Big banks trembled this week as U.S. Federal Reserve Governor Dan Tarullo before Senate Banking earlier this week and announced a tough set of new rules for the largest banks, according to a memo from Federal Financial Analytics.

Big Banks Were Trembling After Fed Testimony, Says Memo

“They should have been even more afraid: his written testimony takes Fed policy one step farther by declaring that the big banks must be safer than a small one,” the memo said.  The only way big banks can be safer than smaller ones is if they turn themselves into smaller ones, the memo noted, a reference to a movement to break apart the large banks and diffuse their destructive potential.

Memo contains a quote on big banks failure

The memo cites a specific quote from Tarullo going to the potential failure of globally systemically important banks. “… [T]he Federal Reserve has been working to develop regulations that are designed to reduce the probability of failure of a GSIB to levels that are meaningfully below those for less systemically important firms and to materially reduce the potential adverse impact on the broader financial system and economy in the event of a failure of a GSIB.”

The key to watch in this effort is not only efforts to prevent the next financial crisis, but plans to unwind the banks in the case of catastrophic failure, an effort sources have indicated is being met with powerful resistance.

Karen Shaw Petrou, author of the memo, noted the Fed’s current policy is taking a “belts and suspenders approach.” This means a two-front war is being deployed to protect the economy. First the keys to the next economic implosion, which is likely to involve derivatives, is prevented.  But if this doesn’t happen, decisions to handle the implosion, with the potential breakup of the banks and isolation of their toxic assets.

“Orderly resolution protects the world from harm, but it nevertheless demands an array of tough new rules so that the resilience of orderly resolution is never tested,” Petruo observed.

Big banks breakup

A question being pondered is can the banks be broken up and some of their market making activities be continued. “Can the world live without derivatives and securities financing – or at least live with a lot less of it – if big banks are shattered into low-risk bits or will the business just migrate to new behemoths?”

The memo notes that Tarullo has discussed exempting smaller banks, which don’t have near the same business model as larger banks, from the Volcker rule.  This is just the start of issues that might have little tolerance for large bank activities that endanger the entire market as a whole.

“With all the new rules coming at them and a new Senate sure to be even less hospitable than the current one to very big banks, this is a critical question big banks must answer persuasively if they want to stay in all the businesses that now rely on them,” the memo concluded.