William C Dudley: Lessons of the crisis - the implications for regulatory
reform
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Partnership for New York City discussion, New York,
20 January 2010.
* * *
It is a pleasure to have the opportunity to speak here today. I will focus on the important
lessons of the recent crisis and how those lessons should inform the regulatory reform effort.
As always, what I have to say reflects my own views and not necessarily those of the Federal
Open Market Committee or the Federal Reserve System.
In my opinion, this crisis demonstrated that a systemic risk oversight framework is needed to
foster financial stability. The financial system is simply too complex for siloed regulators to
see the entire field of play, to prevent the movement of financial activity to areas where there
are regulatory gaps, and, when there are difficulties, to communicate and coordinate all
responses in a timely and effective manner.
Effective systemic oversight requires two elements. First, the financial system needs to be
evaluated in its entirety because, as we have seen, developments in one area can often
have devastating consequences elsewhere. In particular, three broad areas of the financial
system need to be continuously evaluated: large systemically important financial institutions,
payments and settlement systems and the capital markets. The linkages between each must
be understood and monitored on a real-time basis. Second, effective systemic risk oversight
will require a broad range of expertise. This requires the right people, with experience
operating in all the important areas of the financial system.
In this regard, I believe that the Federal Reserve has an essential role to play. The Federal
Reserve has experience and expertise in all three areas - it now oversees most of the
largest U.S. financial institutions; it operates a major payments system and oversees several
others; and it operates in the capital markets every day in managing its own portfolio and as
an agent conducting Treasury securities auctions. Also, as the central bank, it backstops the
financial system in its lender-of-last-resort role.
Compared with where we were in late 2008 and early 2009, financial markets have
stabilized, and the prospect of a collapse of the financial system and a second Great
Depression now seems extremely remote. Even with this progress, however, credit remains
tight, especially for small businesses and households. Economic growth has resumed, but
unemployment has climbed to punishing levels. So while circumstances have improved, they
are still very far from where we want them to be. We have no cause for celebration when the
challenges facing so many businesses and households remain so daunting.
Aggressive and extraordinary official interventions were imperative to bring about this
nascent stabilization of our financial markets and economic recovery. The Federal Reserve
has been at the center of many of these interventions. For example, its efforts over the past
two years to promote market functioning and minimize contagion were critical in preventing
the strains in our financial markets from resulting in even more severe damage to the
economy. These "lender of last resort" interventions on the part of the Fed, including facilities
such as the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility
(PDCF), as well as programs such as the foreign exchange reciprocal currency agreements,
are examples of the rapid and responsive application of basic central bank tenants to the
unique challenges we faced as this crisis evolved. Indeed, in many ways, the crisis has
underscored why the Federal Reserve was created almost a century ago: to provide a
backstop for a banking system prone to runs and financial panics.
Where it proved necessary and feasible to do so, the Fed also used its emergency lending
authority to forestall the disorderly failure of systemically important institutions. These actions
extraordinary -
truly were well outside the scope of our normal operations, but our judgment
was that not taking those actions would have risked a broader collapse of the financial
system and a significantly deeper and more protracted recession. Faced with the choice
between these otherwise unpalatable actions and a broader systemic collapse, the Fed, with
the full support of the Treasury, invoked its emergency lending authority and prevented the
collapse of certain institutions previously considered to have been outside the safety net.
The fact that the Fed needed to take those actions provides a stark illustration of the
significant gaps in our regulatory structure, gaps that must be eliminated. Among those holes
was the absence of effective consolidated oversight of certain large and deeply
interconnected firms; the collective failure of regulators - including the Federal Reserve - to
appreciate the linkages and amplification mechanisms embedded in our financial system;
and the absence of a resolution process that would allow even the largest and most complex
of financial institutions to fail without imperiling the flow of credit to the economy more
broadly. Addressing these shortcomings will require important reforms in our country's
regulatory architecture.
We entered the crisis with an obsolete regulatory system. For one, our regulatory system
was not structured for a world in which an increasingly large amount of credit intermediation
was occurring in nonbank financial institutions. As a result, little attention was paid to the
systemic implications of the actions of a large number of increasingly important financial
institutions - including securities firms, insurance conglomerates and monolines. In addition,
many large financial organizations were funding themselves through market-based
mechanisms such as tri-party repo. This made the system as a whole much more fragile and
vulnerable to runs when confidence faltered.
With the benefit of hindsight, it is clear that the Fed and other regulators, here and abroad,
did not sufficiently understand the importance of some of these changes in our financial
system. We did not see some of the critical vulnerabilities these changes had created,
including the large number of self-amplifying mechanisms that were embedded in the
system. Nor were all the ramifications of the growth in the intermediation of credit by the
nonbank or "shadow banking" system appreciated and their linkages back to regulated
financial institutions understood until after the crisis began.
With hindsight, the regulatory community undoubtedly should have raised the alarm sooner
and done more to address the vulnerabilities facing our banks and our entire financial
system. But this was difficult because our country didn't have truly systemic oversight -
oversight that would be better suited to the new world in which markets and nonbank
financial institutions had become much more important in how credit was intermediated.
Without a truly systemic perspective, it was unlikely that any regulator would have been able
to understand how the risks were building up in our contemporary, market-based system.
The problem was that both banking and nonbank organizations played an important role in
credit intermediation but were subject to differing degrees of regulation and supervision by
different regulatory authorities.
Although these gaps had existed for years, their consequences were not apparent until the
crisis. Difficulties in one part of the system quickly exposed hidden vulnerabilities in other
parts of the system, in a way that our patchwork regulatory system had not been designed to
detect or readily address. In the same way, the crisis revealed the critical deficiencies in the
toolkits available to the regulators to deal with nonbank institutions in duress. Emergency
lending by the Fed might be enough to forestall the disorderly failure of a systemically
important institution and all the wider damage such a failure might cause, but it was a blunt
and messy solution, employed as a stopgap measure because better alternatives were not
available. What is needed - what our country still lacks - is a large-firm resolution process
that would allow for the orderly failure even of a systemically important institution.
Thus, in the fall of 2008, regulators and policymakers found themselves facing the prospect
of the total collapse of a complex and interconnected system. It was these circumstances,
and the prospect they created for an even deeper and more protracted downturn in real
economic activity and employment, that required truly extraordinary actions on the part of the
Federal Reserve, as well as the Treasury and many other agencies. This is a situation in
which the United States must never again find itself.
For its part, the Federal Reserve is hard at work on developing and implementing new
regulations and policy guidance that take on broad lessons of the recent crisis. We are
working with other banking regulators in the United States and overseas to strengthen bank
capital standards, both by raising the required level of capital where appropriate and
improving the risk capture of our standards. We are issuing new guidelines on compensation
practices so that financial sector employees are rewarded for long-term performance and
discouraged from excessive risk-taking. And we are working with foreign regulators to
develop more robust international standards for bank liquidity. We are working to make the
tri-party repo system more robust and reducing settlement risk by facilitating the settlement
of over-the-counter derivatives trades on central counterparties (CCPs). But more needs to
be done and much of this requires action by Congress.
Congress is now considering several proposals for comprehensive regulatory reform,
proposals that merit careful study and debate. Let me offer some general thoughts on the
principles that should guide how we approach reform.
First, it's important to take a clear-eyed and comprehensive view of the financial system we
have today. As I've already suggested, if there is one overriding lesson to be drawn from the
events of the past 18 months, it is that the financial system is just that: a system, and a very
complex one at that. The operational, liquidity and credit interdependencies that characterize
contemporary financial markets and institutions mean that the well-being of any one segment
of the system is inextricably linked to the well-being of the system as a whole. Because of
this, our approach to reform must be guided by a coherent sense of the system as a whole,
not merely by a focus on some of its component parts, as important as they may be.
We need a new regulatory structure that provides for comprehensive and consistent
oversight of all elements of the financial system. This includes effective consolidated
oversight of all our largest and interconnected financial institutions and oversight of payment
and settlement systems. We must make sure that the people doing the regulation have the
power and expertise to ferret out and bring to heel regulatory evasion as it occurs to prevent
abuse and excess from building up in the financial system. In the end, the gaps, not the
overlaps, have been the main shortcoming of our existing regulatory framework.
A second fundamental point is that regulatory reform has to ensure that the financial system
will be robust and resilient even when it comes under stress so that it will not fail in its critical
role in supporting economic activity. No economy can prosper without a well-functioning
financial system - one that efficiently channels savings to the businesses that can make the
most productive use of those savings, and to consumers that need credit to buy a home and
support a family. The fact that our financial system isn't functioning well right now is part and
parcel of our current economic difficulties. This critical link between the "real" and the
"financial" is why we care so much about the systemic risks inherent in banking and finance.
One critical element of systemic risk is what is known as the "too big to fail" problem. Without
sufficiently high capital and liquidity standards, and, as a backstop, a resolution mechanism
that is credible, regulators are faced with a Hobson's Choice when a large, systemically
important financial firm encounters difficulties. On the one hand, if authorities step in to
respond to prevent failure, contagion and collapse of the broader system, that action rewards
the imprudent and can create moral hazard - that is, encouraging others to act irresponsibly
or recklessly in the future in the belief that they will also be rescued or "bailed out." On the
other hand, if authorities do nothing and let market discipline run its course, they run the risk
that the problem will spread and unleash a chain reaction of collapse, with severe and lasting
damage to markets, to households and to businesses.
So what can we do about the "too big to fail" problem? It is clear that we must develop a truly
robust resolution mechanism that allows for the orderly wind-down of a failing institution and
that limits the contagion to the broader financial system. This will require not only legislative
action domestically but intensive work internationally to address a range of legal issues
involved in winding down a major global firm. Second, we need to ensure that the payments
and settlement systems are robust and resilient. By strengthening financial market
infrastructures, we can reduce the risk that shocks in one part of the system will spread
elsewhere. Third, we need to reduce the likelihood that systemically important institutions will
come close to failure in the first place. This can be done by mandating more robust capital
requirements and greater liquidity buffers, as well as aligning compensation with the risks
that are taken by the firm's employees. In addition, instruments such as contingent
capital-debt that would automatically convert to equity in adverse environments - need to be
considered. Such instruments would enable equity capital to be replenished automatically
during stress environments, dampening shocks rather than exacerbating them.
I would now like to take some time to discuss some of the proposals that Congress is
debating regarding regulatory reform. As Congress and the Administration consider what
legislative changes are warranted, the Federal Reserve's actions before and during the crisis
have been getting close inspection. Given the Federal Reserve's key role in our financial
system, and the scale of the damage caused by the financial crisis, this careful scrutiny is
necessary, appropriate and welcome.
Not surprisingly, there are legislative proposals that would significantly alter the Federal
Reserve's powers and responsibilities, particularly with respect to supervision of bank
holding companies. Again, that's entirely within Congress's purview: the Federal Reserve
only has the powers and responsibilities that Congress has entrusted to us. But in drawing
up new legislation, it's important not to throw the baby out with the bathwater - we should
preserve what has worked and fix what hasn't. A dispassionate analysis of what is needed
will almost certainly lead to better decisions and a more effective regulatory framework.
The legislative proposals concerning the Federal Reserve are not limited to the Federal
Reserve's role in supervision. Consider, for example, one proposal that calls for what it terms
"audits" of the Federal Reserve by the U.S. Government Accountability Office (GAO), an arm
of Congress. These wouldn't be audits at all in the commonly understood sense of the term.
The Federal Reserve's financial books and transactions are already audited by wide range of
professionals internal and external to the institution. Rather, these new audits would involve
ex-post review of Federal Reserve monetary policy decisions, a potential first step toward the
politicization of a process that Congress has carefully sought to insulate from political
pressures.
The notion that the Federal Reserve's financial dealings are somehow kept hidden from the
public is a surprisingly widely held view - and it is simply incorrect. An independent outside
audit of the Federal Reserve's books is conducted annually. You can find the results online,
including a detailed accounting of the Federal Reserve's income and operating expenses in
its annual report. The financial books of the regional Federal Reserve Banks also undergo
independent outside audits, also available online. In addition, the GAO is empowered to
review almost all Federal Reserve activities other than the conduct of monetary policy,
including the Federal Reserve's financial operations, which the GAO has done so frequently.
The Federal Reserve's balance sheet is posted online weekly, with considerable detail, in
what's called the H.4.1 report. Finally, an additional accounting of the Federal Reserve's
emergency lending programs created over the last two years is available online in a monthly
report.
But my objection that GAO oversight would be broadened to include a review of monetary
policy decisions is not based just on the fact that the Fed is already subject to considerable
oversight. My principal concern is the damage that could potentially result to the Fed's ability
to achieve its mandate of price stability and maximum sustainable employment. The
effectiveness of monetary policy depends most of all on the Federal Reserve's credibility with
market participants and investors. In particular, both groups need to know that the Fed will
always act to keep inflation in check. That's why Fed Chairman William McChesney Martin
famously joked that the Fed would sometimes need "to take the punchbowl away just as the
party gets going." As you can well imagine, this may not always enhance our popularity,
especially among those who were enjoying the party. But, the fact that markets know that the
Federal Reserve will tighten monetary policy when needed helps keep inflation expectations
in check. This, in turn, helps keep inflation low since inflation expectations affect actual
inflation. The consequence is credibility with respect to the conduct of monetary policy. This
gives the Fed more latitude not to tighten when inflation rises for transient reasons - say, due
to a short-lived spike in oil prices - and more scope to ease credit to support the economy
during economic downturns.
Recognizing these benefits, Congress wisely acted many years ago to exempt monetary
policy decisions from the GAO's wide powers to review Federal Reserve activities. Congress'
decision to bolster the Fed's monetary policy independence has been followed by similar
actions around the world - substantial independence for the central bank in the conduct of
monetary policy is now widely regarded as international best practice. Policy independence
does not absolve the Federal Reserve from accountability for its monetary policy decisions
and the need to clearly explain why they were taken. But it avoids the politicization of
monetary policy decision-making. And this is good because politicized central banks
generally do not have enviable records with regard to inflation, economic growth or currency
stability. Risk premia on financial assets are typically much higher in countries with politicized
central banks.
Of course, a reversal of Congress's earlier decision would not amount to legislative control
over monetary policy decisions. That's not the issue. The issue is that a reversal of
Congress' earlier decision could create the appearance that the legislature seeks to influence
monetary policy decisions by establishing a mechanism to publicly second guess those
decisions. Such a move would blur what has been a careful separation of monetary policy
from politics. Market confidence here and abroad in the Federal Reserve would be
undermined. Asset prices could quickly build in an added risk premium, which might lead to
tighter credit conditions. These unintended consequences would undermine the legislation's
intent.
I'm also concerned about those proposals under consideration that would move the
regulatory and supervisory functions now held by the Federal Reserve to other agencies,
new or existing. At present, the Federal Reserve is the consolidated supervisor for bank
holding companies, a group that has expanded recently as investment banks and other
companies formerly outside the Federal Reserve's purview have been brought under Federal
Reserve oversight. In my view, further disaggregation or fragmentation of regulatory
oversight responsibility is not the appropriate response to our increasingly interconnected,
interdependent financial system. Funneling information streams into diverse institutional silos
leads to communication breakdowns and too often to failure to "connect the dots."
In addition, there are clear synergies between the supervisory process and the Federal
Reserve's monetary policy and financial stability missions. The information we collect as part
of the supervisory process gives us a front-line, real-time view of the state of the financial
industry and broader economy. Monetary policy is more informed as a result. Only with this
knowledge can a central bank understand how the monetary policy impulse will be
propagated through the financial system and affect the real economy.
Similarly, involvement in the supervisory process gives us critical information in fulfilling our
lender-of-last-resort responsibilities. Information sharing with other agencies is simply not as
good as the intimate knowledge and understanding of markets and institutions that is
gathered from first-hand supervision. Indeed, many institutions at the center of the crisis and
arguably the most troubled - Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and the
GSEs - were not supervised by the Federal Reserve. Consequently, when those institutions
came under stress, the Federal Reserve had poorer quality and far less timely information
about the condition of these institutions than would have been the case if we had had the
benefit of direct supervisory oversight.
In fact, some of the hardest choices the Federal Reserve had to make during the most
chaotic weeks of the crisis concerned systemically important firms we did not regulate. It is
not surprising that, in the wake of the crisis, some countries that had separated bank
supervision from the central bank monetary policy role are now reconsidering that division of
labor. That is mainly because coordination problems created difficulties in responding quickly
and effectively in the crisis. Separation made it more difficult to communicate in a timely way
and to understand the broader implications of what was transpiring. It is critical that we not
introduce new inefficiencies and impediments. No matter what steps are taken to improve
our regulatory system and strengthen market discipline, history tells us that there will
inevitably be circumstances in which an informed and effective lender of last resort will play a
critical role in preventing shocks and strains in financial markets and institutions from
generating a broader collapse of the financial system.
Of course, there are legitimate questions as to how broad the Federal Reserve's regulatory
and supervisory responsibilities should be. That question is up to Congress, and should be
decided on the merits. What is fundamentally at issue here is not "turf", but rather how we as
a nation can best ensure that we never again re-live the events of the past few years - that
the legitimate public interests associated with a safe, efficient and impartial banking and
financial system are well served.
In the end, it is critical that financial reform be decided on the basis of the merits. If objective
and careful policymaking prevails, we will all be the better off for it. In contrast, if we fail in
this endeavor, that would truly be tragic. We must act informed by the important lessons that
we have learned from this crisis.
Thank you for your kind attention.