The Fed's blueprint for financial control
Dan Tarullo's recent speech suggests that the central bank is intent on wide regulation of US capital markets.

Federal Reserve Flickr

Janet L. Yellen takes the oath of office, administered by Governor Daniel K. Tarullo, as Chair of the Board of Governors of the Federal Reserve System.

Article Highlights

  • A more useful place to look for guidance on regulation of the financial system is Daniel Tarullo.

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  • Addressing the Chicago Fed Bank Structure Conference, Mr. Tarullo proposed that the central bank must "broaden the perimeter of prudential regulation.

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  • The council has already designated the large insurers AIG and Prudential as SIFIs, and it has many more nonbank financial companies in its sights.

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Much of the financial world hangs on Janet Yellen's every word, looking for policy portents in language that is crafted to be circumspect about the central bank's plans. A more useful place to look for guidance on regulation of the financial system is Daniel Tarullo, a Federal Reserve Board governor and its point man for banking reform. Mr. Tarullo gave a speech in Chicago on May 8 that was as unsettling as it was, by the Fed's inscrutable standards, unguarded.

Addressing the Chicago Fed Bank Structure Conference, Mr. Tarullo proposed that the central bank must "broaden the perimeter of prudential regulation, both to certain nonbank financial institutions and to certain activities by all financial actors." This expansion of regulatory authority would take the Fed far beyond the current power it exercises thanks to the Dodd-Frank law passed in the aftermath of the 2008 financial crises. The casualties of such an expansion could include small- and medium-size banks.

Under Dodd-Frank, ultimate financial regulatory power resides with the Financial Stability Oversight Council, or FSOC, a council of 10 regulators chaired by the Treasury and which includes the Fed chairman. The FSOC can designate asset managers, mutual funds, hedge funds, or even broker-dealers as systemically important financial institutions, or SIFIs, a classification that puts an institution under the Fed's regulatory authority. The council has already designated the large insurers AIG and Prudential as SIFIs, and it has many more nonbank financial companies in its sights.

The council's moves are part of a larger blueprint that Mr. Tarullo has now laid out. In the Chicago speech, he proposed ditching complex Basel III capital and liquidity regulations and reducing regulations on small banks. The new system he outlined would use simpler, Basel I capital charges for small banks, on grounds that the failure of these banks would pose no threat to financial stability. Larger regional banks would require slightly elevated regulatory standards, but nothing too complex.

Once a bank joins a "club" of the 80 largest institutions, however, the Federal Reserve should be its regulator, Mr. Tarullo said, and regulation should focus on annual stress tests. The very largest institutions, U.S. global banks and nonbank SIFIs, would receive the most intrusive Fed oversight and be required to satisfy the full range of new international macroprudential rules.

The regulatory relief that Mr. Tarullo proposes for small- and medium-size banks is likely to lead in time to their demise. The system he outlined would create three bank classes. Small banks would have the highest probability of failure because they are unimportant for financial stability. Larger banks would need additional regulations to reduce the probability of failure because multiple failures of these banks could cause systemic risk. Finally, the largest, systemically important banks would be constantly risk-managed by the Federal Reserve because they are too important to let fail.

The flaw here is that uninsured depositors, primarily businesses and municipalities, would not remain in smaller banks when the chief regulator himself argues that regulations should allow them to have the highest probability of failure. Historical evidence suggests that even fully insured depositors will migrate to larger, too-big-to-fail banks at the first hint of financial trouble.

The Fed has claimed that the Dodd-Frank mandate to ensure the stability of the financial system requires that it have regulatory authority over the shadow banking system—insurance, mutual funds, hedge funds, private-equity funds and anywhere else bank-like financial transactions may occur. In his speech, Mr. Tarullo dismissed state insurance regulation and the Securities and Exchange Commission's investor-protection-based rules as inadequate. He argued that shadow-bank activities conducted in these institutions can create "systemic risk" and thereby require the Fed's macroprudential regulation to ensure financial-system safety.

The FSOC has been busy making SIFI designations even though the Fed has yet to explain the enhanced prudential standards it will impose on nonbank SIFIs. It is likely that the Fed will impose bank-mandated capital and liquidity requirements, as well as limits on the amount that can be borrowed in repurchase agreements and securities lending transactions; new money-fund restrictions; and, very likely, limits on the assets that investment managers can hold. There is little in Dodd-Frank to constrain the Fed's options for imposing heightened prudential standards on nonbank SIFIs.

The process by which the Financial Stability Oversight Council decides that a financial institution is systemically important is neither clearly defined in Dodd-Frank nor is the council subject to congressional oversight. Yet through this process the Federal Reserve can expand its regulatory jurisdiction to any corner of the financial system. The regulatory paradigm that Mr. Tarullo outlined will accelerate the consolidation of the banking system into a few Fed-supervised too-big-to-fail institutions and radically expand the Fed's regulatory authority beyond banks to the entire nonbank financial sector.

Federal Reserve regulation of U.S. capital markets would be a huge mistake. It would retard economic growth, lower investor returns and dull the vibrancy of the country's financial system. The only way to prevent this from happening is new legislation by Congress that would restrict the FSOC's authority to designate financial institutions as systemically important.

Mr. Kupiec, a resident scholar at the American Enterprise Institute, has held senior positions at the Federal Deposit Insurance Corp., International Monetary Fund and Federal Reserve Board. He was chairman of the research task force of the Basel Committee on Banking Supervision (2010-13).

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