Regulators should impose higher capital and liquidity requirements on too-big-to fail banks by linking the two together, said Daniel Tarullo, a governor with the Federal Reserve.
While there is a need for solid minimum requirements for both capital and liquidity, the relationship between both also matters.
"A more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements," Tarullo said.
The approach would reflect the fact that market perception of a given bank’s position depends upon the combination of its funding position and capital levels.
Additionally, regulators should focus on the risk posed by banks and other financial institutions that rely on short-term market funding because they can be subject to runs in a crisis.
The issue at hand is the existing capital rules for bankers and brokers don’t fully reflect the risks that come from such funding.
As a result, Tarullo proposed that a higher capital charge could be imposed to reduce the risks.
"I strongly believe that we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem," he said.
Tarullo issued various proposals including making capital and liquidity closely linked so that banks with stable deposit funding may not need as much capital as those that rely more on short-term financing.
"I think this approach is worth exploring, precisely because it rests upon the link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vulnerable today," Tarullo explained.
He added, "Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strengthening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied."