Their View | The Fed wants capital, not punishment

The following editorial appears on Bloomberg View.

Four years ago, Congress gave U.S. regulators powerful tools to reduce the threat that the country’s largest banks present to the economy. Now the Federal Reserve, under Chair Janet Yellen, looks like it’s finally getting ready to use them.

This is a welcome development, the latest evidence for which came Tuesday. In testimony before the Senate, Federal Reserve Board of Governors member Daniel Tarullo said that the central bank plans to subject systemically important banks to an added capital buffer significantly greater than what international rules require.

The purpose of the so-called surcharge, which could be as much as several percent of risk-weighted assets, is to discourage complexity and fragility. It will be larger, for example, for banks that depend heavily on short-term funding of the kind that proved unreliable during the 2008 crisis.

Tarullo’s testimony comes just a month after the Fed expressed its exasperation with big banks’ “living wills,” in which they are supposed to describe how they could be dismantled through bankruptcy without causing panic or broader economic malaise.

If banks can’t submit convincing plans by next July, the 2010 Dodd-Frank financial-reform law allows regulators to require more capital or even break them up — powers that Tarullo and Martin Gruenberg, chairman of the Federal Deposit Insurance Corp., told the Senate they are prepared to use.

The mood change is visible in other areas as well. The Fed, for example, is requiring that banks have extra capital to absorb the costs of operational failures, such as cybersecurity breaches and the civil and criminal transgressions that have cost tens of billions of dollars in recent years. In doing so, the central bank is effectively recognizing the risks inherent in managing giant organizations with myriad businesses around the world.

The Fed’s efforts to make big banks fund themselves with more capital should not be perceived as punishment. Capital, also known as equity, is money that banks can use to make loans or fund whatever activities they choose. Because it doesn’t have to be paid back like debt, it makes them more resilient in times of crisis — a feature that should be seen as an advantage.

Nonetheless, the biggest U.S. banks operate with astonishingly little capital. As of June 30, the six largest U.S. banks had an average of about $5 in tangible equity for each $100 in assets (by international accounting standards) — far less than smaller banks and enough to absorb a loss of only 5 percent of assets. Executives prefer to rely heavily on debt for two main reasons: It’s relatively cheap thanks to various taxpayer subsidies, and it makes banks’ performance — measured as the return on equity — look better in good times.

Given the incentives big banks face, only regulators can ensure they operate with enough capital for their own good — and for the good of society. The Fed still has a long way to go, but at least it’s headed in the right direction.