daniel k tarullo : regulating systemically important financial firms speech by mr daniel k tarullo, member of the board of governors of the federal reserve system, at the peter g peterson institute for international economics, washington dc, 3 june 2011. * * * as the one - year anniversary of the dodd - frank act approaches, there will be much discussion about the progress that has been made in reforming financial regulation. today i would like to get a head start on this exercise, concentrating on dodd - frank ’ s requirement that the federal reserve board establish special prudential standards for systemically important financial institutions or, as they are now generally known, “ sifis. ” my focus will be on the requirement for more stringent capital standards, which has generated particular interest. let me begin by placing this regulatory task in context. the financial crisis spawned or strengthened many reform agendas – among them consumer protection, securities and commodities market regulation, and traditional bank regulation. but a focus on systemic risk has been central to reform efforts, and fittingly so. it was, after all, a systemic financial crisis that we experienced and that led to the great recession that affects us still today. regulatory reform in the wake of the crisis cannot be judged a success if it does not reduce the incidence and severity of future crises. the pre - crisis regulatory regime had focused mostly on firm - specific or, in contemporary jargon, “ microprudential ” risks. even on its own terms, that regime was not up to the task of assuring safe and sound financial firms. but it did not even attempt to address the broader systemic risks associated with the integration of capital markets and traditional bank lending, including the emergence of very large, complex financial firms that straddled these two domains, while operating against the backdrop of a rapidly growing shadow banking system. a post - crisis regulatory regime must include a significant “ macroprudential ” component, one that addresses two distinct, but associated, tendencies in modern financial markets : first, the high degree of risk correlation among large numbers of actors in quick - moving markets, particularly where substantial amounts of leverage or maturity transformation are involved. second, the emergence of financial institutions of sufficient combined size, interconnectedness, and leverage that their failures could threaten the entire system. in prior speeches i have discussed the correlated risks present in such areas as money market funds and repo markets. 1 this afternoon i turn to some of the issues surrounding regulation of sifis

avoid cliff effects, whereby significant regulatory consequences ensue based on relatively modest differences among firms. on this point, i would note that, while dodd - frank requires us to apply enhanced capital standards to all bank holding companies with more than $ 50 billion in assets, we would not want a big difference between the capital requirements for firms with assets just over that level and those just under that level. thus the supplemental capital requirement for a $ 50 billion firm is likely to be very modest. at the same time, it is important to build in constructive incentive effects. that is, the regulatory structure for sifis should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant. there is little evidence that the size, complexity, and reach of some of today ’ s sifis are necessary in order to realize one such measure is “ covar ” : the prefix “ co ” in front of the conventional abbreviation for value - at - risk is meant to refer to the co - movement of losses for a particular firm with those of the system as a whole. see tobias adrian and markus k. brunnermeier ( 2009 ), “ covar. ” federal reserve bank of new york staff report no. 348. another is “ marginal expected shortfall, ” which predicts how much the stock of a specific financial firm will decline in a day relative to an overall market decline. see viral v. acharya, lasse h. pedersen, thomas philippon, and matthew richardson ( 2010 ). “ measuring systemic risk ”. working paper, new york university stern school of business. bis central bankers ’ speeches achievable economies of scale and scope. 4 some firms may nonetheless believe there are such economies. for them, perhaps, the highest level of an additional sifi capital charge may be worth absorbing. others, though, may conclude in light of the progressive form of the capital requirement that changes in the size and structure of their activities would align better with their returns. the implication of this point is that the enhanced capital requirements should increase based on the metric i discussed a few moments ago. as a theoretical matter, the ideal approach would be a continuous function, by which the percentage rate of the additional requirement would vary precisely with the measure of a firm ’ s systemic importance. an alternative would be a tiered structure, by which firms are divided into several groups on the basis of the systemic metric, with the rate of the additional requirement