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By Emily Stephenson and Douwe Miedema
WASHINGTON (Reuters) - Banks' limits on how much they can borrow should be tighter than what is called for under a global pact, a top Federal Reserve official said, as calls to cut the size of the largest banks continue.
Fed Governor Daniel Tarullo said that the limit, known as a leverage ratio, may have been set too low in Basel III, a worldwide agreement aimed at making banks safer after the devastating 2007-09 financial crisis.
"The new Basel III leverage ratio ... may have been set too low," said Tarullo, the Fed's regulation czar, adding that the central bank could use its powers to "set a higher leverage ratio for the largest firms."
The debate about too-big-to-fail banks - which are perceived as implicitly relying on taxpayers to bail them out no matter how risky their business conduct - has heated up in Washington in the last few weeks.
Critics of Basel III, including many regulators, have said it is too easy on the banks, and that it relies too much on letting banks use complex calculations to determine how much equity they should hold.
Many of the signatories of Basel III across the world, the Fed included, have missed the January deadline set by global leaders to introduce the global pact.
Tarullo expected the rules that the Fed is drawing up with two other regulators - the Federal Deposit Insurance Company and the Office of the Comptroller of the Currency (OCC) - to come out in the next couple of months.
Under Basel III, the leverage ratio stands at 3 percent. Tarullo declined to say by how much it should go up.
Two senators, Sherrod Brown and David Vitter, have introduced a bill that would set the leverage ratio for the biggest banks at 15 percent, a requirement so onerous that it could force them to carve up their businesses.
GovTrack, a website that calculates the likelihood of U.S. laws being adopted, attributes only a 1 percent chance to the proposal becoming law. Still, the bill has caused a flurry of headlines, and is hotly debated.
Banks complain equity is the most expensive way to fund their business, but it is the safest from a taxpayer's or a regulator's perspective. That is because shareholders are the first to lose their money in case of bankruptcy.
Tarullo also said he favored setting minimum requirements for how much long-term debt banks must hold. This debt buffer, which could be converted to equity if the bank failed, would absorb losses in case of financial trouble.
The main threat to bank stability was their reliance on short-term funding, Tarullo said, suggesting that big banks could be allowed to hold less capital than their peers if they relied less on short-term funding.
(Reporting By Emily Stephenson and Douwe Miedema; editing by Andrew Hay)