Feds Look To Shrink Too Big To Fail Banks

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Officials at the U.S. Federal Reserve continue to drop not-so-subtle hints that they feel there is still a problem with too big to fail banks, and the failure of one or more of these financial institutions could have could have a serious negative impact on the wider economy. A Fed official commented on Monday that the agency was finalizing regulations that increase the pressure on large financial firms to shrink.

Comments from Fed Governor Daniel Tarullo on too big to fail banks

Daniel K. Tarullo, the Fed governor in charge of regulatory policy, made the central bank’s intentions clear in testimony that he is giving before the Senate Banking Committee Tuesday. In specific, Tarullo said that the Federal Reserve would suggest special capital requirements for the largest banks that will be even higher than those required under the Basel III international banking rules.

“We intend to improve the resiliency of these firms,” Tarullo said in his testimony. “This measure might also create incentives for them to reduce their systemic footprint and risk profile.”

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Tarullo’s speech also gave Congress an update on progress regulators have made regarding finalizing the Dodd-Frank Act that became law back in 2010.

Too big to fail banks: Comments unsettling for Wall Street

Tarullo’s remarks are likely to unsettle large Wall Street financial firms. Increasing capital requirements means banks borrow less money to finance their lending and trading. The idea is that financial institutions that rely less on borrowing are more stable given financing must come from shareholder funds, which do not have to be repaid at short notice during times of market stress.

Equity funding, however, means it’s harder for a firm to earn a return on its shares that satisfies investors. Some banks might decide it needs to shrink its assets in order to reduce equity funding. Moreover, if too big to fail banks fall considerably in size, they would not be a significant threat to the economy if they collapsed.

However, some large banks do not want to reduce their size. Furthermore, they may argue higher capital requirements means banks will have to cut back in ways that could the availability of credit.

International bank rules already require the largest banks to maintain more capital.. The basic requirement is that a bank’s capital must equal at least 7% of its assets, relative to the risk of the assets. Moreover, international regulations will require the l largest global banks to maintain capital at between 8 and 9.5% of their risk-adjusted assets by the end of 2018..

Tarullo noted that the Fed preferred even higher capital requirements  for the largest American banks. “Noticeably so for some firms,” he said.