Federal Reserve Board Governor Tarullo Outlines Potential Regulatory Initiatives

H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell publication by Mr. Cohen and Samuel R. Woodall III.

On May 3, 2013, Federal Reserve Board Governor Daniel Tarullo delivered a speech outlining potential regulatory initiatives before the Peterson Institute for International Economics in Washington, D.C. In this speech, entitled “Evaluating Progress in Regulatory Reforms to Promote Financial Stability,” Governor Tarullo acknowledged that substantial progress has been made in achieving financial regulatory reform, but he maintains that much more is still needed. [1]

Even beyond the substantive impact of the reforms proposed by Governor Tarullo, his speech is particularly noteworthy for two reasons. First, Governor Tarullo oversees the Federal Reserve Board’s banking supervision and regulation function and was recently appointed as Chairman of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. Second, in the past, Governor Tarullo has used similar speeches to forecast the Federal Reserve’s upcoming regulatory initiatives.

Governor Tarullo’s speech focuses on three general areas of increased regulatory scrutiny: (1) large financial institutions generally; (2) large financial institutions that rely on short-term wholesale funding; and (3) short-term wholesale funding markets, in particular those for securities financing transactions (SFTs). Governor Tarullo proposes a number of regulatory requirements to address what he perceives as the unfinished business of regulatory reform, including both macro- and micro-prudential requirements at an institution-specific level and market practice level.

Specific Regulatory Proposals

Large Financial Institutions

Governor Tarullo suggests that regulatory capital requirements should be increased for large banking organizations.

(i) Higher Capital Requirements. Although he recognizes that U.S. banks “have increased their capital substantially” and that the Basel III capital framework represents “important steps forward,” he explains that the new requirements “are not as high as I would have liked” for larger institutions. Accordingly, he suggests both a “higher leverage ratio for the largest firms” (computed on a Basel III basis) and greater capital surcharges (he said the Basel surcharges “were at the lower end of the range needed”). In addition, Governor Tarullo suggests that the stress tests be revised to provide for comprehensive stressing of trading books. He also indicates that higher capital requirements may be imminent, noting that “requirements to extend and maintain higher levels of capital are on the way,” and states that “it may be desirable for the Basel Committee to return to this calibration [of the capital surcharge] issue sooner rather than later.”

(ii) Long-Term Unsecured Debt Requirement as Supplementary Capital. Governor Tarullo maintains that there is a “clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency.” He describes this requirement as “gone concern” capital that would supplement regulatory capital and suggests that it could be adopted by the Federal Reserve under its Dodd-Frank Section 165 authority.

Large Financial Institutions That Rely on Wholesale Funding

Governor Tarullo expresses special concerns about what he perceives as the systemic risk of large firms that rely on the use of short-term wholesale funding. He suggests that the best approach for addressing this issue is through the imposition of a meaningfully higher liquidity requirement or a meaningfully higher capital requirement, noting that “the relationship between the two also matters.” He identifies as a possible approach, “requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements.” He states that his suggested “approach would allow a firm of systemic importance to choose between holding capital in greater amounts . . ., or changing the amount and composition of its liabilities.” The capital requirements would consist of additional common equity capital requirements that are “material.” The liquidity requirement would include a Basel III Net Stable Funding Ratio score that has “been reworked significantly so as to take account of the macroprudential implications of wholesale funding.”

Short-Term Wholesale Funding Markets

Governor Tarullo both perceives substantial systemic risk from short-term wholesale funding and views the failure to deal with this issue as the most important “gap” in regulatory reform. He is particularly concerned about wholesale funding in the form of SFTs because he believes it can lead to an “adverse feedback loop” from sales of the underlying assets. In discussing the roles of short-term wholesale funding, he notes that to date the regulatory focus of liquidity regulation has been on the liquidity of individual institutions and whether the institution has a matched book. He concludes that from a systemic standpoint, matched books still present risk because of the impact on the market of winding them down.

Governor Tarullo recognizes that attempting to regulate this market through prudentially regulated institutions would be sub-optimal because so much of the market already is, and would further migrate, outside the regulated industry sphere. Accordingly, he suggests regulating transactions rather than participants.

Specifically, in accordance with a Financial Stability Board consultative paper, [2] he recommends requiring a “universal minimum margining requirement applicable directly to SFTs.” He suggests this could take the form of “a minimum amount of over-collateralization as determined by regulators (the amount varying with the nature of the securities collateral), regardless of whether the [SFT] lender or [SFT] borrower were otherwise prudentially regulated.” He acknowledges that this proposal would mark a significant departure from the traditional regulation governing SFTs and may be difficult to calibrate, but he believes such a requirement “seems the most promising avenue toward satisfying the principle of comprehensiveness.”

Governor Tarullo also proposes further limits on rehypothecation of collateral involved in SFTs—that is where “an institution uses assets that have been posted as collateral by its clients for its own purposes.” Although the SEC has already limited this practice, Governor Tarullo argues that the current U.S. limits should be reviewed and steps should be taken to implement similar rules in other countries “[g]iven the combined macroprudential and investor protection concerns raised by rehypothecation.”

Other Noteworthy Comments

Governor Tarullo joins the debate over whether large financial institutions have an “implicit funding subsidy.” He recognizes that the “calculation of a precise subsidy is difficult,” but appears to suggest the view that there likely is such a subsidy based on “at least directionally consistent results.”

Governor Tarullo strongly urges the prompt adoption of final rules implementing the Basel III capital requirements, notwithstanding their infirmities. He notes that opposition to these rules or delay in their implementation would have the ironic result of “lend[ing] assistance to banks that want to avoid strengthening their capital positions.” At the same time, he acknowledges recent criticisms that the Basel III capital requirements are unduly complex and in need of some simplification.

Throughout Governor Tarullo’s remarks, he calls for regulatory requirements to become “progressively stricter as the systemic importance of a firm increases.” To date, Federal Reserve proposals under Dodd-Frank have been relatively uniform, but there are important exceptions for the G-SIB surcharge and the single counterparty credit limit.

The Federal Reserve and other U.S. banking agencies have not yet proposed rules to implement the Basel III liquidity framework in the United States, and there has been substantial speculation as to whether its metrics—the liquidity coverage ratio (LCR) in particular—will apply to all U.S. banking institutions or only a category of larger institutions. Governor Tarullo addresses this issue, commenting that the LCR “will apply only to large institutions [those subject to Section 165 of the Dodd-Frank Act, and], in some cases with stricter standards for firms of greatest systemic importance.”

Long-Term Unsecured Debt

As mentioned above, Governor Tarullo strongly supports a long-term unsecured debt requirement as a capital supplement. This is a concept that we believe is likely to be embodied in a specific Federal Reserve proposal later this year.

Governor Tarullo recognizes that the “details will, as always, be important.” Clearly, there are a number of key aspects of a long-term debt requirement that will need to be determined:

  • How much long-term debt will be required and what is the basis for the calculation?
  • Will the requisite amount be determined on an institution-by-institution basis, or will there be a single formula?
  • Will this requirement be used to implement a “single point of entry” approach in the context of the orderly resolution authority of Title II of the Dodd-Frank Act?
  • Will this only be a holding company requirement?
  • How will “long-term debt” be defined?
  • Governor Tarullo refers to the “consisten[cy] with emerging international practice,” but how will it be possible to adopt similar requirements for both the universal bank model and the bank holding company model?

Concluding Observations

It is obviously unclear at this juncture whether and to what extent the Federal Reserve, other U.S. Federal banking regulators, and the Basel Committee will pursue and ultimately implement the various regulatory initiatives outlined in Governor Tarullo’s speech. What is clear, however, is that Governor Tarullo believes that there needs to be a material increase in the regulatory requirements for larger institutions, particularly those that rely on short-term wholesale funding. Calls for such increased requirements are becoming increasingly prevalent, notwithstanding the already significant increases in capital and liquidity at major U.S. banks. [3]


[1] Daniel K. Tarullo, Member, Board of Governors of Federal Reserve System, Speech at Peterson Institute for International Economics: Evaluating Progress in Regulatory Reforms to Promote Financial Stability (May 3, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.htm.
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[2] Financial Stability Board, Strengthening Oversight and Regulation of Shadow Banking: A Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos (Nov. 18, 2012, Consultative Document), available at http://www.financialstabilityboard.org/publications/r_121118b.pdf.
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[3] See, e.g., Mary John Miller, Under Secretary for Domestic Finance, U.S. Department of the Treasury, Remarks at the Hyman P. Minsky Conference (April 18, 2013), available at http://www.treasury.gov/press-center/press-releases/Pages/jl1902.aspx.
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