The Fed's Blueprint for Financial Control; Dan Tarullo's recent speech suggests that the central bank is intent on wide regulation of U.S. capital markets.
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.</br></br>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.</br></br>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.</br></br>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.</br></br>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.