Banks must face tougher capital standards that allow them not only to survive a major storm but also keep lending to other institutions even in times of stress, the Federal Reserve's top regulator said.
Daniel Tarullo, a Fed board governor who supervises regulatory affairs at the U.S. central bank, said it was unclear bigger is always better for the banking sector, citing the lack of research on the "social utility" of super-sized financial firms.
Capital requirements for institutions designated as important to the financial system "could be reasonably expected to absorb losses associated with systemic stress without extraordinary government assistance, and still be well enough capitalized to serve as sound intermediaries," Tarullo told a conference sponsored by the Richmond Fed.
His comments came just as the Fed released data on emergency lending during the financial crisis, highlighting how dependent both U.S. and foreign banks were on the help of monetary authorities in the turbulent last quarter of 2008.
Tarullo also argued that the threat from activities in less regulated non-bank firms, sometimes referred to as the "shadow banking system," had diminished after the crisis but had not been completely eliminated.
In particular, money market funds and broker-dealers are sufficiently crucial to market functioning that they continue to pose risks despite their smaller size.
He expressed concern that not enough has been done to regulate activities outside bank holding companies and said the Dodd-Frank financial overhaul law fails to deal with possible contagion effects from smaller firms during crises.
Tarullo said existing practices on bank capital were outdated.
"The capital ratios familiar in banking regulation are at best a snapshot of the present and, if reserving for losses has lagged, not even that," he said.
"Actual and potential counterparties are less interested in a firm's capital ratio at the moment they extend liquidity than they are in the ability of the firm to return those funds in the future," Tarullo added.
For that reason, the Fed has focused on banks' common equity ratios in a recent round of stress tests, whose results — unlike those conducted in early 2009 — were not made public.
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