The Federal Reserve is expected to require the biggest U.S. banks to increase reserves in an effort to prevent the possibility of another financial crisis. Federal Reserve Governor Daniel K. Tarullo is scheduled to testify before the U.S. Senate Committee on Banking, Housing and Urban Affairs on Tuesday to introduce new rules, which would impose a so-called capital surcharge to reinforce the banking system by requiring too-big-to-fail banks to increase protections against potential losses.

Mr. Tarullo has advised that the Feds latest proposal would affect the biggest U.S. banks which are deemed “systematically important financial institutions.” By increasing capital reserve requirements, the Fed intends to “improve the resiliency of these firms.”

The capital surcharge may change from year to year, which is expected to consider factors such as size, exposure and international activity, among others. The extent to which banks will be required to increase capital has yet to be announced, however it is reported that some banks could face a surcharge as high as 4.5%. Recent recommendations would surpass increased reserves of 2.5% called for by international regulators at the Basel Committee on Banking Supervision. While many commentators have been critical of the government’s efforts to protect against the possibility of another financial crisis, those that oppose the new tougher capital surcharge argue that it puts U.S. banks at a competitive disadvantage with global rivals.

Volatile Short-Term Funding Penalized

Among the areas of emphasis for the Fed in its new proposal are penalties for U.S. banks engaging in the high-risk practices of short-term, wholesale funding, such as overnight loans. The Wall Street Journal, using data collected by SNL Financial, reported that Goldman Sachs Group and Morgan Stanley, each with short-term funding comprising more than a third of their total liabilities, would be impacted the most by the penalty. Short-term funding was one of the significant factors that lead to the collapse of Lehman Brothers Holdings Inc.

Reducing Risk

The recent move by the Fed is not its first since the advent of the financial crisis. Just last week, regulators implemented liquidity rules that require banks to hold a certain amount of easily convertible liquid assets, such as treasury notes and high-quality corporate debt and equity. According to Federal Financial Analytics, a July analysis of six U.S. banks revealed an increase in capital by $29 billion between 2007 and 2013.

Perhaps the most important practical implication of the Feds proposal is that the new rules create incentives for the too-big-to-fail banks to curb some of their traditional risky practices. In any event, the plan to impose a tougher capital surcharge appears to be a promising step in eliminating the risk of another financial crisis. The notion that the biggest U.S. banks may remain too-big-to-fail indefinitely may soon be coming to an end.