Federal Reserve Governor Daniel Tarullo said enacting a law similar to the Glass-Steagall Act that separates investment and commercial banking could impose “substantial costs” by curtailing the range of services offered by individual banks.

Two other proposals, to place a cap on banks’ non-deposit financing or to require firms to maintain certain levels of long-term debt, may better reduce the risks that led to the 2008 financial crisis and brought down firms such as Bear Stearns Cos., Lehman Brothers Holdings Inc., and American International Group Inc.

“The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options,” Tarullo said Tuesday in remarks prepared for a speech at the Brookings Institution in Washington.

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Also, such a rule could damage many small banks that provide some capital market services to small businesses, he said.

Tarullo, 60, has overseen the implementation of the Dodd- Frank Act, the most sweeping overhaul of financial regulation since the 1930s, and a reorganization of the Fed’s approach to inspecting banks and ensuring financial stability. He was Obama’s first appointee to the Fed and is the lead governor in charge of bank supervision and regulation.

Tarullo said many firms at the center of the financial crisis in 2008 and 2009 were either stand-alone banks or investment banks, such as Lehman Brothers and Washington Mutual Inc.

‘Conceptual Appeal’

Capping a bank’s nondeposit liabilities as a fraction of U.S. GDP has “considerable conceptual appeal,” Tarullo said. Such an approach “allows relative flexibility to the firm in meeting that constraint” since the firm could shrink its balance sheet through selling any assets it wished.

If research showed economies of scale and scope in banking were unlikely to be realized beyond a certain size, then policy makers would “have a point of reference for setting the cap,” he said.

Further analysis of the proposal would be needed, Tarullo said, and may “suggest alternative means to the same policy goals.”

A proposal to require banks to increase the use of long- term debt “would not seem to carry significant hurdles,” he said.

Fed officials meet next week and will probably discuss their quantitative easing policy. Tarullo didn’t comment on monetary policy in the text of his remarks.

Stress Test

The central bank has used annual stress tests of banks’ capital strength to boost tier one common capital to $803 billion for the 19 largest banks from $420 billion in the first quarter of 2009. The ratio capital to assets weighted for risk has about doubled to 10.9 percent from 5.4 percent.

Bank profits have improved as non-performing loans have declined and fee income from consumer banking has increased. Also, mortgage refinancing is booming thanks to the Fed’s quantitative easing strategy aimed reducing mortgage rates and other long-term borrowing costs.

The KBW Bank Index, which tracks 24 large U.S. banks such as Bank of America Corp. and JPMorgan Chase & Co, has increased 22 percent this year versus a 12 percent rise in the Standard & Poor’s 500 stock index.

In the past two months, Tarullo has introduced two new ideas for bank regulation. He said in an Oct. 10 speech that it would be “appropriate” for Congress to legislate an upper boundary for the largest banks that are able to preserve a “too-big-to-fail” quality.

Tougher Rules

The Fed governor said on Nov. 28 at the Yale School of Management in New Haven, Connecticut, that the central bank is planning tougher capital and leverage rules for U.S. units of foreign banks.

“We need to adjust the regulatory requirements for foreign banks in response to changes in the nature of their activities in the United States, the risks attendant to those changes, and instructions from Congress,” Tarullo said.

The Fed will propose a rule that will force non-U.S. firms to house all of their U.S. businesses, including securities trading, within U.S. regulated holding companies, Tarullo said.

Those holding companies also must follow capital and liquidity rules that already apply to U.S. counterparts, he said. That means foreign banks’ local units would have to bolster capital and liquidity in the U.S. to guard against losses and potential runs regardless of their parents’ resources.

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