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June 9, 2008 — “The case for far-reaching reform appears a strong one.”

Financial regulation reform, that is, and it seems like a no-brainer to Daniel K. Tarullo, a member of the board of governors of the Federal Reserve System, who spoke yesterday to the Peterson Institute for International Economics in Washington. The text of the speech is a bit of a grind, written mostly in academic-speak (the speech itself was probably even more of a grind if you had to sit through it after a heavy lunch), but Tarullo’s talk contained some of the clearest signals yet of how the Obama administration wants to place more regulation on the financial sector.

Tarullo played down the nuclear option, which would entail putting limits on “the size (or interconnectedness) of financial institutions,” just because it would be so radical, although he says that kind of thing has an “as least heuristic value” (academic-speak, see?). 

The 800-pound gorilla in the room is what Tarullo describes as the “too-big-to-fail problem,” where a whole slew of giant financial institutions could inflict severe damage to commerce as we know it if any one of them were to go down.

It’s more complicated than the domino theory of banks knocking each other off one at a time, Tarullo posited, and potentially much bigger than the stock market crash of 1987, say, or the collapse of Long-Term Capital Management in 1998. He summed it up — bear with me here — in a 67-word nutshell: “By 2007, unfortunately, the now familiar perils of poorly underwritten asset-backed securities, liquidity strategies based on asset prices, and high leverage had pervaded the financial system. Systemic risk arose not because the illiquidity or insolvency of one firm would directly bring down another, but because of parallel hedging or funding strategies practiced by highly leveraged firms with substantial short-term liabilities that threatened large segments of the market.”

What to do?

Tarullo prescribed three tonics (paraphrased here):

Tonic No. 1 — Push regulators into kicking the Pollyanaish habit of “excessive trust” by demanding, and imposing and enforcing more stringent capital requirements by turning the so-called stress tests recently performed on the 19 biggest banks into a routine industrywide drill and by doing a better job of keeping their finger on the larger pulse.

Tonic No. 2 — Start getting some new laws enacted to regulate “all systemically important financial firms” (hello, hedge funds) and to generally give the government more tools to get under the hood and tinker with the system.

Tonic No. 3 — Leave the nuclear option on the table — a scenario in which financial institutions would be allowed to get this big and no bigger — and here Tarullo seemed to be making what sounded a lot like a veiled threat: If you don’t like Tonic No. 1 or No. 2 how ’bout a mouthful of Tonic No. 3? 

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