I think the time may be coming when the qualitative objection in CCAR should be phased out, and the supervisory examination work around stress testing and capital planning completely moved into the normal, year-round supervisory process, even for the G-SIBs,” Tarullo said, referring to global systemically important banks.

The Volcker Rule is 'too complicated'

Tarullo said the Volcker Rule, which is designed to stop commercial banks from engaging in proprietary trading, was good in theory but hasn't worked out the way regulators planned.

"Several years of experience have convinced me that there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker Rule is too complicated," he said.

Tarullo added that the overriding problem with the Volcker Rule — aside from the fact that it effectively requires five regulatory agencies to promulgate a single rule — was that it did not do an effective job of differentiating proprietary trading (which is barred) from market-making (which is allowed).

He said the rule as drafted sought to establish a process by which regulators could determine a bank’s intent with respect to a certain trade — whether it was intended to be a proprietary trade or to meet a need. That approach has not been successful, he said.

“The hope was that, as the application of the rule and understanding of the metrics resulting from it evolved, it would become easier to use objective data to infer subjective intent,” Tarullo said. “This hasn’t happened, though. I think we just need to recognize this fact and try something else.”

Adjusting the supplemental leverage ratio might make sense

Tarullo added that the push by some in Congress and elsewhere to have a simple leverage ratio serve as the primary prudential capital regulation is wrongheaded, since those ratios tend to encourage the holding of riskier assets.

But he added that applying the Fed’s supplementary leverage ratio equally to all eight U.S. globally significant banks may also be poorly considered, since some of those banks — particularly the custody banks BNY Mellon and State Street — do not have the same risk profiles as others with investment banking activities.

“To truly assure the safety and soundness of the financial system, a leverage ratio serving as the sole or dominant form of prudential regulation would probably have to be set considerably higher, at a level where the impact on financial intermediation could be quite substantial,” Tarullo said.

“One, but certainly not the only, way to do this would be for the enhanced supplemental leverage ratio to be 1 percent for the firms with a 1% to 1.5% risk-based surcharge, 1.5% for those with a 2% or 2.5% risk-based surcharge, and 2% for those at 3% or above.”

Dodd-Frank was supposed to be hard, but easier than a breakup

Tarullo noted that the approaches outlined in Dodd-Frank such as higher capital and liquidity requirements and tighter supervision have been hard on banks, but those rules were one of a handful of approaches that regulators could have taken in response to a crisis as massive as the one that befell the financial sector in 2008 and 2009.

The alternatives, he said, were either imposing hard activities-based rules on the banking industry — such as the reimposition of a Glass-Steagall-like barrier between commercial and investment banking — or an outright breakup of the largest banks. The regulatory approach taken in the Fed’s immediate response to the crisis and outlined in Dodd-Frank should be considered the least disruptive of the available options, he said.

“It is not surprising that the Dodd-Frank Act implementation has been a major undertaking, that banks (and sometimes supervisors) feel overwhelmed by the breadth of the resulting compliance effort, and that there is some overlap among some of the regulations,” Tarullo said. “This outcome was, in effect, the price of the largest banks not being subject to a direct structural solution such as breakup.”

Partisanship prevented Dodd-Frank from being improved

Additionally, Tarullo said that, unlike most transformative pieces of legislation, Dodd-Frank has not benefited from the kinds of legislative tightening that make bills better and more streamlined in the wake of experience and hindsight. Partisanship, he said, can be blamed for the current state of the law, and Congress should identify ways to improve those aspects of Dodd-Frank that are widely acknowledged to need adjustment.

“Partisan divisions prevented this from happening. And the novelty of many of the forms of regulations adopted by financial regulators, either in implementing the Dodd-Frank Act or under existing authorities, almost assures that some recalibration and reconsiderations will be warranted on the basis of experience," he said.

Among those improvements, he said, are raising the threshold for systemically important financial institutions from $50 billion of assets and for small-bank exemptions from $10 billion. He added that eliminating community banks from any Volcker Rule requirements would also make sense given the lack of systemic impact or even proprietary activities present at the community bank level.

Capital levels may still be too low

Finally, Tarullo said that banks’ capital levels may still be too low and could potentially stand to be increased, especially when considering the potential benefit of preventing another financial crisis or mitigating the effects of a cyclical downturn.

Although big banks have complained that capital levels are too high, Tarullo noted that lending activity is up, as are corporate profits at banks.

“Given the healthy increases in lending over the last several years and the record levels of commercial bank profits recorded in 2016, it would seem a substantial overreach to claim that the new regulatory system is broadly hamstringing either the banking industry or the economy,” Tarullo said.

Both simple leverage ratios and risk-based models have their place in prudential regulation, Tarullo said, but various studies by Fed economists have suggested that the existing Tier 1 capital ratios fall on the lower end of a spectrum of potential capital levels that would help banks withstand a financial calamity.

“One might conclude that a modest increase in these requirements — putting us a bit further from the bottom of the range — might be indicated,” Tarullo said. “In trying to avoid a future financial crisis, it is wise to err somewhat toward the higher end of the range of possible required capital levels for this group of firms.”

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