Federal Reserve Board of Governors member Dan Tarullo.

U.S. stocks are little changed in early afternoon trading on Thursday, with the S&P 500 (SNPINDEX:^GSPC) and the Dow Jones Industrial Average (DJINDICES:^DJI) (DJINDICES: $INDU) down 0.06% and 0.01%, respectively, at 1:15 p.m. EDT. Bank shares are underperforming, with the KBW Nasdaq Bank Index up 0.04%.

The Fed has some more tough love for top banks

Daniel Tarullo, the man The Wall Street Journal this week dubbed "the most powerful man in banking," appeared on Bloomberg Television this morning, and he put the country's largest banks on notice.

In a development that highlights the Federal Reserve's dogged approach toward the problem of "too big to fail," Govenor Tarullo indicated that the Fed will incorporate the capital surcharges on the top eight U.S. banks in its annual round of "stress tests" to a bank's capital position under adverse economic scenarios. The change would not apply until 2017, at the earliest.

Last July, the Federal Reserve finalized the capital surcharges that apply to these so-called GSIBs (global systemically important banks). The surcharges range from one percentage point for Bank of New York Mellon Corp to four-and-a-half points for JPMorgan Chase & Co. The surcharges are added to the minimum common equity Tier one ratio for banks under the Basel 3 framework agreed to by international regulators in the wake of the financial crisis.

A baptism by fire

Tarullo sits on the Board of Governors of the Federal Reserve, and he chairs the central bank's Committee on Banking Supervision. On joining the Fed, he had a baptism by fire: He took office on Jan. 28, 2009 -- fewer than six weeks before the U.S. stock market bottomed. On March 8, 2009, the KBW Bank Index, which has price history going back to May 1992, put in its all-time low of 18.62 (the index closed at 71.13 yesterday).

That experience surely left an impression on him, but rather than forcing the banks to break themselves, he has been progressively and methodically ratcheting up the pressure on large banks. These institutions are, for the first time, experiencing an economic disadvantage linked to their size that creates a trade-off, with the benefit of an implicit government guarantee. Lo and behold, this trade-off is having a direct impact on the banks' economic decision-making and capital allocation.

Where are the returns?

Bank executives and investors are getting to grips with a prickly new environment. From 2009 onwards, neither B of A nor Citi has produced a single quarter in which they've earned a return on equity above the 10% that analysts use as a benchmark figure for big banks' cost of equity.

Similarly, since 2009, shares of Bank of America Corp and Citigroup Inc have never traded above their book values. Even shares of JPMorgan Chase & Co. -- which didn't suffer so much as a single quarterly loss during the financial crisis -- have not traded at more than a 30% premium to their book value in that seven-and-a-half-year period. The price-to-book multiple relates directly to a company's ability to earn a return above its cost of equity capital.

I'm impressed with the Fed's actions in this area -- it appears to be taking the problem of too-big-to-fail seriously, and capital requirements is arguably the single best tool for minimizing that risk. For banks, the pressure is on to focus on profitable activities and to resize where necessary. Ultimately, that process will benefit shareholders, too, even if there will be some hand-wringing from the market along the way.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.