Federal Reserve Moving to Increase Capital Requirements for Banks

Federal Reserve officials are moving towards forcing banks, especially large banks, to start collecting a new form of debt that would convert into equity if they hit tough financial times.

Federal Reserve Gov. Daniel K. Tarullo and Federal Reserve Bank of Boston President Eric Rosengren both offered the idea of “contingent capital”, which makes many large banks nervous because it would be an expensive way to raise money.

Officials believe the idea will achieve multiple goals to help maintain the liquidity and stability of banks. Because the debt would convert to equity, it would give banks capital during times of crisis without having to lure in new investors.

The Federal Reserve is also hoping that the new requirement would impose disciple on large banks. Investors in the instruments would likely pressure banks to avoid taking excessive risks because their investment value could be diluted or wiped out when they converted debt to equity. Since there’s the possibility that investors could lose money during rocky times, there’s the possibility that these instruments could be very costly.

Daniel Tarullo had this to say during a luncheon speech in Washington, “A regularly issued special debt instrument that would convert to equity during times of financial distress could add market discipline both through the pricing of newly issued instruments and through the interests of current shareholders in avoiding dilution,”

Federal Reserve Bank of New York President William Dudley also commented that he liked the idea last week, and stated the debt could convert to capital if certain benchmarks were met, such as the deterioration of the bank or the banking system on a broader level.

Tarullo stated that Federal Reserve officials and other regulators are looking at requiring larger financial institutions to hold more capital than their counterparts. Tarullo also stated that there wouldn’t be a specific threshold that divided banks between those that had to hold more capital than those that didn’t. Instead, Tarullo said that he expects there would be a sliding scale of increasingly higher capital charges depending on how large or complex a financial company was. Tarullo also had made it a point to state that policy makers had not come to any firm conclusions on a specific policy.

Rosengren suggested that policy makers discuss ways of simplifying how banks are structured to make them easier to breakup if needed, but stopped short of suggesting that commercial banks shouldn’t be allowed to get involved with investment banking activities as former Fed Chairman Paul Volcker suggests.