How The Federal Reserve Is Pushing Big Banks To Break Themselves Up

The Federal Reserve isn’t forcing big banks to break up. But neither is the nation’s top financial regulator making it easy to be big.

On Thursday, two top Fed officials announced tough new requirements for the eight largest American banks, opening a new front in the Fed’s regulatory regime. The measures would force big banks to “fully internalize the risk” they pose to the financial system, Fed Gov. Jerome Powell said.

“I have not reached any conclusion that a particular bank needs to be broken up or anything like that,” Powell told attendees at a banking conference, according to the Wall Street Journal. Rather, the Fed would add pressure to financial institutions “to the point at which it becomes a question that banks have to ask themselves.”

In other words, Fed officials wouldn’t mind if the largest “too big to fail” banks split up. They just don’t want to get their hands dirty.

The Fed intends to push the banks through higher capital requirements. All banks are required to keep a certain amount of their assets locked up safely to ensure that they have enough cash to weather a period of unforeseen difficulties, with the largest banks forced to set aside the highest share of assets.

Those capital requirements don’t come cheap. Every dollar set aside as capital cushion is a dollar that can’t be bet against to make a profit. Last year, JPMorgan Chase & Co. cited new capital buffers as one of the three biggest drags to the bank’s return on equity. At a certain point, those costs make it uneconomical to remain so large.

What the Fed is intending to do, according to Powell and fellow Fed Gov. Daniel Tarullo, is increase the level of capital big banks must hold to pass their stress tests, annual reviews by financial regulators of major banks’ ability to withstand a crisis.

“This will be a significant increase in capital,” Tarullo told Bloomberg, indicating that the new requirements will be phased in over several years. “We need to have those eight most systemically important institutions more resilient than other banks in the economy.”

The new requirements would apply to banks deemed global systemically important financial institutions: JPMorgan, Citigroup, Bank of America, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, State Street and Wells Fargo.

Capital requirements have increased since the global financial crisis, forcing most of the largest U.S. banks to reduce their size. But significant concerns remain. In April, the Federal Deposit Insurance Corp. and the Fed failed five of these banks on submissions known as living wills, in which companies explain how they would resolve themselves in the event of insolvency without crashing the financial system.

Examining the data from the living wills, a research unit of the Treasury Department later found that the largest banks “have not reduced either their complexity or their interconnectedness.”

The Fed has the authority, acting jointly with the FDIC, to eventually force the breakup of banks that fail their living wills. But the comments from Tarullo and Powell show the Fed is taking a less direct approach to the issue.

“I think it likely that firms are going to have to change, in some cases their size, in some cases their business model and in some cases their organization,” Tarullo told WSJ.