Federal Reserve Governor Daniel Tarullo has a plan to control the risks posed by "too big too fail" banks — a plan that does not need Congressional approval.

Tarullo proposes higher capital reserves for banks using wholesale funding.

That sector, especially securities financing transactions such as repo, reverse repo, securities lending and borrowing and securities margin lending, remains vulnerable to disastrous bank runs, he said at a speech at the Peterson Institute for International Economics.

Editor's Note: Economist Warns: ‘Money From Heaven a Path to Hell.’ See Evidence.

Requirements should apply to all types of financial institutions, he noted. If they only apply to some types of wholesale funding or certain types of financial institutions, there's a risk of regulatory arbitrage.

"Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT) or hedge fund," Tarullo stated.

He suggested that new rules have progressively larger liquidity requirements for larger institutions.

"The systemic risks associated with runs on wholesale funding would, almost by definition," Tarullo noted, "be exacerbated if a very large user of that funding were to come under serious stress."

Much has been done to control too-big-to-fail banks and systemic risks, but more work must be done to solve regulatory gaps, Tarullo said.

"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 explained. "This is the major problem that remains."

The regulatory wall between traditional lending and capital markets broke down due to technology and business innovations, leading to the rise of shadow banking.

"In short," he said, "the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system's reliance on wholesale funding."

The Brown-Vitter bill in Congress would require large banks to increase capital reserves to guard against future bailouts. Lobbying against the bill, banks argue that tougher capital requirements would impede lending and slow the recovery.

Analysts doubt Brown-Vitter will pass Congress, but regulators can implement Tarullo's idea without Congressional approval, according to The Washington Post.

"The beauty of this approach is that regulators get to both raise capital levels and encourage banks to avoid short-term wholesale funding," Jaret Seiberg, an analyst at Guggenheim Securities, told The Post.

Editor's Note: Economist Warns: ‘Money From Heaven a Path to Hell.’ See Evidence.