Fed should be tougher on large banks, Yellen says

By Douwe Miedema and Emily Stephenson

WASHINGTON, Nov 14 (Reuters) - Big banks can still borrow more cheaply than competitors and should face tougher rules, the prospective new head of the U.S. Federal Reserve told lawmakers on Thursday.

Large banks may have an edge because markets think they have government backing in times of crisis, said Janet Yellen, President Barack Obama's choice to be the Fed's new head, unveiling some new steps the central bank could take to encourage those firms to downsize.

"Most studies point to some subsidy that may reflect too big to fail," she said during a hearing into her nomination before the Senate Banking Committee.

"Since those firms do pose (a) systemic risk to the financial system, we should be making it tougher for them to compete, and encouraging them to be smaller and less systemic."

Yellen, currently the Fed's vice chair, largely echoed the Fed's existing policy on bank regulation, but did reveal some new details of her thinking about Wall Street's role in commodity markets and on short-term funding.

Wall Street critics argue that banks such as JPMorgan Chase (Berlin: CMC.BE - news) and Citigroup (NYSE: C - news) are too big to fail, and politicians such as Sen. Sherrod Brown - an Ohio Democrat - have introduced bills that could force them to cut their size.

A government report found on Thursday that bigger banks received more support than smaller firms from government backstops, such as deposit guarantees and the Fed's discount window, during the 2007-09 financial crisis.

The six biggest banks participated in crisis-era emergency programs, although they later stopped relying on much of that federal support, the U.S. Government Accountability Office report said.

U.S. regulators have been scrambling to write tough new rules for banks that were required by the 2010 Dodd-Frank law, which Congress passed to overhaul Wall Street oversight.

The law called for banks to rely less on debt, hold assets that could be sold quickly in a credit crunch and stop making risky trades with their own money. Regulators are still wrestling with the details of some of these changes.

MORE RULES

Yellen said the Fed is considering additional rules that were not part of the Dodd-Frank requirements, and may write requirements for Wall Street's activities in physical commodity markets once the Fed winds up a review of banks' raw materials trading.

The Fed said in July it was reviewing a 2003 decision to allow regulated banks, including Citigroup and Barclays (Berlin: BCY.BE - news) , to trade in oil, metals and other commodities.

That led to banks' ownership of assets like oil storage tanks and power plants, and accusations of price manipulation.

Thursday was the first time a Fed official had said new rules could come out of its review into raw materials trading by Goldman Sachs (NYSE: GS-PB - news) , JPMorgan (Other OTC: JPAPZ - news) and other banks, results of which are expected early next year.

"We may be involved in additional rule-making as we complete this review," Yellen said.

Brown, the Ohio Democrat, will question the Fed next week at a sub-committee hearing about whether banks' commodity dealings distort prices in markets from electricity in California to aluminum.

Yellen also said the Fed expects to be able to address concerns about a rule that forces banks to isolate risky derivatives trading into separate business units - the so-called push-out rule - without changing the law.

The rule is aimed at separating swaps from federal government backstops such as deposit insurance. Banks say complying with the rule would be too costly and complex.

A total of 70 Democrats in the House of Representatives voted along with Republicans last month to adopt a bill to undo most of the provision, a victory for bank lobbyists even if the proposal stands a slim chance of becoming law.

Yellen also said concerns about banks' overly-heavy reliance on short-term funding - a crucial cause of the collapse of Lehman Brothers in 2008 - could be fixed by asking them to put up higher safety buffers, or margin.

Governor Dan Tarullo, the Fed's main spokesperson on financial regulation, first said the central bank was working on the rule in July, but did not provide details.