Fed’s Tarullo: Stunted Growth Without Regulation

Despite the green shoots spotted across the economy — recently by US Treasury secretary Tim Geithner — a long road remains before recovery, and the only thing powerful enough to sustain growth just might be tighter government regulation.

That is, according to one Federal Reserve Board member, Daniel Tarullo. In a speech given earlier today, he says he sees economic growth resuming later this year, despite “painfully slow” recovery to follow.

Tarullo points toward the slowed pace of decline in the last few quarters as an indication of the economy settling toward bottom and warns that continued economic strain may dull the slope on the upward side of the recession. Of particular concern to US households is rising unemployment — now up to 9.4% — and falling house prices.

But the strain felt across the economy didn’t start with inflated house prices, Tarullo argues, but rather the failure or inability of the regulating agencies to prevent such bubbles in the first place.

Systemic, interconnected firms took risks that led to the scope of the recession, making a clear case for more regulation going forward, he says. Fallout from the Lehman Brothers’ collapse and repercussions of government intervention in AIG and Bear Stearns demonstrates systemic risk is beyond current regulation.

Tarullo urges a “major reorientation of our regulatory and supervisory system,” as this lack of regulation allowed rapid and unsustainable appreciation of some asset prices, including subprime mortgages, some securitization products and credit default swaps.

“There was a massive breakdown of risk management and a suspension of simple common sense within many financial firms” in the events that led to the recession, Tarullo says.

The solution? More government, according to Tarullo. Regulating agencies should adjust policies where needed, depending on the shortcomings observed from the past crisis. Regulators should discuss legislation that would proactively deal with systemic risk. They should develop ideas and proposals that might not be immediately adoptable but prove useful in the development of policy alternatives.

As for specific regulations, Tarullo suggests tighter capital requirements for financial institutions, in both the quality and amount of capital held. He calls for the supervision of bank holding companies as well as the development of a “resolution regime” for systemically significant non-banks similar to that of the Federal Deposit Insurance Corp. for depository banks. He recommends detailed requirements for assessing the stability of the US financial system and addressing the potential for systemic risk within payment and settlement systems.

There are limits to the extent of government control within the new regulation, Tarullo says. For example, restricting the size or degree of interconnectedness among financial institutions would mark a significant break the way the regulators have traditionally operated.

Write to Diana Golobay.