Daniel K Tarullo: Macroprudential regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Yale Law School Conference on Challenges in Global Financial Services,
New Haven, Connecticut, 20 September 2013.
* * *
Real world crises have a way of shaking up the intellectual foundations of policy disciplines.
Elements of received wisdom are undermined, while certain heterodox or less mainstream
views are seen as more valid or important than had been widely recognized. The financial
crisis of 2007-2009 was no exception. Some ideas, such as the efficient markets hypothesis,
have taken some hits, as others have risen to prominence. An example of the latter is the
view that financial stability must be an explicit economic policy goal. A corollary of this view is
that a "macroprudential" perspective - generally characterized as focused on the financial
system as a whole as opposed to the well-being of individual firms - should be added to
traditional prudential regulation.
A single speech cannot hope to touch on, much less do justice to, the many theoretical and
policy issues encompassed by the term macroprudential. In my remarks this afternoon I will
focus principally on the project of recasting the regulation and supervision of large financial
firms so as to realize the macroprudential objective of reducing systemic risk. Specifically, I
will offer five propositions that I think should guide this project over the next couple of years.
In so doing, I will explain some of the key steps that have already been taken and identify
some priorities that remain, though even here I do not pretend to comprehensiveness. Before
addressing the macroprudential dimension of regulating large financial firms, however, let me
provide some context by briefly reviewing the evolving idea of macroprudential policy.
Macroprudential policy
Although the crisis and its aftermath have created a broader consensus for the proposition
that financial stability should be a more explicit objective of economic policy, there is
considerably less convergence around theories of, metrics for, and policy prescriptions to
promote, financial stability. Policy and academic writing generally limits the term
"macroprudential" to measures directed specifically at countering risks in the financial system
that, if realized, can severely impact real activity.1
But adoption of consistent terminology
does not itself resolve questions of whether, for example, increases in systemic risk are
endogenous to the financial system and thus follow a somewhat regular cyclical pattern, or
are instead somewhat randomized, albeit repeated, phenomena.2
Differences in views of the origins of systemic risk obviously affect views of the best ways to
measure it and, of course, the best policies to contain it. One example, of particular interest
to central bankers, is the ongoing debate about the circumstances under which monetary
policy should be adjusted to take account of financial stability concerns. Lying behind the
various positions in this debate are differing views on how systemic risk propagates, and thus
on the relative efficacy of monetary versus macroprudential policies.
Progress in these debates is complicated by the fact that, by definition, financial stability
policies are directed toward preventing or mitigating rare events, rather than outcomes such
as inflation and unemployment that are continuously observable. This focus on tail risks
raises important issues of accountability in the institutional design of macroprudential policies
and also complicates the task of testing financial stability theories and proposed policies.
Yet even against the backdrop of what is still a comparatively underdeveloped understanding
of financial stability,3 commentators and policymakers have compiled and, in some cases,
developed so-called "toolkits" of possible macroprudential measures. These measures are
thought available for use against one or both of two frequently identified dimensions of
systemic risk: procyclicality and interconnectedness.4
Of course, the attractiveness of many
of these tools will depend on one's views of a variety of theoretical, institutional, and practical
questions.
The tools identified can be variously categorized. One useful distinction is between measures
designed to prevent systemic risk from building (often termed "lean-against-the-wind"
measures) and those designed to increase the resiliency of the financial system should
systemic risk nonetheless build sufficiently that broad-based stress ensues. Another
distinction is between time-varying and time-invariant measures, with the former based on a
response - either discretionary or in accordance with a rule - to some measured increase in
risk.
Macroprudential foundation for the regulation of large banking organizations
It is worth noting that the term "macroprudential regulation" can be found in Bank for
International Settlements (BIS) documents beginning more than 30 years ago. It appears to
have originated in specific contrast to traditional banking regulation, which a 1979
background paper at the BIS characterized as focused on "sound banking practice and the
protection of depositors at the level of the individual bank."5 In fact, much of the New Deal
legislation that would define the financial regulatory structure for more than 40 years was in
direct response to what we would today call systemic concerns, including banking panics and
excessive leverage in equity markets.6 In the late 1970s, though, there was indeed reason for
the development of an explicitly macroprudential perspective. The New Deal regulatory
system was beginning to break down in the face of profound changes in financial markets,
most importantly the progressive integration of capital market and traditional lending
3
There is actually quite a rich history of policy measures in the United States that we would today call
"macroprudential." See Douglas J. Elliott, Greg Feldberg, and Andreas Lehnert (2013), "The History of
Cyclical Macroprudential Policy in the United States," Finance and Economics Discussion
Series 2013-29 (Washington: Board of Governors of the Federal Reserve System, May). It is notable
that the enactment and use of a number of tools waned as the integration of capital markets with
traditional lending functions accelerated in the last quarter of the 20th century, though even if there is a
causal relationship between these two phenomenon, it is not clear which way the causality runs
(perhaps in both directions).
4
The terminology may differ among commentators. For example, "cross-sectional" is sometimes used in
place of interconnectedness, a term that may have some appeal to the extent it moves away from the
traditional domino image of one failing firm knocking down another, and also embraces dynamics such
as contagion across the financial system arising from correlated asset holdings and sources of funding.
5
Piet Clement (2010), "The term 'macroprudential': origins and evolution (PDF)," BIS Quarterly Review
(March), pp. 2-3.
6
The establishment of federal deposit insurance and the separation of commercial banking from
investment banking - two key elements of New Deal financial reforms - were very much directed at
what would today be characterized as systemic risks.
activities. The forms of regulation that were evolving as substitutes - principally, though not
only, minimum capital requirements - were largely based on what various BIS papers
characterized as a microprudential approach to regulation.
It is, however, equally worth noting that the use of the term macroprudential - and, it would
seem, the influence of the concerns lying behind the term - was somewhat irregular in the
three decades after it was coined. Discussion of the concept and its implications for
regulation was more likely to be found in the papers of a few academics and intrepid BIS
researchers than in the pronouncements of senior regulators or other official sector
representatives. One important exception is a speech delivered in September 2000 by the
late Andrew Crockett, then the General Manager of the BIS.7 For several reasons, that
speech is a good point of reference for us today - as a nod to Sir Andrew's foresight, as an
occasion for regret that his words were not more closely heeded by regulators,8
and as a way
of illustrating how the challenge of macroprudential financial regulation has grown in the
years since.
Sir Andrew's speech contained much that is now familiar and broadly accepted, but was
fairly uncommon at the time: He distinguished between the objectives of microprudential
regulation - protecting against idiosyncratic risk in a bank - and macroprudential regulation -
protecting against systemic risk. He set forth a description of the financial cycle that could be
read as a loose paraphrase of Hyman Minsky's theory of financial instability.9 He identified
the procyclical and asset-correlation concerns regarding large bank activities that have
commanded so much attention in the past several years. And, again foreshadowing many
recent discussions, he suggested macroprudential tools both to increase resiliency (as
through capital regulation with a systemic perspective) and to lean against the wind in an
effort to slow or limit the growth of unsustainable asset bubbles (as through maximum
loanto-value ratio requirements).
The Crockett speech holds up very well today. With the benefit of the experience gained from
the intervening financial crisis, an intense period of analysis from a macroprudential
perspective, and a variety of regulatory initiatives, I offer these five propositions both to
reinforce and to supplement the views Sir Andrew expressed 13 years ago.
Five propositions for a macroprudential approach to regulating financial institutions
1. A Macroprudential Perspective Should Dominate the Regulation and Supervision of Large
Financial Institutions. Sir Andrew entitled his speech "Marrying the Micro- and
MacroPrudential Dimensions of Financial Stability," suggesting an equal partnership between the
two regulatory dimensions, as he called them. My own sense is that we need to concentrate
our post-crisis efforts to reshape the regulation and supervision of large financial institutions
7
Andrew D. Crockett, General Manager of the Bank for International Settlements and Chairman of the
Financial Stability Forum (2000), "Marrying the Micro- and Macro-Prudential Dimensions of Financial
Stability (PDF)," speech delivered at the Eleventh International Conference of Banking Supervisors in
Basel, Switzerland, September 21.
8
Reading between the lines, one wonders whether Sir Andrew anticipated that his call for action might not
be taken up by banking regulators. He styled his remarks as "provocative" and concluded by suggesting
they were but "a small awareness-raising step in what, if pursued, is likely to be a long road."
9
Crockett, 2000 speech: "A review of the instances of financial instability would reveal some shared
stylised elements. There is first an over-extension phase during which financial imbalances build up,
accompanied by benign economic conditions. In this phase, asset prices are buoyant and their surge
tends to feed, and be fed by, rapid credit expansion, domestically or internationally. Leverage, in overt or
hidden forms, accumulates in balance sheets, masked in part by the favourable asset price
developments. The trigger for a reversal is essentially unpredictable. It can originate either in the
financial sphere (e.g., an asset price correction) or in the real economy (e.g., a spontaneous unwinding
of an investment boom). The process then moves into reverse. Ex post, a financial cycle is evident."
on measures reflecting the macroprudential dimension, at least for a time. This view is
consistent with the Congressional emphasis on financial stability and systemic risk
considerations in the Dodd-Frank Wall Street Reform and Consumer Protection Act.10
To be sure, idiosyncratic problems such as certain operational risks may threaten large
institutions, and traditional regulation and supervision surely have an important ongoing role
to play. But the dynamics observed during the financial crisis of highly correlated asset
holdings, shared risks, and contagion among the largest firms suggest that the well-being of
any one of these firms cannot be considered in isolation from the well-being of the system as
a whole. Severe problems at such institutions are far more likely to arise from vulnerabilities
to common stresses, and severe problems at such firms are far more likely to exacerbate
systemic weaknesses. Since the health of any one of these large institutions is tied to the
health of these firms as a group, good microprudential regulation may itself require a
macroprudential dimension.
The reorientation of the Federal Reserve's supervision of large, complex financial firms is
reflected organizationally in the Large Institution Supervision Coordinating Committee
(LISCC). The LISCC was created three years ago to facilitate the execution of horizontal,
cross-firm analysis of the largest firms and to centralize supervision of these firms so as to
promote an integrated and consistent supervisory approach. The LISCC includes senior staff
not only from the supervisory staffs of the Board and Reserve Banks, but also from the
Board's Office of Financial Stability, Division of Monetary Affairs, Division of Research and
Statistics, and other relevant divisions. This "interdisciplinary" approach to large bank
supervision not only fosters more rigorous microprudential regulation, it also facilitates and
formalizes a broader look at systemic risks by using quantitative methods to evaluate
macroeconomic and financial risks, and how they could affect individual firms and the firms
collectively.
2. Building Greater Resiliency is Central to the Macroprudential Regulation of Large Financial
Institutions. In early 2009 there was widespread doubt about the solvency of the financial
system as a whole, particularly at many of the large firms that had directly or indirectly been
deeply involved in mortgage markets and associated securitizations. When we created the
first supervisory stress test on the fly, as it were, our aim was to stabilize, and restore
confidence in, the financial system as a whole by ensuring that the 19 largest bank holding
companies were sufficiently capitalized that they could continue serving as viable financial
intermediaries. So the focus on resiliency was initially a matter of necessity.
But there is also logic to making the resiliency of the largest firms the most important part of
our ongoing macroprudential regulatory agenda. Just as a microprudential approach to
regulation has come to emphasize building up capital because it makes the individual firm
better able to absorb losses from any source, including unpredictable ones, so an
appropriately refocused set of macroprudential capital requirements can help make the
financial system better able to withstand shocks from unanticipated, as well as familiar,
sources. As mentioned by Andrew Crockett, a macroprudential perspective suggests two
ways in which resiliency should be strengthened: the first is to treat the financial system as a
whole as the "portfolio" of assets subject to safety and soundness oversight; the second is to
apply stricter regulations on firms of systemic importance whose failure would carry a good
chance of endangering the entire system. In the last four years, we have developed both
kinds of measures to increase resiliency.
Following our use of stress tests of the nation's 19 largest bank holding companies in the
midst of the crisis, Congress included in the Dodd-Frank Act a requirement of annual
supervisory stress tests for a larger group of firms: all those with greater than $50 billion in
assets. These stress tests, and an associated supervisory review of the capital processes
and practices of the covered firms, have in just a few years become a core part of the
oversight of these large firms.
Our stress testing program is one form of the first type of macroprudential resiliency
measure. It also provides a good example of how sound microprudential regulation of the
largest banking firms can be difficult to distinguish from regulation with a macroprudential
orientation. Conventional capital requirements are by their nature somewhat
backwardlooking, reflecting loss expectations based on past experience and loss recognition that often
occurs well after the likelihood of loss has become clear. Rigorous stress testing helps
compensate for these shortcomings through a forward-looking assessment of the losses that
would be suffered under stipulated adverse economic scenarios, so that capital can be built
and maintained at levels high enough for the firms to withstand such losses and still remain
viable financial intermediaries. This forward-looking aspect of stress testing automatically
builds capital, and boosts resilience, in the face of weakening loan-underwriting standards
because, for any given adverse scenario, weaker underwriting standards will imply higher
losses. Also, because the firms are stressed simultaneously, supervisors are able to identify
and take account of correlated exposures and other common risks.11 The firms covered by
the Dodd-Frank Act supervisory stress tests account for more than 70 percent of U.S.
banking sector assets, thus approaching Sir Andrew's standard of a supervisory perspective
that examines the assets of the financial system as a whole.
The effectiveness of stress testing as a macroprudential tool depends, of course, on how the
tests are constructed. For example, a macroprudential perspective must inform the
construction of the scenarios against which the assets and revenues of the banks are
stressed. Such a perspective argues for incorporating particular risks to the financial system
even when there is some uncertainty regarding the probability of a particular risk being
realized. For example, the scenario might include a sharp drop in house prices if analysis
suggested - but did not confirm - that there was overheating in the housing market, and if
supervisors judged that large banks had correlated exposures to the housing sector. That is,
the stress tests provide for resiliency in the event the risk comes to pass, without necessarily
requiring other measures to restrict directly the lending or other activity lying behind the risk.
A macroprudential perspective also counsels against injecting more procyclicality into the
financial system by, for example, simply assuming a standard deterioration in economic
conditions from whatever the baseline projections might be. Such an approach would
overlook the tendency of systemic risk to build during strong, prolonged expansions, when
underwriting standards decline, rising asset prices make secured lending seem safer, and
defaults wane. The approach we are instead taking is that, under such conditions, our
severely adverse scenario would assume a level of unemployment during the stress period
comparable to that observed in past severe recessions, not simply an increase in
unemployment comparable to the increase observed during those recessions.12 Thus, the
scenario's unemployment rate would feature a larger and sharper rise in the unemployment
rate as economic expansions proceed.
Finally, stress tests must be modified so as to avoid incentivizing firms to correlate their asset
holdings or adopt correlated hedging strategies. This potential problem can be illustrated by
reference to the market shocks we have applied to the trading books of the six largest
financial firms in the last two stress tests. The shocks, designed to be severe, consisted of
instantaneous, hypothetical jumps in asset prices based on those observed over the entire
second half of 2008. The resulting trading losses are - as one would expect - quite large.
Even so, had we simply used the same shocks that we used in the 2009 exercise,
unchanged from the historical experience, we would have underestimated the potential
losses associated with subsequent developments. For that reason, we modified the market
shock scenario in 2011 to take account of Eurozone stress and then further modified the
hypothesized stress in 2012 to include sharp moves in interest rates. We will continue to
modify the market shock regularly to incorporate salient risks that were not necessarily
present in 2008 and to ensure that firms cannot artificially improve their performance on the
test through holding significant amounts of certain assets that happened to perform well in
that period.
The second kind of macroprudential resiliency measure reduces the chances of distress or
failure for financial companies of systemic importance to a greater degree than for other
firms. Key provisions of Dodd-Frank aim at this form of resiliency. One extends the perimeter
of regulation by authorizing the Financial Stability Oversight Council (FSOC) to subject
nonbank financial companies to supervision and regulation by the Federal Reserve if the
council "determines that material financial distress" at such a company, or its nature, size, or
other characteristics or activities "could pose a threat to the financial stability of the United
States."13 Another requires the Federal Reserve to establish a broad set of enhanced
prudential standards, both for bank holding companies with total consolidated assets of
$50 billion or more and for nonbank financial companies designated by the FSOC as
systemically important, "[i]n order to prevent or mitigate risks to the financial stability of the
United States."14 The required standards include capital requirements, liquidity requirements,
stress testing, single-counterparty credit limits, an early remediation regime, and
riskmanagement and resolution-planning requirements. These requirements are to increase in
stringency in accordance with the relative systemic importance of the companies.
The capital surcharges that we will apply under this authority provide a clear example of this
kind of macroprudentially motivated regulation. A microprudential requirement is informed by
asking what level of capital would be necessary to allow the firm to remain a viable financial
intermediary even after absorbing losses that, within a fairly high level of confidence, might
be encountered over some relevant timeframe. A macroprudential capital requirement should
take account of the fact that there would be very large negative externalities associated with
the disorderly failure of any systemically important financial institution (SIFI), distinct from the
costs incurred by the firm, its stakeholders, and the federal deposit insurance fund.
As already suggested, the failure of such a firm, especially in a period of stress, significantly
increases the chances that other financial firms will themselves experience great stress, for
two reasons. First, direct counterparty impacts can lead to a classic domino effect. Second,
because losses in a tail event are much more likely to be correlated for firms deeply engaged
in trading, structured products, and other capital market instruments, all such firms are
vulnerable to accelerating losses as troubled firms sell their assets into a declining market.
Enhanced capital requirements should take into account these costs. Thus, the aim of
financial stability capital standards is to reduce further the probability that the firm might fail
under stress through a requirement to hold additional capital. These additional capital
requirements can also help offset any funding advantage derived from the perceived status
of such institutions as too-big-to-fail.
In acting on this rationale for capital standards to mitigate risks to financial stability, we first
sought to ensure that there would be an international initiative to develop financial stability
capital standards for global systemically important financial institutions. The Basel
Committee, an international body of supervisors that includes the U. S. banking agencies,
took up this agenda and developed a framework covering more than two dozen large
financial firms from around the world. Later this year, we will issue under the authority
granted by Dodd-Frank a proposed set of capital surcharges congruent with that framework.
The task of determining how much additional capital is needed to reduce the probability of a
systemically important firm's failure to more acceptable levels is not a straightforward one. In
calibrating the surcharge, the Basel Committee, with a good bit of input from the Federal
Reserve, began with what has been termed the "expected impact" approach, which calls for
additional capital to reduce the probability of the firm's failure sufficiently to equalize the
expected impact on the financial system of the failure of a systemically important firm and the
failure of a banking firm just outside systemic status.15 But implementing this concept is
complicated by the fact that, despite some very useful metrics that have been developed in
the past few years for measuring the systemic risk associated with a particular firm, there is
certainly no generally accepted approach.16 Indeed, differences among reasonable
assumptions in applying the expected impact approach led to a fairly broad range of potential
surcharges. The 1 to 2-1/2 percent amounts negotiated within the Basel Committee are at
the low end of that range, reflecting a good deal of caution - frankly, more caution than I
think would have been desirable, even given the uncertainties. Regardless of one's views on
calibration, though, the motivation and methodology for what have become known as "SIFI
surcharges" are clearly macroprudential.
One last point on macroprudential resiliency measures is that they can have secondary
effects that serve the lean-against-the-wind aim of macroprudential policies. For example, a
supervisory stress test can assign a higher loss rate to a certain class of assets in a
hypothesized adverse scenario because they are particularly vulnerable to potential shocks
and thus susceptible to particularly sharp declines in a serious recession. To the extent that
firms learn over time that such assets will be treated that way, there is at least a mild
disincentive to hold them. As I will discuss in a moment with respect to countercyclical capital
requirements, we should not overstate this lean-against-the-wind effect, but perhaps not
dismiss it out of hand either.
15
For example, if the loss to the financial system from the failure of a systemically important firm would be
five times that resulting from failure of the non-systemic firm, then the firm would have to hold additional
capital sufficient to make the expected probability of failure one-fifth that of the non-systemic institution.
16
Among the useful efforts along these lines are a measure of Conditional Value-at-Risk (CoVaR) (see
Tobias Adrian and Markus K. Brunnermeier (2011), "CoVaR (PDF)," Federal Reserve Bank of New York
Staff Reports 348 (New York: Federal Reserve Bank of New York, September), and a measure of
systemic risk based on each firm's contribution to the expected capital shortfall of the entire financial
system in a crisis (see Christian T. Brownlees and Robert F. Engle (2011), "Volatility, Correlation and
Tails for Systemic Risk Measurement," New York University Working Paper (New York: New York
University, June). The concept behind the latter measure is also described in Viral V. Acharya, Christian
Brownlees, Farhang Farazmand, and Matthew Richardson (2011), "Measuring Systemic Risk," in
Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (New York:
Wiley Publishers), pp. 87-119. Updated systemic risk rankings are maintained by the authors here. A
helpful review of the efforts to measure systemic risk is Monica Billio, Mila Getmansky, Andrew W. Lo,
and Loriana Pelizzon (2010), "Measuring Systemic Risk in the Finance and Insurance Sectors (PDF),"
MIT Sloan School Working Paper 4774-10 (Cambridge, MA: MIT Sloan School of Management, March).
3. Time-Varying Measures Will Play a More Limited Role. Some discussions of
macroprudential policy appear to contemplate a somewhat regular adjustment - up and
down - of both resiliency and lean-against-the-wind measures. The idea is to proceed in an
intentionally countercyclical fashion by attempting to restrain rapid, unsustainable increases
in credit extension or asset prices and to relax those restraints as economic conditions
deteriorate. This is a conceptually appealing approach, but, as various commentators on
macroprudential policy options have noted, one that raises a fair number of significant
issues: the reliability of measures of excess or systemic risk, the appropriate officials to be
making macroprudential decisions, the speed with which measures might realistically be
implemented and take effect, and the right calibration of measures that will be effective in
damping excesses while not unnecessarily reducing well-underwritten credit flows in the
economy.
If the measures are designed to be targeted, questions of efficacy may be raised by those
who believe that suppression of excess credit or asset price increases in one sector will likely
result only in the redirection of credit and speculation to other sectors until underlying
macroeconomic and financial conditions have ceased enabling such activities. If, on the
other hand, the measures are designed to be fairly broad-based, the more basic question of
the appropriate role of monetary policy may be raised by those who are focused on reactive
policies that "get in all the cracks" of the financial system, not just the heavily regulated
portion occupied by large financial firms.
Finally, we should probably be skeptical as to how effective a macroprudential relaxation of
regulatory requirements can be on the downside of economic cycles. Market discipline,
which may have been lax in boom years, tends to become very strict when conditions
deteriorate rapidly. Even if supervisors were to announce a relaxation in regulatory
requirements, in stressed economic conditions, investors and counterparties may well look
unfavorably on reductions in capital levels (even from higher levels) or relaxation of
underwriting standards at any one firm, notwithstanding the potential benefits for the
economy as a whole were all large firms to follow suit. Anticipating such a reaction, senior
management of banks may thus have strong non-regulatory incentives to act as if
microprudential regulation continued to dominate.
In short, the task of buffering the financial system against a tail event seems more tractable
than that of moderating the financial cycle. But these questions of economic knowledge and
institutional capacities should be grounds for proceeding cautiously, not for eschewing
timevarying measures entirely. It is true that the state of the art of financial stability risk
assessment is still in a relatively early stage. But it is reasonable to think that the amount of
effort being put into these efforts in governments, central banks, international organizations,
and universities will produce some well-conceived and well-tested metrics over time. Some
deviations from historical patterns are, even under existing states of knowledge, surely clear
enough to justify some action.
Moreover, in the absence of time-varying macroprudential tools, the burden of systemic risk
containment will rest entirely elsewhere. For time invariant measures to bear this burden, it
might be necessary to have through-the-cycle constraints that strengthen financial stability at
greater cost to economic activity. If a central bank is reluctant ever to use monetary policy in
pursuit of financial stability goals at the expense of more immediate employment and price
stability goals, the burden on time invariant measures would be large indeed. Even if
financial stability objectives are effectively incorporated into monetary policy, monetary
tightening will surely not be the correct response to most instances of increasing leverage or
asset prices that raise macroprudential concerns. Well-developed time-varying measures
might be effective in slowing the increase in systemic risk to give monetary policymakers
more time to evaluate the need for a monetary policy response.
There are two obvious places to begin a considered development of time-varying tools. One
is in the traditional supervisory oversight of practices at regulated institutions, as enhanced
by the increasingly horizontal, interdisciplinary features of large bank supervision. Good
supervisio