Daniel K Tarullo: Dodd-Frank implementation
Testimony by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 9 September 2014.
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Chairman Johnson, Ranking Member Crapo, and other members of the committee, thank
you for the opportunity to testify on the Federal Reserve's activities in mitigating systemic risk
and implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act
(DoddFrank Act). In testifying before this committee in February, I noted my hope and expectation
that this year would be the beginning of the end of our implementation of the major
provisions of the Dodd-Frank Act. Seven months later, we are on track to fulfill that
expectation. The Federal Reserve and other banking supervisors have continued to make
progress in implementing the congressional mandates in the Dodd-Frank Act, promoting a
stable financial system, and strengthening the resilience of banking organizations. In today's
testimony, I will provide an update on the Federal Reserve's implementation of the
DoddFrank Act and describe key upcoming regulatory and supervisory priorities to address the
problems of "too big to fail" and systemic risk. The Federal Reserve is committed to
continuing to work with our fellow banking agencies and with the market regulators to help
ensure that the organizations we supervise operate in a safe and sound manner and are able
to support activity in other sectors of the economy.
As we complete our revisions to the financial regulatory architecture, we are cognizant that
regulatory compliance can impose a disproportionate burden on smaller financial institutions.
In addition to overseeing large banking firms, the Federal Reserve supervises approximately
800 state-chartered community banks that are members of the Federal Reserve System, as
well as several thousand small bank holding companies. In my testimony, I also will describe
how the Federal Reserve is seeking to ensure that its regulations and supervisory framework
are not unnecessarily burdensome for community banking organizations so they can
continue their important function of safe and sound lending to local communities.
Recent Dodd-Frank Act implementation milestones
Since the passage of the Dodd-Frank Act more than four years ago, the Federal Reserve
and the other agencies represented at this hearing have completed wide-ranging financial
regulatory reforms that have remade the regulatory landscape for financial firms and
markets. Internationally, at the Basel Committee on Banking Supervision (BCBS), we have
helped develop new standards for global banks on risk-based capital, leverage, liquidity,
single-counterparty credit limits, and margin requirements for over-the-counter derivatives.
We have also worked with the Financial Stability Board (FSB) to reach global agreements on
resolution regimes for systemic financial firms and on a set of shadow banking regulatory
reforms.
Domestically, we have completed many important measures. We approved final rules
implementing the Basel III capital framework, which help ensure that U.S. banking
organizations maintain strong capital positions and are able to continue lending to
creditworthy households and businesses even during economic downturns. We implemented
the Dodd-Frank Act's stress testing requirements, which are complemented by the Federal
Reserve's annual Comprehensive Capital Analysis and Review. Together, these supervisory
exercises provide a forward-looking assessment of the capital adequacy of the largest U.S.
banking firms. Pursuant to section 165 of the Dodd-Frank Act, we established a set of
enhanced standards for large U.S. banking organizations to help increase the resiliency of
their operations and thus promote financial stability. In addition, the Federal Reserve
implemented a rule requiring foreign banking organizations with a significant U.S. presence
to establish U.S. intermediate holding companies over their U.S. subsidiaries and subjecting
such companies to substantially the same prudential standards applicable to U.S. bank
holding companies. We finalized the Volcker rule to implement section 619 of the
DoddFrank Act and prohibit banking organizations from engaging in short-term proprietary trading
of certain securities and derivatives. These and other measures have already created a
financial regulatory architecture that is much stronger and much more focused on financial
stability than the framework in existence at the advent of the financial crisis.
More recently, the Federal Reserve, often in tandem with some or all of the other agencies
represented at this hearing, has made progress on a number of other important regulatory
reforms. I will discuss those steps in more detail.
Liquidity rules for large banking firms
Last week, the Federal Reserve and the other U.S. banking agencies approved a final rule,
consistent with the enhanced prudential standards requirements in section 165 of the
DoddFrank Act, which implements the first broadly applicable quantitative liquidity requirement for
U.S. banking firms. Liquidity standards for large U.S. banking firms are a key contributor to
financial stability, as they work in concert with capital standards, stress testing, and other
enhanced prudential standards to help ensure that large banking firms manage liquidity in a
manner that mitigates the risk of creditor and counterparty runs.
The rule's liquidity coverage ratio, or LCR, requires covered banking firms to hold minimum
amounts of high-quality liquid assets - such as central bank reserves and high-quality
government and corporate debt - that can be converted quickly and easily into cash
sufficient to meet expected net cash outflows over a short-term stress period. The LCR
applies to bank holding companies and savings and loan holding companies with $250 billion
or more in total consolidated assets or $10 billion or more in on-balance-sheet foreign
exposures. The rule also applies a less stringent, modified LCR to bank holding companies
and savings and loan holding companies that are below these thresholds but with more than
$50 billion in total assets. The rule does not apply to bank holding companies or savings and
loan holding companies with less than $50 billion in total assets, nor to nonbank financial
companies designated by the Financial Stability Oversight Council (FSOC). The Federal
Reserve will apply enhanced liquidity standards to designated nonbank financial companies
through a subsequently issued order or rule following an evaluation of each of their business
models, capital structures, and risk profiles.
The rule's LCR is based on a liquidity standard agreed to by the BCBS but is more stringent
than the BCBS standard in several areas, including the range of assets that qualify as
highquality liquid assets and the assumed rate of outflows for certain kinds of funding. In addition,
the rule's transition period is shorter than that in the BCBS standard. The accelerated
phasein of the U.S. LCR reflects our objective that large U.S. banking firms maintain the improved
liquidity positions they have already built following the financial crisis, in part because of our
supervisory oversight. We believe the LCR will help ensure that these improved liquidity
positions will not weaken as memories of the financial crisis fade.
The final rule is largely identical to the proposed rule, with a few key adjustments made in
response to comments from the public. Those adjustments include changing the scope of
corporate debt securities and publicly traded equities qualifying as high-quality liquid assets,
phasing in reporting requirements, and modifying the stress period and reporting frequency
for firms subject to the modified LCR.
Swap margin reproposal
Sections 731 and 764 of the Dodd-Frank Act require the establishment of initial and variation
margin requirements for swap dealers and major swap participants (swap entities) on swaps
that are not centrally cleared. These requirements are intended to ensure that the
counterparty risks inherent in swaps are prudently limited and not allowed to build to
unsustainable levels that could pose risks to the financial system. In addition, requiring all
uncleared swaps to be subject to robust margin requirements will remove economic
incentives for market participants to shift activity away from contracts that are centrally
cleared.
The Federal Reserve and four other U.S. agencies originally issued a proposed rule to
implement these provisions of the Dodd-Frank Act in April 2011. Following the release of the
original proposal, the BCBS and the International Organization of Securities Commissions
began working to establish a consistent global framework for imposing margin requirements
on uncleared swaps. This global framework was finalized last September. After considering
the comments that were received on the April 2011 U.S. proposal and the recently
established global standards, the agencies issued a reproposal last week. Under the
reproposal, swap entities would be required to collect and post initial and variation margin on
uncleared swaps with another swap entity and other financial end user counterparties. The
requirements are intended to result in higher initial margin requirements than would be
required for cleared swaps, which is meant to reflect the more complex and less liquid nature
of uncleared swaps.
In accordance with the statutory requirement to establish margin requirements regardless of
counterparty type, the reproposal would require swap entities to collect and post margin in
connection with any uncleared swaps they have with nonfinancial end users. These
requirements, however, are quantitatively and qualitatively different from the margin
requirements for swaps with financial end users. Specifically, swaps with nonfinancial end
users would not be subject to specific, numerical margin requirements but would only be
subject to initial and variation margin requirements at such times, in such forms, and in such
amounts, if any, that the swap entity determines is necessary to address the credit risk posed
by the counterparty and the transaction. There are currently cases where a swap entity does
not collect initial or variation margin from nonfinancial end users because it has determined
that margin is not needed to address the credit risk posed by the counterparty or the
transaction. In such cases, the reproposal would not require a change in current practice.
The agencies believe that these requirements are consistent with the Dodd-Frank Act and
appropriately reflect the low level of risk presented by most nonfinancial end users.
The agencies in the reproposal have taken several steps to help mitigate any impact to the
liquidity of the financial system that could result from the swap margin requirements. These
steps include incorporating an initial margin requirement threshold below which exchanges of
initial margin are not required, allowing for a wider range of assets to serve as eligible
collateral, and providing smaller swap entities with an extended timeline to come into
compliance. We look forward to receiving comments on the reproposal.
Modifications to the supplementary leverage ratio and adoption of the enhanced
supplementary leverage ratio
Also last week, the Federal Reserve and the other U.S. banking agencies approved a final
rule that modifies the denominator calculation of the supplementary leverage ratio in a
manner consistent with the changes agreed to earlier this year by the BCBS. The revised
supplementary leverage ratio will apply to all banking organizations subject to the advanced
approaches risk-based capital rule starting in 2018. These modifications to the
supplementary leverage ratio will result in a more appropriately measured set of leverage
capital requirements and, in the aggregate, are expected to modestly increase the stringency
of these requirements across the covered banking organizations.
This rule complements the agencies' adoption in April of a rule that strengthens the
internationally agreed-upon Basel III leverage ratio as applied to U.S.-based global
systemically important banks (GSIBs). This enhanced supplementary leverage ratio, which
will be effective in January 2018, requires U.S. GSIBs to maintain a tier 1 capital buffer of at
least 2 percent above the minimum Basel III supplementary leverage ratio of 3 percent, for a
total of 5 percent, to avoid restrictions on capital distributions and discretionary bonus
payments. In light of the significantly higher risk-based capital rules for GSIBs under
Basel III, imposing a stricter leverage requirement on these firms is appropriate to help
ensure that the leverage ratio remains a relevant backstop for these firms.
Key regulatory priorities
As we near the completion of the implementation of the major provisions of the Dodd-Frank
Act, some key regulatory reforms remain unfinished. To that end, the Federal Reserve
contemplates near- to medium-term measures to enhance the resiliency and resolvability of
U.S. GSIBs and address the risks posed to financial stability from reliance by financial firms
on short-term wholesale funding.
The financial crisis made clear that policymakers must devote significant attention to the
potential threat to financial stability posed by our most systemic financial firms. Accordingly,
the Federal Reserve has been working to develop regulations that are designed to reduce
the probability of failure of a GSIB to levels that are meaningfully below those for less
systemically important firms and to materially reduce the potential adverse impact on the
broader financial system and economy in the event of a failure of a GSIB.
GSIB risk-based capital surcharges
An important remaining Federal Reserve initiative to improve GSIB resiliency is our
forthcoming proposal to impose graduated common equity risk-based capital surcharges on
U.S. GSIBs. The proposal will be consistent with the standard in section 165 of the
DoddFrank Act that capital requirements be progressively more stringent as the systemic
importance of a firm increases. It will build on the GSIB capital surcharge framework
developed by the BCBS, under which the size of the surcharge for an individual GSIB is a
function of the firm's systemic importance. By further increasing the amount of the most
lossabsorbing form of capital that is required to be held by firms that potentially pose the greatest
risk to financial stability, we intend to improve the resiliency of these firms. This measure
might also create incentives for them to reduce their systemic footprint and risk profile.
While our proposal will use the GSIB risk-based capital surcharge framework developed by
the BCBS as a starting point, it will strengthen the BCBS framework in two important
respects. First, the surcharge levels for U.S. GSIBs will be higher than the levels required by
the BCBS, noticeably so for some firms. Second, the surcharge formula will directly take into
account each U.S. GSIB's reliance on short-term wholesale funding. We believe the case for
including short-term wholesale funding in the surcharge calculation is compelling, given that
reliance on this type of funding can leave firms vulnerable to runs that threaten the firm's
solvency and impose externalities on the broader financial system.
Resolvability of GSIBs
Our enhanced regulation of GSIBs also includes efforts to improve their resolvability. Most
recently, in August, the Federal Reserve and the Federal Deposit Insurance Corporation
(FDIC) completed reviews of the second round of resolution plans submitted to the agencies
in October 2013 by 11 U.S. bank holding companies and foreign banks. Section 165(d) of the
Dodd-Frank Act requires banking organizations with total consolidated assets of $50 billion
or more and nonbank financial companies designated by the FSOC to submit resolution
plans to the Federal Reserve and the FDIC. Each plan must describe the organization's
strategy for rapid and orderly resolution in the event of material financial distress or failure. In
completing the second round reviews of these banking organizations' resolution plans, the
FDIC and the Federal Reserve noted certain shortcomings in the resolution plans that the
firms must address to improve their resolvability in bankruptcy. Both agencies also indicated
the expectation that the firms make significant progress in addressing these issues in their
2015 resolution plans.
In addition, the Federal Reserve has been working with the FDIC to develop a proposal that
would require the U.S. GSIBs to maintain a minimum amount of long-term unsecured debt at
the parent holding company level. While minimum capital requirements are designed to
cover losses up to a certain statistical probability, in the even less likely event that the equity
of a financial firm is wiped out, successful resolution without taxpayer assistance would be
most effectively accomplished if a firm has sufficient long-term unsecured debt to absorb
additional losses and to recapitalize the business transferred to a bridge operating company.
The presence of a substantial tranche of long-term unsecured debt that is subject to bail-in
during a resolution and is structurally subordinated to the firm's other creditors should reduce
run risk by clarifying the position of those other creditors in an orderly liquidation process. A
requirement for long-term debt also should have the benefit of improving market discipline,
since the holders of that debt would know they faced the prospect of loss should the firm
enter resolution.
The Federal Reserve is working with global regulators, under the auspices of the FSB, to
develop a proposal that would require the largest, most complex global banking firms to
maintain a minimum amount of loss absorbency capacity beyond the levels mandated in the
Basel III capital requirements.
Another element of our efforts to promote resolvability of large banking organizations
involves the early termination rights of derivative counterparties to GSIBs. Some of the
material operating subsidiaries of GSIBs are counterparties to large volumes of
over-thecounter derivatives and other qualifying financial contracts that provide for an event of default
based solely on the insolvency or receivership of the parent holding company. Although the
Dodd-Frank Act created an orderly liquidation authority (OLA) to better enable the
government to resolve a failed systemically important financial firm - and the OLA's stay and
transfer provisions can prevent exercise of such contractual rights by counterparties to
contracts under U.S. law - the OLA provisions may not apply to contracts under foreign law.
Accordingly, counterparties of the foreign subsidiaries and branches of GSIBs may have
contractual rights and substantial economic incentives to accelerate or terminate those
contracts as soon as the U.S. parent GSIB enters OLA. This could render a resolution
unworkable by resulting in the disorderly unwind of an otherwise viable foreign subsidiary
and the disruption of critical intra-affiliate activities that rely on the failing subsidiary. The
challenge would be compounded in a bankruptcy resolution because derivatives and other
qualifying financial contracts are exempt from the automatic stay under bankruptcy law,
regardless of whether the contracts are governed by U.S. or foreign law.
The international regulatory community is working to mitigate this risk as well. The Federal
Reserve is working with the FDIC and global regulators, financial firms, and other financial
market actors to develop a protocol to the International Swaps and Derivatives Association
(ISDA) Master Agreement to address the impediments to resolvability generated by these
early termination rights. The FSB will be reporting progress on this effort in the fall.
Short-term wholesale funding
As I have noted in prior testimony before this committee, short-term wholesale funding plays
a critical role in the financial system. During normal times, it helps to satisfy investor demand
for safe and liquid investments, lowers funding costs for borrowers, and supports the
functioning of important markets, including those in which monetary policy is executed.
During periods of stress, however, runs by providers of short-term wholesale funding and
associated asset liquidations can result in large fire sale externalities and otherwise
undermine financial stability. A dynamic of this type engulfed the financial system in 2008.
Since the crisis, the Federal Reserve has taken several steps to address short-term
wholesale funding risks. The Basel III capital framework and the Federal Reserve's stress
testing regime have significantly increased the quantity and quality of required capital in the
banking system, particularly for those banking organizations that are the most active
participants in short-term wholesale funding markets. Similarly, the implementation of liquidity
regulations such as the LCR, together with related efforts by bank supervisors, will help to
limit the amount of liquidity risk in the banking system.
We have also taken steps to reduce risks posed by the use of short-term wholesale funding
by actors outside the banking system. These include leading an effort to reduce reliance by
borrowers in the tri-party repo market on intraday credit from clearing banks and increasing
the regulatory charges on key forms of credit and liquidity support that banks provide to
shadow banks. In part because of these actions and in part because of market adjustments,
there is less risk embedded in short-term wholesale funding markets today than in the period
immediately preceding the financial crisis. The short-term wholesale funding markets are
generally smaller, the average maturity of short-term funding arrangements is moderately
greater, and collateral haircuts are more conservative. In addition, the banking organizations
that are the major intermediaries in short-term wholesale funding markets are much more
resilient based on the measures I discussed earlier.
Nevertheless, we believe that more needs to be done to guard against short-term wholesale
funding risks. While the total amount of short-term wholesale funding is lower today than
immediately before the crisis, volumes are still large relative to the size of the financial
system. Furthermore, some of the factors that account for the reduction in short-term
wholesale funding volumes, such as the unusually flat yield curve environment and lingering
risk aversion from the crisis, are likely to prove transitory.
Federal Reserve staff is currently working on three sets of initiatives to address residual
short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate
the use of short-term wholesale funding into the risk-based capital surcharge applicable to
U.S. GSIBs. The second involves proposed modifications to the BCBS's net stable funding
ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a
provider of short-term funding to other market participants. The third is numerical floors for
collateral haircuts in securities financing transactions (SFTs) - including repos and reverse
repos, securities lending and borrowing, and securities margin lending.
Modifications to the NSFR could be designed to help address the types of concerns
described in my previous testimony regarding SFT matched book activity. In the classic fact
pattern, a matched book dealer uses SFTs to borrow on a short-term basis from a cash
investor, such as a money market mutual fund, to finance a short-term SFT loan to a client,
such as a leveraged investment fund. The regulatory requirements on SFT matched books
are generally low despite the fact that matched books can pose significant microprudential
and macroprudential risks. Neither the BCBS LCR nor the NSFR originally finalized by the
Basel Committee would have imposed a material charge on matched book activity.
In January, the BCBS proposed a revised NSFR that would require banks to hold a material
amount of stable funding against short-term SFT loans, as well as other short-term credit
extensions, to nonbank financial entities. By requiring banks that make short-term loans to
hold stable funding, such a charge would help limit the liquidity risk that a dealer would face if
it experiences a run on its SFT liabilities but is unable to liquidate corresponding SFT assets.
In addition, by making it more expensive for the dealer to provide short-term credit, the
charge could help lean against excessive short-term borrowing by the dealer's clients.
Turning to numerical floors for SFT haircuts, the appeal of this policy measure is that it would
help address the risk that post-crisis reforms targeted at banking organizations will drive
systemically risky activity toward places in the financial system where prudential standards
do not apply. In its universal form, a system of numerical haircut floors for SFTs would
require any entity that wants to borrow against a security to post a minimum amount of
excess margin to its lender that would vary depending on the asset class of the collateral.
Like minimum margin requirements for derivatives, numerical floors for SFT haircuts would
serve as a mechanism for limiting the build-up of leverage at the transaction level and could
mitigate the risk of procyclical margin calls.
Last August, the FSB issued a consultative document that represented an initial step toward
the development of a framework of numerical floors. However, the FSB's proposal contained
some significant limitations, including that its scope was limited to transactions in which a
bank or broker-dealer extends credit to an unregulated entity and that the calibration of the
numerical floor levels was relatively low. Since then, the FSB has been actively considering
whether to strengthen the proposal along both of these dimensions.
Financial sector concentration limits
In May, the Federal Reserve proposed a rule to implement section 622 of the Dodd-Frank
Act, which prohibits a financial company from combining with another company if the
resulting financial company's liabilities exceed 10 percent of the aggregate consolidated
liabilities of all financial companies. Under the proposal, financial companies subject to the
concentration limit would include insured depository institutions, bank holding companies,
savings and loan holding companies, foreign banking organizations, companies that control
insured depository institutions, and nonbank financial companies designated by the FSOC
for Federal Reserve supervision. Consistent with section 622, the proposal generally defines
liabilities of a financial company as the difference between its risk-weighted assets, as
adjusted to reflect exposures deducted from regulatory capital, and its total regulatory capital.
Firms not subject to consolidated risk-based capital rules would measure liabilities using
generally accepted accounting standards. We anticipate finalizing this rule in the near term.
Credit risk retention
Section 941 of the Dodd-Frank Act requires firms generally to retain credit risk in
securitization transactions they sponsor. Retaining credit risk creates incentives for
securitizers to monitor closely the quality of the assets underlying a securitization transaction
and discourages unsafe and unsound underwriting practices by originators. In August 2013,
the Federal Reserve, along with several other agencies, revised a proposal from 2011 to
implement section 941. The Federal Reserve is working with the other agencies charged by
the Dodd-Frank Act with implementing this rule to complete it in the coming months.
Rationalizing the regulatory framework for community banks
Before closing, I would like to discuss the Federal Reserve's ongoing efforts to minimize
regulatory burden consistent with the effective implementation of our statutory responsibilities
for community banks, given the important role they play within our communities. Over the
past few decades, community banks have substantially reduced their presence in lines of
businesses such as consumer lending in the face of competition from larger banks benefiting
from economies of scale. Today, as a group, their most important forms of lending are to
small- and medium-sized businesses. Smaller community banks - those with less than
$1 billion in assets - account for nearly one-fourth of commercial and industrial lending, and
nearly 40 percent of commercial real estate lending, to small- and medium-sized businesses,
despite their having less than 10 percent of total commercial banking assets. These figures
reveal the importance of community banks to local economies and the damage that could
result if these banks were unable to continue operating within their communities.
Banking regulators have taken many steps to try to avoid unnecessary regulatory costs for
community banks, such as fashioning more basic supervisory expectations for smaller, less
complex banks and identifying which provisions of new regulations are relevant to smaller
banks. In this regard, the Federal Reserve has worked to communicate clearly the extent to
which new rules and policies apply to smaller banks and to tailor them as appropriate. We
also work closely with our colleagues at the federal and state banking regulatory agencies to
ensure that supervisory approaches and methodologies are consistently applied to
community banks.
But several new statutory provisions apply explicitly to some smaller banks or, by failing to
exclude any bank from coverage, apply to all banks. The Federal Reserve is supportive of
considering areas where the exclusion of community banks from statutory provisions that are
less relevant to community bank practice may be appropriate. For example, we believe it
would be worthwhile to consider whether community banks should be excluded from the
scope of the Volcker rule and from the incentive compensation requirements of section 956
of the Dodd-Frank Act. The concerns addressed by statutory provisions like these are
substantially greater at larger institutions and, even where a practice at a smaller bank might
raise concerns, the supervisory process remains available to address what would likely be
unusual circumstances.
Another area in which the Federal Reserve has made efforts to right-size our supervisory
approach with regard to community banks is to improve our off-site monitoring processes so
that we can better target higher risk institutions and activities. Research conducted for a
2013 conference sponsored by the Federal Reserve System and the Conference of State
Bank Supervisors addressed the resilience of the community bank model and showed how
some banks performed better than others during the recent crisis. Building on this research,
we are updating our off-site monitoring screens to reflect experience gained during the crisis
and recalibrating our examination scoping process for community banks to focus our testing
on higher-risk banks and activities, and whenever possible reduce procedures for banks of
lower risk.
Recognizing the burden that the on-site presence of many examiners can place on the
dayto-day business of a community bank, we are also working to increase our level of off-site
supervisory activities. Responding to on-site examinations and inspections is of course a
cost for community banks, but this cost must be weighed against the supervisory benefit of
face-to-face interactions with bank examiners to explore and resolve institution-specific
concerns. The Federal Reserve aims to strike the appropriate balance of off-site and on-site
supervisory activities to ensure that the quality of community bank supervision is maintained
without creating an overly burdensome process. To that end, last year we completed a pilot
on conducting parts of the labor-intensive loan review off-site using electronic records from
banks. Based on good results with the pilot, we are planning to continue using this approach
in future reviews at banks where bank management is supportive of the process and where
electronic records are available. We are also exploring whether other examination
procedures can be conducted off-site without compromising the ability of examiners to
accurately assess the safety and soundness of supervised banks.
Conclusion
The Federal Reserve has made significant progress in implementing the Dodd-Frank Act and
other measures designed to improve the resiliency of banking organizations and reduce
systemic risk. We are committed to working with the other