Daniel Tarullo, a governor of the Federal Reserve System, spoke for the first time last week about potentially imposing a size cap on the largest U.S. banks. His language, naturally, was that of a central banker.

“To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow,” he said in a speech at the University of Pennsylvania Law School. “There is, then, a case to be made for specifying an upper bound.”

His point was simple and clear. Creditors to very large financial institutions believe they receive downside protection from the government -- primarily through measures that the Fed would put in place in the event of financial distress. This gives large bank holding companies and other financial enterprises the ability and incentive to become even larger, which in turn increases the perceived subsidy and further lowers their funding costs.

Financial systems can become unstable in many ways, as Tarullo points out. And limiting bank size shouldn’t be seen as a panacea. But speaking of the post-2008 approach to reducing financial-sector risks, particularly as embodied by the Dodd-Frank law of 2010, Tarullo emphasized:

“To the extent one can fairly induce an underlying principle, it is that the moral hazard associated with too-big-to-fail institutions should be counteracted in a variety of ways.”

Capital Requirements

In this spirit, he also expressed support for “enhanced capital requirements” for large banks. “These additional capital requirements,” he said, “can also help offset any funding advantage derived from the perceived status of such institutions as too-big-to-fail.” And he further urged a “strong presumption” that acquisitions by very large financial-sector firms would be turned down.

Tarullo is the lead Fed governor for many bank regulatory issues, including equity capital. These statements mark a significant -- perhaps even dramatic -- shift in thinking at the central bank. Tarullo looks to Congress to decide on potential size caps, but lawmakers rely heavily on the expertise of the Fed in thinking about how to handle such technical matters.

There are five reasons to expect this issue to gain momentum after the presidential election.

First, there is a deeper understanding of the problems inherent to very large banks. A new book by former Federal Deposit Insurance Corp. Chairman Sheila Bair, “Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself,” makes the economics and regulatory politics abundantly clear. And her compelling points about the political power of the big banks are affirmed by Jeff Connaughton’s “The Payoff: Why Wall Street Always Wins,” which takes you inside the lobbying of government. Why would anyone want our largest banks to obtain more political power?

Second, there is a growing realization that very large banks are -- among other things -- too big to manage. Over the summer, we had repeated evidence of mismanagement within these huge, complex corporations: Libor fixing; money-laundering charges against HSBC Holdings Plc and Standard Chartered Plc; and the $5.8 billion loss by JPMorgan Chase & Co.’s “London Whale.” Now banks face a fresh round of accusations that they routinely mismanaged their mortgage businesses and misled investors during the boom years -- and then mistreated borrowers when housing prices collapsed.

GDP Share

Third, there has long been a law on the books that attempted to limit the size of our largest banks. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 established that no bank can have more than 10 percent of total retail deposits. The flaw in that legislation is that most of the growth in bank size since 1994 has been due to wholesale financing, not retail deposits. Tarullo sensibly proposes to “limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product.”

Fourth, there is already proposed legislation that puts forward this idea. In 2010, Senator Sherrod Brown of Ohio and then Senator Ted Kaufman of Delaware proposed an amendment to Dodd-Frank that would have capped bank size; it received 33 votes and died on the Senate floor. Brown has since reintroduced this legislation: the Safe, Accountable, Fair and Efficient Banking Act. The proposed law’s bottom line is that no bank holding company could exceed $1.1 trillion in total assets (including off-balance-sheet assets) -- a constraint that would be binding only for JPMorgan, Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. No non-bank financial company could be larger than about $400 billion in assets.

Fifth, putting a responsible cap on bank size plays very well in Ohio, Brown’s home state -- as well as a battleground for the presidential candidates this year and probably in the future. Senator John Sherman, of the eponymous Sherman Act, was a Republican from Ohio; the state has a history of taking on concentrated power. (For more on the Sherman Act comparison with Brown-Kaufman, I recommend this blog post by Connaughton, a former chief of staff to Senator Kaufman.)

Capping bank size is the modern equivalent of trust busting, and attracts support from across the political spectrum. People on the right and left don’t understand why megabanks should get implicit government subsidies and worry that top executives of very large banks have become too powerful.

Both concerns are legitimate and need to be addressed. Now the Fed is pushing in the same direction.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

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To contact the writer of this article: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net