Fed's Tarullo: Reform Must Address Too-Big-To-Fail Problem

Sponsored Links

Federal Reserve Governor Daniel Tarullo said Wednesday that financial reform cannot be fully successful until it adequately addresses systemic risk and the too-big-to-fail problem.

Speaking at the Exchequer Club in Washington, D.C., Tarullo said that the roots of the current too-big-to-fail problem lie in changes "in the organization of financial firms and markets that squeezed the traditional business model of commercial banking."

Tarullo said that the regulatory system relaxed restrictions on the type and geographic scope of bank activities and allowed the financial services industry to be dominated by a large set of financial companies centered on a large commercial bank.

The governor stressed that policies should be implemented during periods of financial stability that "will diminish the chances that, in some future period of financial distress, a government will believe it must intervene to prevent the failure of a large financial institution."

Tarullo added that steps should be taken to contain the problem of moral hazard in the financial industry, but he said that it cannot not realistically be expected that it would be eliminated completely.

"What we can reasonably expect and, indeed, should insist upon, is that we take steps to contain the problem such that the social costs associated with the consequences of the misaligned incentives do not exceed the benefits associated with the operation of the institutions or markets in which the moral hazard exists," he said.

Tarullo then outlined solutions and regulatory reforms that could help to address moral hazard and the too-big-to-fail problem. These include strengthening capital, liquidity and risk management requirements for banking organizations and creating special capital requirements based on a firm's systemic importance.

He added that market discipline must also be enhanced in order to promote responsible behavior by large financial firms and their investors and counterparties.

"First, establishing the realistic prospect of losses for investors and counterparties in a large financial institution should change their calculations in deciding whether to enter a transaction with the firm, and thus lead to a more complete incorporation of risk into the terms of such a transaction," he said. "Second, the assessment of that risk by these financial actors, as reflected in the pricing of their investments and contracts with a firm, can itself provide valuable information to regulators."

Tarullo did warn, however, that financial instability could still pose a threat to the economy, even if most too-big-to fail concerns were alleviated. He stressed that other reform measures, such as the regulation of derivatives markets, should also be carefully considered, though he said that no reform program that fails to address too-big-to-fail could be considered sufficient.

"And in suggesting that policymakers should continue to examine possible measures beyond the current reform agenda, I certainly do not intend to suggest that the current agenda should be delayed," he concluded. "I only urge that we all keep the too-big-to-fail problem front and center as the regulatory reform effort moves forward."

Federal Reserve Governor Daniel Tarullo said Wednesday that financial reform cannot be fully successful until it adequately addresses systemic risk and the too-big-to-fail problem. Speaking at the Exchequer Club in Washington, D.C., Tarullo said that the roots of the current too-big-to-fail problem lie in changes "in the organization of financial firms and markets that squeezed the traditional business model of commercial banking." (Market News Provided by RTTNews)