UPDATE 1-Fed's Tarullo says breaking up big banks too hard

Wed Oct 21, 2009 2:33pm EDT

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By Pedro Nicolaci da Costa

WASHINGTON Oct 21 (Reuters) - Breaking up big financial institutions is too impractical to be considered a solution to the problem of dangerously large banks, Federal Reserve Board Governor Daniel Tarullo said on Wednesday.

Speaking to the Exchequer Club of Washington, Tarullo argued instead that Congress should give regulators the authority to wind down troubled firms in a way that ensures shareholders and creditors face losses.

"A regime that raised the real prospect of losses for shareholders and creditors would add a third alternative to the unattractive existing options of bailout and disorderly bankruptcy," Tarullo said in prepared remarks.

Former Fed Chairman Alan Greenspan said last week firms considered too big to fail might have to be broken up, but Tarullo dismissed that notion, saying it was too difficult to execute.

"This is more a provocative idea than a proposal," said Tarullo. "To my knowledge, no one has offered anything like standards for undertaking this task."

Congress must also make sure that all institutions that have the potential to be "systemically important" should come under regulators' purview, Tarullo added.

He did not touch directly on the outlook for the broader economy or monetary policy in his speech but he did trace the crisis to a deregulatory wave that began some decades ago.

"The regulatory system accommodated the growth of capital market alternatives to traditional financing by relaxing many restrictions on the type and geographic scope of bank activities, and virtually all restrictions on affiliations between banks and nonbank financial firms," Tarullo said.

Echoing some of the potential regulatory countermeasures now gaining ground in policy-making circles, Tarullo talked about the possibility of placing higher capital requirements on firms considered too big to go down.

He also discussed a new kind of regulatory requirement called "contingent capital," debt instruments that would turn into shares in times of crisis. Regulators hope this would reinforce market discipline by making managers leery of allowing capital to be depleted beyond a certain level.

Tarullo warned against doing too much, however, saying overregulation would cut off access to capital for those who need it most.

"There is some danger that simply piling on a series of administrative reforms and restrictions intended to constrain the behavior of firms would have unnecessarily adverse consequences for the availability of credit on risk-sensible terms for consumers and businesses alike," Tarullo argued. (Editing by James Dalgleish)