Daniel K Tarullo: Evaluating progress in regulatory reforms to promote
financial stability
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Peterson Institute for International Economics, Washington DC, 3 May 2013.
* * *
More than five years after the failure of Bear Stearns marked an escalation of the financial
crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues
over the appropriate set of policy responses to protect against financial instability. In recent
months, there has been, in particular, a renewal of interest in additional measures to address
the too-big-to-fail problem. In some respects, the persistence of debate is unsurprising. After
all, the severity of the crisis and ensuing recession, and the frustratingly slow pace of
economic recovery, have properly occasioned much thought about the structure of the
financial system and the fundamentals of financial regulation.
Continuing discussion of these issues is part of a protracted policy debate over financial
regulatory reform. Some argue that little has changed and that the needed reform is a single,
dramatic policy change (though that single policy differs considerably among those taking
this view). Others argue that reforms already enacted are sufficient to ensure financial
stability. Still others contend that there has already been too much of a regulatory response,
which is suppressing credit extension and faster economic recovery.
I think most of us would acknowledge, upon reflection, that a good bit has been done, or at
least put in motion, to counteract the problems of too-big-to-fail and systemic risk more
generally. At the same time, I believe that more is needed, particularly in addressing the risks
posed by short-term wholesale funding markets. This afternoon I would like both to highlight
the importance of what has already been accomplished and, at somewhat greater length, to
identify what I believe to be the key steps that remain. Before turning to these subjects,
though, I begin with a brief reprise of the origins of the financial crisis, to remind ourselves of
the vulnerabilities that led to the crisis and that remain of concern today. It should, but does
not always, go without saying that proposed solutions should actually help solve the
problems at hand, and do so in a manner that minimizes the costs to otherwise productive
activities.
Vulnerabilities exposed by the crisis
Beginning in the 1970s, the separation of traditional lending and capital markets activities
established by New Deal financial regulation began to break down under the weight of
macroeconomic turbulence, technological and business innovation, and competition. During
the succeeding three decades these activities became progressively more integrated, fueling
the expansion of what has become known as the shadow banking system, including the
explosive growth of securitization and derivative instruments in the first decade of this
century.
This trend entailed two major changes. First, it diminished the importance of deposits as a
source of funding for credit intermediation, in favor of capital market instruments sold to
institutional investors. Over time, these markets began to serve some of the same maturity
transformation functions as the traditional banking systems, which in turn led to both an
expansion and alteration of traditional money markets. Ultimately, there was a vast increase
in the creation of so-called cash equivalent instruments, which were supposedly safe,
shortterm, and liquid. Second, this trend altered the structure of the industry, both transforming the
activities of broker-dealers and fostering the emergence of large financial conglomerates.
There was, in fact, a symbiotic relationship between the growth of large financial
conglomerates and the shadow banking system. Large banks sponsored shadow banking
entities such as Structured Investment Vehicles (SIVs), money market funds, asset-backed
commercial paper conduits, and auction rate securities. These firms also dominated the
underwriting of assets purchased by entities within the shadow banking system.
Though motivated in part by regulatory arbitrage, these developments were driven by more
than regulatory evasion. The growth and deepening of capital markets lowered financing
costs for many companies and, through innovations such as securitization, helped expand
the availability of capital for mortgage lending. Similarly, the rise of institutional investors as
guardians of household savings made a wide array of investment and savings products
available to a much greater portion of the American public.
But these changes also helped accelerate the fracturing of the system established in the
1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new
regulatory mechanisms were put in place to control new risks. When, in 2007, questions
arose about the quality of some of the assets on which the shadow banking system was
based - notably, those tied to poorly underwritten subprime mortgages - a classic adverse
feedback loop ensued. Investors formerly willing to lend against almost any asset on a
shortterm, secured basis were suddenly unwilling to lend against a wide range of assets, notably
including the structured products that had become central to the shadow banking system.
Liquidity-strained institutions found themselves forced to sell positions, which placed
additional downward pressure on asset prices, thereby accelerating margin calls on
leveraged actors and amplifying mark-to-market losses for all holders of the assets. The
margin calls and booked losses would start another round in the adverse feedback loop.
Severe repercussions were felt throughout the financial system, as short-term wholesale
lending against all but the very safest collateral froze up, regardless of the identity of the
borrower. Moreover, as demonstrated by the intervention of the government when Bear
Stearns and AIG were failing, and by the aftermath of Lehman Brothers' failure, the universe
of financial firms that appeared too-big-to-fail during periods of stress extended beyond the
perimeter of traditional safety and soundness regulation.
In short, the financial industry in the years preceding the crisis had been transformed into
one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed
the new system's reliance on wholesale funding. The relationship between large firms and
shadow banking meant that strains on wholesale funding markets could both reflect and
magnify the too-big-to-fail problem. These were not the relatively slow-developing problems
of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving
episodes that risked turning liquidity problems into insolvency problems almost literally
overnight.
However, note that while the presence of too-big-to-fail institutions substantially exacerbates
the vulnerability created by the new system, they do not define its limits. Even in the absence
of any firm that may individually seem too big or too interconnected to be allowed to fail, the
financial system can be vulnerable to contagion. An external shock to important asset
classes can lead to substantial uncertainty as to underlying values, a consequent reluctance
by investors to provide short-term funding to firms holding those assets, a subsequent spate
of fire sales and mark-to-market losses, and the potential for an adverse feedback loop. An
effective set of financial reforms must address both these related problems of too-big-to-fail
and systemic vulnerability.
Regulatory response to date
As is obvious from the scope of the Dodd-Frank Wall Street Reform and Consumer
Protection Act and the amount of activity at the regulatory agencies, reform efforts to date
have been extensive. They have also been significant. Without trying to give a full review, let
me draw your attention to some of the more notable accomplishments, which can be
categorized in three groups.
First, the basic prudential framework for banking organizations is being considerably
strengthened, both internationally and domestically. Central to this effort are the Basel III
changes to capital standards, which create a new requirement for a minimum common equity
capital ratio. This new standard requires substantial increases in both the quality and quantity
of the loss-absorbing capital that allows a firm to remain a viable financial intermediary. Basel
III also established for the first time an international minimum leverage ratio which, unlike the
traditional U.S. leverage requirement, takes account of off-balance-sheet items.
Second, a series of reforms have been targeted at the larger financial firms that are more
likely to be of systemic importance. When fully implemented, these measures will have
formed a distinct regulatory and supervisory structure on top of generally applicable
prudential regulations and supervisory requirements. The governing principle for this new set
of rules is that larger institutions should be subject to more exacting regulatory and
supervisory requirements, which should become progressively stricter as the systemic
importance of a firm increases.
This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special
regulations applicable with increasing stringency to large banking organizations.1 Under this
authority, the Federal Reserve will impose capital surcharges on the eight large U.S. banking
organizations identified in the Basel Committee agreement for additional capital requirements
on banking organizations of global systemic importance. The size of a surcharge will vary
depending on the relative systemic importance of the bank. Other rules to be applied under
Section 165 - including counterparty credit risk limits, stress testing, and the quantitative
short-term liquidity requirements included in the internationally-negotiated Liquidity Coverage
Ratio (LCR) - will apply only to large institutions, in some cases with stricter standards for
firms of greatest systemic importance.
An important, related reform in Dodd-Frank was the creation of orderly liquidation authority,
under which the Federal Deposit Insurance Corporation can impose losses on a failed
systemic institution's shareholders and creditors and replace its management, while avoiding
runs and preserving the operations of the sound, functioning parts of the firm. This authority
gives the government a real alternative to the Hobson's choice of bailout or disorderly
bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under
development in other countries, and international consultations are underway to plan for
cooperative efforts to resolve multinational financial firms.
A third set of reforms has been aimed at strengthening financial markets generally, without
regard to the status of relevant market actors as regulated or systemically important. The
greatest focus, as mandated under Titles VII and VIII of Dodd-Frank, has been on making
derivatives markets safer through requiring central clearing for derivatives that can be
standardized and creating margin requirements for derivatives that continue to be written and
traded outside of central clearing facilities. The relevant U.S. agencies are working with their
international counterparts to produce an international arrangement that will harmonize these
requirements so as to promote both global financial stability and competitive parity. In
addition, eight financial market utilities engaged in important payment, clearing, and
settlement activities have been designated by the Financial Stability Oversight Council as
systemically important and, thus, will now be subject to enhanced supervision.
As you can tell from my description, many of these reforms are still being refined or are still in
the process of implementation. The rather deliberate pace - occasioned as it is by the rather
complicated domestic and international decisionmaking processes - may be obscuring the
significance of what will be far-reaching change in the regulation of financial firms and
markets. Indeed, even without full implementation of all the new regulations, the Federal
Reserve has already used its stress-test and capital-planning exercises to prompt a doubling
in the last four years of the common equity capital of the nation's 18 largest bank holding
companies, which hold more than 70 percent of the total assets of all U.S. bank holding
companies. The weighted tier 1 common equity ratio, which compares high-quality capital to
risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to
11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from
$393 billion to $792 billion during the same period.
Gaps in regulatory reform
Despite this considerable progress, we have not yet adequately addressed all the
vulnerabilities that developed in our financial system in the decades preceding the crisis.
Most importantly, relatively little has been done to change the structure of wholesale funding
markets so as to make them less susceptible to damaging runs. It is true that some of the
clearly risky forms of wholesale funding that existed before the crisis, such as the infamous
SIVs, have disappeared or substantially contracted. But significant continuing vulnerability
remains, particularly in those funding channels that can be grouped under the heading of
securities financing transactions (SFTs).2
Repo, reverse repo, securities lending and borrowing, and securities margin lending are part
of the healthy functioning of the securities market. But, in the absence of sensible regulation,
they are also potentially associated with the dynamic I described earlier of exogenous shocks
to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls,
and fire sales. Indeed, some have argued that this dynamic is exacerbated by a "maturity rat
race," in which each creditor acts to shorten the maturity of its lending so as to facilitate quick
and easy flight, and in which creditors pay relatively little attention to the recovery value of
the underlying assets.3
With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are
substantially higher than before the crisis, and requirements to extend and maintain higher
levels of capital are on the way. The regularization and refinement of rigorous stress testing
may be the single most important supervisory improvement to strengthen the resilience of
large institutions. The creation of orderly liquidation authority and the process of resolution
planning advance prospects for increasing market discipline. But questions remain as to
whether all this is enough to contain the problem. The enduring potential fragility of a
financial system substantially dependent on short-term wholesale funding is especially
relevant in considering the impact of severe stress or failure at the very large institutions with
very large amounts of such funding.
Concern about the adequacy of policy responses to date is supported by some recent
research that attempts to quantify the implicit funding subsidy enjoyed by certain institutions
by looking to such factors as credit ratings uplifts, differentials in interest rates paid on
deposits or in risk compensation for bank debt and equity, and premia paid for mergers that
would arguably place the merged firm in the too-big-to-fail category.4 The calculation of a
precise subsidy is difficult, and each such effort will likely occasion substantial disagreement.
But several measures provide at least directionally consistent results.
Key additional reform measures
In sketching out the kinds of steps needed to address these remaining vulnerabilities, let me
begin with wholesale funding generally, and then circle back to too-big-to-fail.
Short-term wholesale funding
At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other
measure that applies more or less comprehensively to all uses of short-term wholesale
funding, without regard to the form of the transactions or whether the borrower was a
prudentially regulated institution. The aspiration to comprehensiveness is important for two
reasons. First, the risks associated with short-term funding are as much or more
macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low
risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and
subject to remargining requirements. The dangers arise in the tail and apply to the entire
financial market when the normally safe, short-term lending contracts dramatically in the face
of sudden and significant uncertainty about asset values and the condition of counterparties.
A regulatory measure should force some internalization by market actors of the systemic
costs of this intermediation.
Second, to the degree that regulatory measures apply only to some types of wholesale
funding, or only to that used by prudentially regulated entities, there will be a growing risk of
regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a
commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge
fund.
Stating the goal is easy, but executing it is not, precisely because short-term wholesale
funding is used in a variety of forms by a variety of market actors. Determining appropriately
equivalent controls is a challenging task and, with respect to institutions not subject to
prudential regulation, there may be questions as to where - if at all - current regulatory
authority resides. And, of course, there is the overarching problem of calibrating the
regulation so as to mitigate the systemic risks associated with these funding markets, while
not suppressing the mechanisms that have become important parts of the modern financial
system in providing liquidity and lowering borrowing costs for both financial and non-financial
firms. For all these reasons, it may well be that the abstract desirability of a single,
comprehensive regulatory measure may not be achievable in the near term.
Still, at least as a starting point, we would do well to consider measures that apply broadly.
One option is to change minimum requirements for capital, liquidity, or both at all regulated
firms so as to realize a macroprudential, as well as microprudential, purpose. In their current
form, existing and planned liquidity requirements produced by the Basel Committee aim
mostly to encourage maturity-matched books. While maturity mismatch by core
intermediaries is a key financial stability risk in wholesale funding markets, it is not the only
one. Even if an intermediary's book of securities financing transactions is perfectly matched,
a reduction in its access to funding can force the firm to engage in asset fire sales or to
abruptly withdraw credit from customers. The intermediary's customers are likely to be highly
leveraged and maturity transforming financial firms as well, and, therefore, may then have to
engage in fire sales themselves. The direct and indirect contagion risks are high. Thus, the
long-term and short-term liquidity ratios might be refashioned so as to address directly the
risks of large SFT books.
Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the
financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital
charge applied to SFTs might be a useful piece of a complementary set of macroprudential
measures, though an indirect measure like a capital charge might have to be quite large to
create adequate incentive to temper the use of short-term wholesale funding.
By definition, both liquidity and capital requirements would be limited to banking entities
already within the perimeter of prudential regulation. The obvious questions are whether
these firms at present occupy enough of the wholesale funding markets that standards
applicable only to them would be reasonably effective in addressing systemic risk and, even
if that question is answered affirmatively, whether the imposition of such standards would
soon lead to significant arbitrage through increased participation by those outside the
regulatory circle.
In part for these reasons, a second possibility that has received considerable attention is a
universal minimum margining requirement applicable directly to SFTs. The Financial Stability
Board has already issued a consultative paper, and received public comment, on the idea.
Under such a regime, all repo lenders, for example, could be required to take a minimum
amount of over-collateralization as determined by regulators (the amount varying with the
nature of the securities collateral), regardless of whether the repo lender or repo borrower
were otherwise prudentially regulated. This kind of requirement could be an effective tool to
limit procyclicality in securities financing and, thereby, to contain the risks of runs and
contagion. Of course, it also raises many of the issues that make settling on a single policy
instrument so hard to achieve,5 and the decision on calibration would be particularly
consequential. Still, the concept has much to be said for it and seems the most promising
avenue toward satisfying the principle of comprehensiveness. It is definitely worth pursuing.
As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in
shortterm wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the
present, we can continue to work on discrete aspects of these markets, such as through the
diminution of reliance on intraday credit in triparty repo markets that is being achieved by
Federal Reserve supervision of clearing banks and through the money market fund reforms
that I expect will be pursued by the Securities and Exchange Commission. We might also
think about less comprehensive measures affecting SFTs, such as limits on rehypothecation,
when an institution uses assets that have been posted as collateral by its clients for its own
purposes.6 But I do not think that the post-crisis program of regulatory reform can be judged
complete until a more comprehensive set of measures to address this problem is in place.
Too-big-to-fail
Before discussing policies specifically directed at too-big-to-fail, let me say a word about the
capital regime that should be applicable to all banks, on top of which any additional
requirements for systemically important institutions would be built. The first order of business
is to complete the Basel III rulemaking as soon as possible. The required increases in the
quality and quantity of minimum capital, and the introduction of an international leverage
ratio, represent important steps forward for banking regulation around the world. U.S. banks
have increased their capital substantially since the financial crisis began, and the vast
majority already have Tier 1 common risk-based ratios greater than the Basel III 7 percent
requirements.
The new requirements, while big improvements, are not as high as I would have liked, and
the agreement contains some provisions I would have omitted or simplified. In coming years
we may well seek changes. Indeed, I continue to be a strong advocate of establishing
simpler, standardized risk-based capital requirements and am encouraged at the initial work
being done on the topic of simplification in the Basel Committee. And we will certainly
simplify the final capital rules here in the United States so as to respond to the concerns
expressed by smaller banks. But opposing, or seeking delay in, Basel III would simply give
an excuse to banks that do not meet Basel III standards to seek delay from their own
governments. It would be ironic indeed if those who favor higher or simpler capital
requirements were unintentionally to lend assistance to banks that want to avoid
strengthening their capital positions.
Turning to specific policies to address too-big-to-fail, the first task is to implement fully the
capital surcharge for systemically important institutions, the LCR, resolution plans, and other
relevant proposed regulations. But, completion of this agenda, significant as it is, would leave
more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have
said before, proposals to impose across-the-board size caps or structural limitations on
banks - whatever their merits and demerits - embody basic policy decisions that are
properly the province of Congress.7
However, that does not mean there is no role for regulators. On the contrary, Section 165 of
the Dodd-Frank Act gives the Federal Reserve the authority, and the obligation, to apply
regulations of increasing stringency to large banking organizations in order to mitigate risks
to financial stability. In any event, it is unlikely that the problems associated with
too-big-tofail institutions can be efficiently ameliorated using a single regulatory tool. The explicit
expectation in Section 165 that there will be a variety of enhanced standards seems
welladvised. We should be considering ways to use this authority in pursuit of three
complementary ends: (1) ensuring the loss absorbency needed for a credible and effective
resolution process, (2) augmenting the going-concern capital of the largest firms, and
(3) addressing the systemic risks associated with the use of wholesale funding.
There is clear need for a requirement that large financial institutions have minimum amounts
of long-term unsecured debt that could be converted to equity and thereby be available to
absorb losses in the event of insolvency. Although the details will, as always, be important,
there appears to be an emerging consensus among regulators, both here and abroad, in
support of the general idea. Debt subject to this kind of bail-in would supplement the
increased regulatory capital in order to provide greater assurance that, should the firm
become insolvent, all losses could be borne using resources within the firm. This requirement
for additional "gone concern" capital would increase the prospects for orderly resolution and,
thereby, counteract the moral hazard associated with expectations of taxpayer bailouts.
Switzerland has already adopted a requirement of this sort, and similar proposals are being
actively debated in the European Union. A U.S. requirement, enacted under the Federal
Reserve's Section 165 authority, would both strengthen our domestic resolution mechanisms
and be consistent with emerging international practice.
With respect to "going concern" capital requirements, there is a good case for additional
measures to increase the chances that large financial institutions remain viable financial
intermediaries even under stress. To me, at least, the important question is not whether
capital requirements for large banking firms need to be stronger than those included in
Basel III and the agreement on capital surcharges, but how to make them so and with what
specific risks in mind. In this regard, I would observe that our stress tests and
capitalplanning requirements have already strengthened capital standards by making them more
forward-looking and more responsive to economic developments. As we gain experience,
and as the annual process becomes smoother for both the banks and the Federal Reserve,
we have the opportunity to enhance the stress tests by, for example, varying the scenario for
stressing the trading books of the largest firms, so as to reflect changes in the composition of
those books.
As to regulatory measures of capital outside the customized context of stress testing, one
approach is to revisit the calibration of two existing capital measures applicable to the largest
firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a
complementary relationship between the greater sensitivity of risk-based capital
requirements and the check provided by the leverage ratio on too much leverage arising from
low-risk-weighted assets. This relationship has obviously been changed by the substantial
increase in the risk-based ratio resulting from the new minimum and conservation buffer
requirements of Basel III. The existing U.S. leverage ratio does not take account of
off-balance-sheet assets, which are significant for many of the largest firms. The new Basel
III leverage ratio does include off-balance-sheet assets, but it may have been set too low.
Thus, the traditional complementarity of the capital ratios might be maintained by using
Section 165 to set a higher leverage ratio for the largest firms.
The other capital measure that might be revisited is the risk-based capital surcharge
mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower
end of the range needed to achieve the aim of reducing the probability of these firms' failures
enough to offset fully the greater impact their failure would have on the financial system. At
the time these surcharges were being negotiated, I favored a somewhat greater requirement
for the largest, most interconnected firms.8 Here, after all, is where the potential for negative
externalities is the greatest, while the marginal benefits accruing from scale and scope
economies are hardest to discern. While it is clearly preferable at this point to implement
what we have agreed, rather than to seek changes that could delay any additional capital
requirement, it may be desirable for the Basel Committee to return to this calibration issue
sooner rather than later.
The area in which the most work is needed is in addressing the risks arising from the use of
short-term wholesale funding by systemically important firms. The systemic risks associated
with runs on wholesale funding would, almost by definition, be exacerbated if a very large
user of that funding were to come under serious stress. There could also be greater negative
externalities from a disruption of large, matched SFT positions on the books of a major
financial firm than if the same total activity were spread among a greater number of dealers.
Thus, in keeping with the principle of differential and increasingly stringent regulation for
large firms, there is a strong case to be made for taking steps beyond any generally
applicable measures that are eventually applied to SFTs or short-term wholesale funding
more generally.
One possibility would be to have progressively greater minimum liquidity requirements for
larger institutions under the LCR and the still-under-construction Net Stable Funding Ratio
(NSFR).9 There is certainly some appeal to following this route, since it would build on all the
work done in fashioning these liquidity requirements. The only significant additional task
would be calibrating the progressivity structure. However, there are at least two
disadvantages to this approach. First, the LCR and, at least at this stage of its development,
the NSFR, both rest on the implicit presumption that a firm with a perfectly matched book is
in a fundamentally stable position. As a microprudential matter, this is probably a reasonable
assumption. But under some conditions, the disorderly unwind of a single, large SFT book,
even one that was quite well maturity matched, could set off the kind of unfavorable dynamic
described earlier. Second, creating liquidity levels substantially higher than those
contemplated in the LCR and eventual NSFR may not be the most efficient way for some
firms to become better insulated from the run risk that can lead to the adverse feedback loop
and contagion possibilities discussed earlier.
A more interesting approach would be to tie liquidity and capital standards together by
requiring higher levels of capital for large firms unless their liquidity position is substantially
stronger than minimum requirements. This approach would reflect the fact that the market
perception of a given firm's position as counterparty depends upon the combination of its
funding position and capital levels. It would also supplement the Basel capital surcharge
system, which does not include use of short-term wholesale funding among the factors used
to calculate the systemic "footprint" of each firm, and thus determine its relative surcharge.
While there is decidedly a need for solid minimum requirements for both capital and liquidity,
the relationship between the two also matters. Where a firm has little need of short-term
funding to maintain its ongoing business, it is less susceptible to runs. Where, on the other
hand, a firm is signif