In a speech Friday in Washington, D.C., Federal Reserve Governor Daniel Tarullo stated that federal regulators should mandate capital surcharges as a means of disincentivizing mergers by systemically important financial institutions (“SIFIs”), in cases that would increase risk without yielding substantial public benefits. Specifically, he stated that “There is little evidence that the size, complexity, and reach of some of today‟s SIFIs are necessary in order to realize achievable economies of scale… The regulatory structure for SIFIs should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant.” Tarullo is the Fed governor in charge of supervision and regulation, and he added that the Fed is currently working on a metric that would apply to banks with more than $50 billion in assets, and would gradually increase capital standards according to measures of systemic importance including size.
In his speech, Tarullo also contested the idea that these heightened capital requirements are a form of punishment for large firms, or that identifying the largest firms would increase moral hazard. Tarullo stated that there is “little if any research” showing that the biggest banks need their magnitude in order to achieve economies of scope and scale. He added that “moral hazard is already undermining market discipline on firms that are perceived too-big-to-fail.”
He also provided some insight into the FSOC‟s thinking on the different approaches under consideration for identifying the additional capital levels SIFIs will be responsible for meeting. Based on the speech it appears that one of them, dubbed by Tarullo as the “expected impact” approach, is having the most influence on Fed staff so far. This approach seeks to impose capital requirements based on assumptions about the costs to the economy of the failure of both a designated mega-bank and a smaller bank. As Tarullo said, “if the loss to the financial system from the failure of a SIFI would be five times that resulting from failure of the non-systemic firm, then the SIFI would have to hold additional capital sufficient to make the expected probability of failure one-fifth that of the non-SIFI.” It was unclear from his remarks if Tarullo, the Fed, or the FSOC intend to apply this rule across the board on all SIFI‟s or just certain institutions. Obviously applying this type of capital requirement on the non-bank financial institutions that receive SIFI designations would be a game changing event to their business models.
Finally, in a direct attack on a concept that is gaining strength in Europe, he stated that international financial regulators should not allow contingent convertible bonds to meet additional capital requirements.