Daniel K Tarullo: Financial regulation in the wake of the crisis
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, at the Peterson Institute for International Economics, Washington DC,
8 June 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
As has been widely observed in recent weeks, there are signs that the rapid decline in
economic activity of the past few quarters is slowing. The latest data give some reason to
hope that we are approaching a bottom in economic activity and that growth will resume later
this year. Yet stabilization or improvement would begin from very low levels compared with
those that prevailed in recent years. Recovery may be painfully slow, and the economy will
remain unusually vulnerable to new shocks. The news remains bad in two areas of direct
importance to American families: Unemployment continues to rise and housing prices
continue to decline.
One important reason why many observers predict only a gentle slope on the upward side of
the recession curve is that, despite some progress, financial markets continue to exhibit
signs of strain. Government-provided liquidity and guarantees remain as necessary supports
in many areas. Because the collapse of these same markets set off the present crisis and the
serious recession that has followed, the case for far-reaching reform appears a strong one.
Indeed, the leverage and interconnectedness of firms in the financial services sector, and the
critical role that financial intermediaries play in modern economies, mean that a malfunction
in the financial industry can immediately and profoundly harm the entire economy. For this
reason, governments in the United States and in other countries have provided extensive
support for certain financial firms and markets in periods of high distress. As we have seen to
our dismay in the last year, even where such support is forthcoming, the resulting damage
inflicted on the real economy by the financial sector can still be extensive, and the potential
costs to taxpayers can still be high.
If we have learned anything from the present crisis, it is that systemic risk was very much
built into our financial system. One element of systemic risk, the too-big-to-fail phenomenon,
was as significant as had been argued by the likes of Gary Stern, my colleague on the
Federal Open Market Committee, who warned in 2004 that the too-big-to-fail problem was
"real, costly, and becoming more severe."1 Moreover, as evidenced by government
intervention when Bear Stearns and AIG were failing, and by the fallout from the failure of
Lehman Brothers, the universe of firms that appeared too-big-to-fail during periods of stress
included more than insured depository institutions and extended beyond the perimeter of
traditional safety and soundness regulation.
A major reorientation of our regulatory and supervisory system is needed to address head-on
the problem of systemic risk. My subject today is how we should understand and undertake
the improvement of microprudential regulation and the development of macroprudential
regulation. The theme I want to highlight is how, to a considerable extent, the integration of
traditional lending, trading activities, and capital markets defines both of these tasks.2
A recent history of financial regulation
Systemic crises typically reveal failures across the financial system. The present situation is
no exception, with fundamental problems apparent in both the private and public sectors.
There was a massive breakdown of risk management and a suspension of simple common
sense within many financial firms. We also witnessed serious shortcomings in government
regulation of financial institutions and markets as, for example, with respect to subprime
mortgages, certain securitization practices, and some uses of credit default swaps. These
weaknesses were revealed as rapid and unsustainable appreciation of some asset prices -
especially in residential real estate - continued for a considerable time.
But, while these failings of recent years - and the global macroeconomic imbalances within
which these failings were nurtured - surely ignited and exacerbated the current crisis, the
breadth and depth of the financial breakdown suggest that it has much deeper roots. In many
respects, this crisis is the culmination of changes in both the organization and regulation of
financial markets that began in the 1970s.
Following the banking crisis of the early 1930s, and the famous bank holiday declared by
President Roosevelt soon after his inauguration, Congress enacted dramatic new measures
that would define financial regulation for decades. Most important for commercial banking
were creation of the Federal Deposit Insurance Corporation (FDIC) and the Glass-Steagall
Act. Glass-Steagall sharply limited both the securities business of commercial banks and
their affiliations with securities firms. Creation of the FDIC addressed the problem of runs and
panics by insuring the bank accounts of the vast majority of Americans. With the new
insurance, retail deposits became a highly stable source of relatively attractive financing for
banks, supported by the 1933 statutory prohibition of interest payments on demand deposits
and the Fed's Regulation Q upper limit on interest rates paid on savings deposits, which
together suppressed competition for deposits among banks.
Along with preexisting strictures included in the National Banking Act and state laws,
GlassSteagall established a regulatory system that largely confined commercial banks to
traditional lending activities and because of controls on branching and interstate acquisitions,
to a relatively narrow geographic area. Like the later Bank Holding Company Act,
GlassSteagall was intended to help insulate banks from risks that could be transmitted from
securities and other non-banking activities. This regulatory approach fostered a banking
system that was, for the better part of 40 years, quite stable and reasonably profitable,
though not particularly innovative in meeting the needs of depositors and borrowers.
Like much of the economy, commercial banking was buffeted by the turbulent
macroeconomic developments of the 1970s, which saw the demise of the Bretton Woods
exchange rate system, a serious recession, and then high levels of inflation. These forces,
along with technological and business innovations, helped produce an increasingly tight
squeeze on the traditional commercial banking business model. The squeeze came from
both the liability side, in the form of more attractive savings vehicles such as money market
funds, and from the asset side, with the growth of public capital markets and international
competition.
Some banks responded to this predicament by looking for higher returns from their traditional
activities through lending to new and often less creditworthy borrowers at higher interest
rates - a strategy that yielded at best mixed results. Other banks responded by borrowing
short and lending long - a poor strategy in a rising interest rate environment. A more
common industry response was to seek removal or relaxation of the regulations that confined
the activities, affiliations, and geographic reach of banks. While they differed with banks on
some important particulars, supervisors were sympathetic to this industry request, in part
because of the potential threat to the viability of the traditional commercial banking system.
The period of relative legal and industry stability that had followed the 1933 legislation thus
gave way, beginning in the 1970s, to a nearly 30-year period during which many prevailing
restrictions on banks were relaxed. A good number were loosened through administrative
action by the banking agencies, but there were regular and important statutory measures
heading in the same direction. This legislative trend culminated in the Gramm-Leach-Bliley
Act of 1999, which consolidated and extended the administrative changes that had allowed
more extensive affiliations of commercial banks with investment banks, broker-dealers,
merchant banks, and other financial firms.
By the turn of the century, then, the Depression-era cluster of restrictions on commercial
banks had been substantially loosened. Banks could operate nationally, had few practical
restrictions on their ability to pay competitive deposit rates, could conduct a much broader
range of activities within their own operations, and could affiliate with virtually any kind of
financial firm. Meanwhile, of course, financial engineering had been rapidly changing the
character of the financial services sector as a whole. Securitization and associated derivative
instruments were merging capital markets and traditional lending activities, fueling the growth
of what has become known as the shadow banking system. As a result, both the asset mix
and sources of funding of many banks were shifting, sometimes dramatically. Various larger
banks were also becoming involved, either directly or through their affiliates, in the full range
of activities associated with securitization - including sponsoring and administering special
purpose vehicles used in the securitization process.
Perhaps because the removal of activities and affiliation restrictions occurred in stages,
rather than in a single legislative or administrative action, there was no announced new
regulatory emphasis to address the changed industry. In practice, however, regulators relied
increasingly on capital requirements, accounting rules, and to a lesser extent, limits on bank
transactions with their corporate affiliates, to promote the safety and soundness of banking
organizations.
Although they had long used bank capital ratios as a supervisory tool, U.S. bank regulators
did not impose explicit minimum capital requirements until the 1980s. In the ensuing quarter
century, the attention of banking regulators has been heavily oriented toward elaborating
capital requirements to reflect more precisely the particular risks faced by a financial
institution - first through the Basel I process and more recently through the lengthier and
more complex Basel II process. The emphasis on capital measures was reinforced when,
following the savings and loan calamity, Congress instructed federal banking agencies to use
declining capital ratios as the trigger for "prompt, corrective" remedial action that was
intended to constrain regulatory forbearance.
The proximate reason for the move towards capital requirements in the early 1980s was
regulator concern about the decline in capital ratios of the largest banks - a concern
reinforced by Congress, as it saw some of those large banks facing enormous losses on their
loans to foreign countries. At the same time, however, regulators were coming to regard
capital requirements as a supple prudential tool. As activity and, eventually, affiliation
restrictions were loosened, capital requirements seemed a promising way to provide a buffer
against bank losses from any activities in which the bank or its affiliates might engage.
Support also developed for the proposition that minimum capital levels could, by maintaining
a material equity value for the bank, serve as a disincentive for excessive risk-taking by
management and shareholders.
As the activities and affiliations of banks became increasingly complex, regulators also relied
more on focused supervisory attention to the specific risks of each institution. Similarly, they
demanded that banks enhance their own internal risk-management systems. As with capital
requirements, regulators reasoned that a good risk-management system could effectively
promote bank stability in the face of quickly changing bank activities. The two regulatory
trends - seeking greater risk-sensitivity in capital requirements and greater effectiveness of
internal risk-management systems - came together in Basel II's advanced internal
ratingsbased approach to capital regulation.
Thus, at the onset of the current crisis, the financial regulatory system had accommodated
the growth of capital market alternatives to traditional financing by relaxing some restrictions
on bank activities and virtually all restrictions on affiliations between banks and non-bank
financial firms. In place of the superseded restrictions were capital requirements focused on
credit and market risk, along with a greater emphasis on supervision and risk management,
especially at larger firms. These legal changes facilitated a wave of mergers and acquisitions
that created a number of very large, highly complex financial holding companies centered on
a large commercial bank. These were subject to prudential regulation. At the same time,
there was a group of very large, significantly leveraged "free-standing" investment banks
whose market practices were regulated by securities laws, but were not subject to prudential
regulation.
The imperative of regulatory reorientation
There were, of course, many ways in which this financial regulatory system fell short of the
objectives of maintaining stability in the financial system. Any one explanation inevitably
oversimplifies what was a complex and long-developing set of vulnerabilities. However, as I
have earlier suggested, I believe an analysis can be profitably organized around the premise
that the regulatory system did not come close to adequately accounting for the impact of
trading and capital market activities on both traditional banking and systemic risk. This basic
point was manifest in three important deficiencies of the prevailing regime: the shortcomings
of microprudential regulation, the "boundary" problem, and the relatively undeveloped nature
of a macroprudential complement to conventional financial regulation.
At the microprudential level, although an intense focus on refining capital requirements for
credit risk had certainly led to the increased risk-sensitivity of those requirements and, more
recently, to advances in internal risk management, it came at the expense of attention to
other risks. In particular, there was insufficient appreciation of the implications of the growth
of the shadow banking system for the balance sheets of commercial banks, not to mention
other financial firms. Capital requirements for asset-backed securities were clearly
inadequate, based as they were on a 10-day trading horizon and with insufficient attention to
the credit risks inherent in these traded instruments. On the other side of the balance sheet,
insufficient action was taken to address the considerable liquidity risks for the many firms that
depended on the wholesale funding provided by securitization, commercial paper issuance,
and other sources - funding that was often poorly matched to the maturity of the firm's
assets.
More generally, bank holding company supervision was principally focused on protecting the
commercial bank within the holding company. There was probably too little attention to the
risks faced, and created, by the entire holding company, including the affiliates principally
involved in trading and other capital market activities. This weakness may be explained in
part by the supervisory approach embedded in the Gramm-Leach-Bliley Act. By dividing
supervisory authority for holding company affiliates among a number of supervisors based on
their charter or activity, that law elevated the concept of "functional regulation" to the potential
detriment of a more effective form of consolidated supervision. But it was also the case that
not enough supervisory scrutiny was given to the risks associated with securitization, the
common exposures of different affiliates, and the implications of the massive growth of
offbalance-sheet assets for safety and soundness. Indeed, supervisors sometimes seemed
themselves to underappreciate the importance of reputational risk, which to some degree
undermined the entire concept of an off-balance-sheet asset.
The boundary problem is simply stated: Systemic risk concerns, including too-big-to-fail
issues, extended beyond bank holding companies to firms that were unregulated, at least for
safety and soundness purposes. Indeed, a dramatic development of the crisis was the series
of runs on nondepository financial institutions. A combination of leverage, extensive
counterparty relationships, and dependence upon asset sales for liquidity made such
institutions both vulnerable to a wholesale funding run and a threat to the entire system.
One of the many striking consequences of the crisis for the U.S. financial system is that none
of the five large, free-standing investment banks that existed in 2007 remains so today.
Lehman, of course, declared bankruptcy. Two have been absorbed into existing bank holding
companies, and the remaining two have been converted into new bank holding companies,
which made them eligible for emergency government liquidity and guaranty assistance. In
effect, then, government assistance has been available ex post to protect the counterparties
of four of the five firms. Yet none was subject to a statutory ex ante framework for prudential
regulation.
Solving the boundary problem alone will not counterbalance contemporary sources of
systemic risk. The rapid development of market-based financial intermediation has also
highlighted the need for a macroprudential regulatory approach to complement more
conventional prudential supervision. Of course, systemic risk and the associated problem of
too-big-to-fail have long concerned financial regulators. Traditionally, though, systemic risk
was thought to rest in the potential for the failure of one bank to produce depositor panic that
infected other, solvent banks, or for the failure of one large bank to bring down counterparties
that were dependent upon payments from the first institution. Federal deposit insurance
addressed the first source of systemic risk. The second risk was offset by regulations
designed to ensure the solvency of each bank and by the potential availability of liquidity
from the Federal Reserve in its role as lender of last resort.
The metaphor frequently invoked in thinking about systemic risk was a row of dominoes. If
one bank fell - either becoming illiquid because of a deposit run, or insolvent because of
severe losses - then the whole row might be toppled. A limited version of this dynamic
occurred in the mid-1980s when Continental Illinois Bank, systemically important because so
many other banks held deposits in it, had to be rescued by the FDIC after a foreign depositor
run that followed heavy losses. For the last quarter century, however, the near misses in our
financial system have originated not from this classic pattern, but from outside the
commercial banking system.
The new market-based liquidity problems arose from sudden sharp movements in asset
prices that led to enormous market uncertainty concerning the values of those assets. As
now liquidity-strained institutions made increasingly distressed asset sales, they placed
further downward pressure on asset prices, leading to margin calls for leveraged actors and
mark-to-market losses for all holders of the assets. Since multiple firms were relying on
similar marketable assets as a ready source of liquidity, extreme price declines could ensue,
engendering a negative feedback loop that, if unchecked, would threaten the solvency of
firms operating on the assumption of liquidity through asset sales or borrowings secured by
such assets.
In the cases of the 1987 stock market crash and the 1998 implosion of Long Term Capital
Management, the damage was contained by quick emergency actions initiated by the
Federal Reserve. By 2007, unfortunately, the now familiar perils of poorly underwritten
assetbacked securities, liquidity strategies based on asset prices, and high leverage had pervaded
the financial system. Systemic risk arose not because the illiquidity or insolvency of one firm
would directly bring down another, but because of parallel hedging or funding strategies
practiced by highly leveraged firms with substantial short-term liabilities that threatened large
segments of the market.
This "interplay of complexity and tight coupling"3 in funding practices poses a fundamentally
different set of hazards from those conjured up by the image of a row of dominoes. The more
apt metaphor is of a dense network whose connections are often obscure to many
participants, in which the risk is not simply of counterparty exposure, but of the potential for
liquidity problems at a firm with which they have no relationship to affect their own balance
sheets and liquidity positions. The characteristics of this market-based liquidity system have
been explicated by commentators writing from both biographical4 and theoretical5
perspectives. Although some regulatory attention was devoted to these risks following the
earlier-mentioned market events, there is clearly the need for a comprehensive approach to
analyzing and, where appropriate, taking action to address them.
Framing a post-crisis regulatory program
How, then, should we respond to the shortcomings of the current financial regulatory system,
shortcomings so plainly highlighted by the most serious financial crisis experienced by our
country since the Depression? Let me state at the outset that I do not believe the answer lies
in an effort to recreate the regulatory system of the 1960s. Capital market developments of
the last several decades are not going to be fundamentally reversed, nor should we want
them to be. Reform by nostalgia is not usually an effective approach, since it tends to forget
the problems of the past and deny how much has changed. The task is to refashion a
regulatory structure so as to encourage the efficient allocation of capital to productive uses,
while protecting the financial system from the defects and excesses that are inherent in
financial markets.
For those of us at the regulatory agencies, I believe there should be a three-part response:
•
first, the agencies should adjust their policies and practices in light of the lessons
learned from examination of past shortcomings or of new problems revealed by the
crisis;
•
second, we should contribute to the discussion of possible Congressional initiatives
that could provide useful new legislative authorities to help contain systemic risk and
the problem posed by institutions that are too-big-to-fail; and
•
third, we should be developing ideas and proposals that are not appropriate for
adoption now - and, indeed, may never be - but are worthy of consideration to inform
the debate on policy alternatives.
As to internal policies and practices under existing authority, before I arrived at the Board,
the Federal Reserve had undertaken a systematic review of supervisory practices in the
precrisis period. That process is yielding a variety of lessons, which will be implemented to
improve the process of consolidated supervision. At the same time, because even the
highest quality supervision has its limits, particularly in the oversight of large, complex
institutions, it is important to attend to other regulatory tools. The three pillars of rules,
supervision, and market discipline laid out in the Basel II capital framework should be the
foundation for regulation of financial institutions more generally.
With respect to applicable rules, a parallel Board process of examining current regulations
has already led to numerous initiatives, many in conjunction with our fellow American
regulators and the foreign regulators in the Basel Committee on Banking Supervision. Some
of the more important of these initiatives include upgrading the quality of capital held by
regulated institutions, overhauling the capital requirements applicable to market risk, and
assessing the various ways in which regulation has had an undesirable pro-cyclical effect.
While it is clear that improved capital regulation alone would not have prevented the financial
crisis, it is equally clear that large financial institutions should have been required to hold
higher levels of capital in the pre-crisis period.
There is one further point that is important to make on the topic of minimum capital
requirements and indeed of all rules in prudential regulation. A rule that looks on paper to be
a good approach to a regulatory concern can sometimes turn out not to be so in practice.
Rules will not serve their purpose if they cannot be implemented correctly by firms or
monitored and enforced adequately by regulators.
The central role of liquidity problems in fomenting the crisis also suggests the need for
considerable attention to ensuring that firms have adequate liquidity risk-management
practices. While the most serious liquidity problems occurred outside traditional commercial
bank lending and borrowing activities, the crisis revealed significant fragilities in financial
institutions' extensive use of short-term repurchase agreements and reverse repurchase
agreements to finance large portions of dealer inventory and trading positions. The resulting
pressures in the tri-party repo market reveal why liquidity concerns must be addressed at
both the firm-specific and system levels.
Market discipline has at times been proposed as the principal means either to ensure the
stability of financial institutions or to counter too-big-to-fail concerns. This has always
seemed to me an interesting intellectual position, but a quite impractical one. The
opaqueness of complex financial institutions is unlikely ever to be fully penetrated, and
market analysts can share misperceptions of risk with those inside financial institutions. As
the U.K. Financial Services Authority has pointed out, credit risk spreads for major financial
institutions in the spring of 2007 suggested that bank riskiness was at historically low levels,
despite the imminence of major problems.6
Yet one need not subscribe to an exaggerated view of the potential of market discipline in
order to believe that there is considerable room for progress in enhancing the transparency
of financial firm operations so as to permit better market monitoring. Indeed, the relatively
short shrift given to disclosure requirements in the Basel II process reminds us how
supervisors can at times place excessive trust in their own capacities to identify risks and
evaluate risk-management capacities.
A different kind of market, or at least non-government, discipline should be fostered in the
internal corporate policies of financial institutions. Adequate management oversight of firm
operations and board of director oversight of management are as important to prudential
regulatory policy as they are to corporate law. Similarly, compensation systems that
incentivize employees to take actions that entail excessive risk in light of expected returns
and costs can also have adverse effects on firm safety and soundness. While there is reason
to proceed carefully in this area, there is a real need for additional supervisory action to
strengthen previous guidance on compensation. The Board is currently developing proposals
that will help ensure that compensation systems take appropriate account of the riskiness of
the firm's activities as well as the firm's financial performance.
Finally, we are augmenting our supervisory approach for bank holding companies to include
a more explicitly systemic perspective. "Horizontal reviews" of risks, risk management, and
other practices across multiple financial firms can help identify both common trends and
firmspecific weaknesses. The recently completed Supervisory Capital Assessment Program
(SCAP) of the nation's 19 largest bank holding companies both confirmed and advanced the
utility of this supervisory technique. Use of a uniform set of supervisory stress parameters
facilitated more precise identification of institution-specific strengths and weaknesses in both
risk and risk-management capacities. Although the SCAP was an unprecedented exercise in
an unprecedented situation, some lessons learned from our conduct of the exercise will be
incorporated into more routine supervisory practice.
More broadly, a systemic risk perspective requires that the Board conduct more closely
coordinated supervision of major bank holding companies. This is the direction in which we
will be moving - with more extensive, regular integration of Board staff into the ongoing
supervisory activities of Reserve Bank staff, as well as greater emphasis upon common
approaches to monitoring and supervising large institutions.
As to a desirable legislative agenda, Chairman Bernanke has recently discussed the Board's
views,7 and I testified on the subject before the Senate Banking Committee in March.8 So, as
important as this second piece of a post-crisis regulatory agenda is, I will not fully discuss it
this afternoon. Let me instead review in summary fashion what we regard as the key
components of a legislative agenda to contain systemic risk.
First, there should be a statutory requirement for consolidated supervision of all systemically
important financial firms - not just those affiliated with an insured bank as provided for under
the Bank Holding Company Act of 1956 (BHC Act). A robust, consolidated supervisory
framework, like the one embodied in the BHC Act, provides a supervisor with the tools it
needs to understand, monitor and, when appropriate, restrain the risks associated with an
organization's consolidated or group-wide activities. While the changes in the status of the
formerly free-standing investment banks have removed one important set of firms that fell
outside the boundary of prudential regulation, there will surely be other such systemically
important firms in the future. Moreover, it is important to foreclose the possibility that firms
might move into BHC status during periods of financial stress and reverse that status in order
to escape regulation in calmer times.
Second, there should be a resolution regime for systemically important non-bank institutions
to complement the current regime for banks under the Federal Deposit Insurance Act. In
most cases, federal bankruptcy laws provide an appropriate framework for the resolution of
nonbank financial institutions. However, this framework does not sufficiently protect the
public's strong interest in ensuring the orderly resolution of nondepository financial
institutions when a failure would pose substantial systemic risks. The absence of such a
regime leaves government authorities without a third alternative to the potentially unattractive
options of uncontrolled bankruptcy or broad government assistance. The resolution regime is
thus an important piece in an agenda to address the too-big-to-fail problem.
Third, there should be clear authority for special regulatory standards - such as for capital,
liquidity, and risk-management practices - applicable to systemically important firms. The
contribution of these firms to the aggregate level of risk within the financial system and the
huge negative externalities that would be produced by the failure of any one of these firms
provide powerful arguments for such standards. If there is more than one consolidated
supervisor of the universe of systemically important firms, it would be important to designate
a single agency to enact these standards, perhaps after consultation with the others.
Fourth, there should be an explicit statutory requirement for analysis of the stability of the
U.S. financial system. Given the difficulties in identifying with precision latent systemic risks,
and in distinguishing such risks from more benign market developments, it would seem wise
to involve multiple agencies in this analytic and reporting effort, perhaps as a designated
subgroup of the President's Working Group on Financial Markets. Congress might also want
to require this group to issue periodic reports on the stability of the U.S. financial system, in
order to disseminate its own views and elicit the considered views of observers outside the
government.
Fifth, additional statutory authority is needed to address the potential for systemic risk in
payment and settlement systems. Payment and settlement systems are the foundation of our
financial infrastructure. Financial institutions and markets depend upon the smooth
functioning of these systems and their ability to manage counterparty and settlement risks
effectively. Thus if a system is not well-designed and able to manage the risks arising from
participant defaults or operational disruptions, significant liquidity or credit problems could
result. Currently, the Federal Reserve relies on a patchwork of authorities, largely