Daniel K Tarullo: Regulatory reform
Testimony of Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 29 October 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Chairman Frank, Ranking Member Bachus, and other members of the Committee, thank you
for the invitation to testify this morning on systemic regulation, prudential matters, resolution
authority, and securitization. The financial crisis was the product of many factors, including
the tight integration of lending activities with the issuance, trading, and financing of securities;
gaps in the financial regulatory structure; widespread failures of risk management across a
range of financial institutions; and, to be sure, significant shortcomings in financial
supervision. More fundamentally, though, it demonstrated that the regulatory framework had
not kept pace with far-reaching changes in the financial sector, and the concomitant growth
of new sources of risk to both individual institutions and the financial system as a whole.
Because the roots of the crisis reached so deeply into the very nature of the financial system,
a broad program of reform is required. Much can be, and needs to be, done by supervisors -
under their existing statutory authorities - to contain systemic risk generally and the
too-bigto-fail problem in particular. As the discussion draft released by Chairman Frank recognizes,
there is also a clear need for the Congress to provide significant additional authority and
direction to the regulatory agencies.
Essential elements of this legislative agenda include: ensuring that all financial institutions
that may pose significant risk to the financial system are subject to robust consolidated
supervision; establishing a systemic risk oversight council to identify, and coordinate
responses to, emerging risks to financial stability; directing all financial supervisors to take
account of risks to the broader financial system as part of their normal oversight
responsibilities; establishing a new special resolution process that allows the government to
wind down in an orderly way a failing financial institution that threatens the entire financial
system while also creating a credible process for imposing losses on the firm's shareholders
and creditors and assuring that the financial industry, not taxpayers, ultimately bears any
additional costs associated with the resolution process; providing for consistent and robust
prudential supervision of key payment, clearing, and settlement arrangements; and
addressing weaknesses in the securitization process that came to light during the crisis.
Chairman Frank's discussion draft addresses each of these areas and, in the Board's view,
provides a strong framework for achieving a safer, more stable financial system. In addition
to addressing these areas for legislative change, I will discuss some of the actions the
Federal Reserve and our supervisory colleagues are taking under existing authorities to
strengthen the supervision and regulation of financial institutions - particularly large, complex
institutions - and to prevent regulatory arbitrage.
Consolidated supervision of systemically important financial institutions
The current financial crisis has clearly demonstrated that risks to the financial system can
arise not only in the banking sector, but also from the activities of other large, interconnected
financial firms - such as investment banks and insurance companies - that traditionally have
not been subject to the type of mandatory prudential regulation and consolidated supervision
applicable to bank holding companies. Chairman Frank's discussion draft would close this
important gap in our regulatory structure by providing for all financial institutions that may
pose significant risks to the financial system to be subject to the framework for consolidated
prudential supervision that currently applies to bank holding companies. As I will discuss
shortly, it also provides for these firms to be subject to enhanced standards, reflective of the
risk they pose to the financial system. These provisions should prevent financial firms that do
not own a bank - but that nonetheless pose risks to the overall financial system because of
the size, risks, or interconnectedness of their financial activities - from avoiding
comprehensive supervisory oversight.
In one sense, a requirement that all systemically important firms be subject to prudential
supervision would not lead to a major change in our regulatory system. During the financial
crisis, a number of very large financial firms became bank holding companies. Thus, the
Federal Reserve has already become the consolidated supervisor of most of the nation's
large, interconnected financial institutions. Yet a critical part of a reform agenda directed at
systemic risk and the too-big-to-fail problem is ensuring that other financial firms that may
pose a systemic threat also are subject to robust consolidated supervision. Such a measure
would allow the regulatory system to adapt if activities migrate from supervised institutions to
other firms, leading those firms to become very large and interconnected, or in response to
other developments in the financial system. Moreover, such a provision would serve as a
kind of insurance policy against the possibility of a firm that opted for the benefits of being a
bank holding company during the financial crisis deciding to exit that status during calmer
times.
The discussion draft also would require the development of enhanced regulation and
supervision, including robust capital, liquidity, and risk-management requirements, to
address and mitigate systemic risks. Enhanced requirements, particularly for large,
interconnected firms, are needed not only to protect the stability of individual institutions and
the financial system as a whole, but also to counteract any incentive for financial firms to
become very large in order to be perceived as too big to fail. This perception can materially
weaken what should be the normal market incentive of creditors to monitor the firm's
risktaking and appropriately price these risks in their transactions with the firm. When this
incentive is weakened, moral hazard increases, allowing the firm to raise funds at a price that
may not fully reflect the firm's risk profile. As a result, the firm is likely to choose a level of risk
that is excessive both for itself and, potentially, for society at large. Moreover, this distortion
creates a playing field that is tilted against smaller firms not perceived as having the same
degree of government support. Development of a mechanism for the orderly resolution of
nonbank financial firms that threaten financial stability, which I will discuss later, is an
important additional tool for addressing the too-big-to-fail problem.
The discussion draft would reinforce the changes in supervision already under way at the
Federal Reserve and the other banking agencies. As already announced, we have
strengthened capital requirements for trading activities and securitization exposures. We
continue to work with other regulators to strengthen the capital requirements for other types
of on- and off-balance-sheet exposures and to improve the quality of capital overall.1
Beyond these generally applicable capital requirements, we must develop capital standards
and other supervisory tools addressed specifically to the systemic risks of large,
interconnected firms. One possible approach is a special charge - possibly a special capital
requirement - that would adjust based on the risks posed by the firm to the financial system.
Ideally, this requirement would be calibrated to become more stringent as the firm's systemic
risks increase, although developing a metric for such a requirement would be highly
challenging. Another potentially promising option is to require that selected financial
institutions issue specified amounts of contingent capital. Such capital could take the form of
debt instruments that convert to common equity during times of macroeconomic stress or
when losses erode the institution's capital base. Such instruments would pre-position capital
on the balance sheets of each of these institutions, ready to be converted into the form that
provides the best loss-absorption capacity precisely when that capacity is most needed. And,
if well devised, it would inject an additional element of market discipline into large financial
firms, because the price of those instruments would reflect market perceptions of the stability
of the firm.
The financial crisis also highlighted weaknesses in liquidity risk management at major
financial institutions, including an overreliance on short-term funding. To address these
issues, the Federal Reserve helped lead the development of revised international principles
for sound liquidity risk management, which have been incorporated into new interagency
guidance now out for public comment.2 Together with our U.S. and international
counterparts, we are also considering quantitative standards for liquidity exposures similar to
those for capital adequacy, with the goal of ensuring that internationally active firms can fund
themselves even during periods of severe market instability. With supervisory
encouragement, large banking organizations have, for the most part, already significantly
increased their liquidity buffers and are strengthening their management of liquidity risks.
Beyond modifying applicable rules and standards, the Federal Reserve is revamping its
approach toward supervising the largest financial institutions. In doing so, we have drawn on
our experience earlier this year in conducting the special Supervisory Capital Assessment
Program (SCAP), which involved forward-looking, cross-firm, aggregate analyses of 19 of the
largest bank holding companies. While the SCAP itself was an extraordinary exercise for an
extraordinary time, we are incorporating into our ongoing supervisory process the essential
SCAP approach of bringing firm-specific assessments of on-site examiners together with
systematic analyses of industry experience, economic trends, and possible stress scenarios.
Thus, we have increased our emphasis on horizontal examinations, which focus on particular
risks or activities across a group of banking organizations, and we have broadened the
scope of the resources we bring to bear on these reviews.
For example, we currently are conducting a horizontal assessment of internal processes for
evaluating capital adequacy at the largest U.S. banking organizations, focusing in particular
on how shortcomings in fundamental risk management and governance for these processes
could impair firms' abilities to estimate capital needs. This exercise is central to the goal of
having each firm maintain adequate capital to provide a buffer against possible losses
associated with its particular set of activities and exposures. Using findings from these
reviews, we will work with firms over the next year to bring their processes into line with
supervisory expectations. Supervisors will use the information provided by firms about their
processes as one factor in the assessment of the adequacy of firms' overall capital levels.
For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, then
supervisors will place less credence on the firm's own internal capital evaluation and may
demand higher capital cushions, among other things.
As part of this overall approach to large institution supervision, we are creating an enhanced
quantitative surveillance program for large, complex organizations that would use
supervisory information, firm-specific data analysis, and market-based indicators in an effort
to identify emerging risks to specific firms as well as to the industry as a whole. This work will
be performed by a multidisciplinary group composed of our economic and market
researchers, supervisors, market operations specialists, and other experts within the Federal
Reserve System. In addition, periodic scenario analysis will be used to enhance our
understanding of the consequences of changes in the economic environment for both
individual firms and for the broader system. Finally, to support and complement these
initiatives, we are working with the other federal banking agencies to develop
morecomprehensive and more-frequent information-reporting requirements for the largest firms.
The crisis also has highlighted the potential for compensation practices at financial
institutions to encourage excessive risk-taking and unsafe and unsound behavior - not just
by senior executives, but also by other managers or employees who have the ability,
individually or collectively, to materially alter the risk profile of the institution. Bonuses and
other compensation arrangements should not provide incentives for employees at any level
to behave in ways that imprudently increase risks to the institution, and potentially to the
financial system as a whole.
Last week, the Federal Reserve issued proposed guidance on incentive compensation
practices to promote the prompt improvement of incentive compensation practices
throughout the banking industry.3 This guidance, which is consistent with the international
principles and standards issued by the Financial Stability Board earlier this year, will be
supplemented by supervisory initiatives to spur and monitor the industry's progress toward
the implementation of safe and sound incentive compensation arrangements, identify
emerging best practices, and advance the state of practice more generally in the industry.4
One of these initiatives involves a special horizontal review of incentive compensation
practices at 28 large, complex banking organizations under the Federal Reserve's
supervision.
To be fully effective, consolidated supervisors must have clear authority to monitor and
address safety and soundness concerns and systemic risks in all parts of an organization,
working in coordination with other supervisors wherever possible. As the crisis has
demonstrated, large firms increasingly operate and manage their businesses on an
integrated, firmwide basis, with little regard for the corporate or national boundaries that
define the jurisdictions of individual functional supervisors, and stresses at one subsidiary
can rapidly spread within the consolidated organization. A consolidated supervisor thus
needs the ability to understand and address risks that may affect the risk profile of the
organization as a whole, whether those risks arise from one subsidiary or from the linkages
between depository institutions and nondepository affiliates. Chairman Frank's proposal
would make useful modifications to the provisions added to the law by the
Gramm-LeachBliley Act in 1999 that limit the ability of a consolidated supervisor to monitor and address
risks within an organization and its subsidiaries on a groupwide basis.
Systemic risk oversight
For purposes of both effectiveness and accountability, the consolidated supervision of an
individual firm, whether or not it is systemically important, is best vested with a single agency.
However, the broader task of monitoring and identifying systemic risks that might arise from
the interaction of different types of financial institutions and markets - both regulated and
unregulated - may exceed the capacity of any individual supervisor. Instead, we should seek
to marshal the collective expertise and information of all financial supervisors to identify and
respond to developments that threaten the stability of the system as a whole.
The discussion draft released by Chairman Frank would advance this objective in two
important ways. First, it would establish an oversight council - composed of representatives
of the agencies and departments involved in the oversight of the financial sector - that would
be responsible for monitoring and identifying emerging systemic risks across the full range of
financial institutions and markets. In addition, the council would have the ability to coordinate
responses by member agencies to mitigate identified threats to financial stability. And,
importantly, the oversight council would have the authority to recommend that its member
agencies, either individually or collectively, adopt heightened prudential standards for the
firms under the agencies' supervision in order to mitigate potential systemic risks. Examples
of such risks could include rising and correlated risk exposures across firms and markets;
significant increases in leverage that could result in systemic fragility; and gaps in regulatory
coverage that arise in the course of financial change and innovation, including the
development of new practices, products, and institutions. The council also would identify
those financial firms that should be subjected to enhanced prudential standards and
supervision on a consolidated basis.5
Second, the discussion draft would reinforce the authority of individual financial agencies to
take macroprudential considerations into account in exercising their supervisory and
regulatory functions. A macroprudential outlook, which considers interlinkages and
interdependencies among firms and markets that could threaten the financial system in a
crisis, provides an important complement to the current microprudential focus of financial
supervision and regulation. Each supervisor's participation in the oversight council would
greatly strengthen that supervisor's ability to see and understand threats to financial stability
and craft appropriate responses for the institutions and markets under their supervision.
The Federal Reserve already has begun to incorporate a systemically focused approach into
our supervision of large, interconnected firms. Doing so requires that we go beyond
considering each institution in isolation and pay careful attention to interlinkages and
interdependencies among firms and markets that could threaten the financial system in a
crisis. For example, the failure of one firm may lead to runs by wholesale funders of other
firms that are seen by investors as similarly situated or that have exposures to the failing
firm. These efforts are reflected, for example, in the expansion of horizontal reviews and the
quantitative surveillance program I discussed earlier.
Improved resolution process
Another critical element of an agenda to contain systemic risk is the creation of a new regime
that would allow financial firms to fail without posing risks to the broader financial system or
the economy. In most cases, the federal bankruptcy laws provide an appropriate framework
for the resolution of nonbank financial institutions. However, the bankruptcy code does not
sufficiently protect the public's strong interest in ensuring the orderly resolution of a nonbank
financial firm whose failure would pose substantial risks to the financial system and to the
economy. Indeed, after the Lehman Brothers and AIG experiences, there is little doubt that
we need an alternative to the existing options of bankruptcy and bailout for such firms.
The discussion draft released by Chairman Frank would provide the government with
important new tools to restructure or wind down a failing firm in a way that passes on losses
to shareholders and creditors of the firm while mitigating the risks to financial stability and the
economy. For example, it would allow the government to sell assets, liabilities, and business
units of the firm; transfer the systemically significant operations of the firm to a new bridge
entity that can continue these operations with minimal disruptions; and repudiate contracts of
the firm, subject to appropriate recompense.
This proposal would not guarantee the survival of any financial firm, nor is it designed to aid
shareholders or creditors of a failing firm. To the contrary, the proposal would establish the
expectation that shareholders and creditors of the firm will bear losses as a result of the
firm's failure. And any assistance provided in the course of the resolution process to prevent
severe disruptions to the financial system would be repaid by the firm or the financial
services industry. Establishing credible processes for imposing losses on the shareholders
and creditors of a failing firm is essential to restoring a meaningful degree of market
discipline and addressing the too-big-to-fail problem. Indeed, restoring discipline through
changes directed at the behavior of investors and counterparties would be an important
complement to the regulatory and supervisory changes that I discussed earlier, which seek
to address the too-big-to-fail problem through actions directed at the firms themselves.
Financial firms of any size should be resolved under the bankruptcy code whenever possible.
Thus, this new regime should serve only as an alternative to the bankruptcy code, available
when needed to address systemic concerns, and its use should be subject to high standards
and checks and balances. The discussion draft would allow the new regime to be invoked
with respect to a particular firm only with the approval of multiple agencies, and only upon a
determination that the firm's failure and resolution under the bankruptcy code or otherwise
applicable law would have serious adverse effects on financial stability and the U.S.
economy. These standards, which are similar to those governing the use of the systemic risk
exception to least-cost resolution in the Federal Deposit Insurance Act, appear appropriate
and should help ensure that these new powers are invoked only when circumstances dictate
their use.
The discussion draft provides that the ultimate costs of any assistance needed to facilitate
the orderly resolution of a large, highly interconnected financial firm be recouped through the
sale or dissolution of the troubled firm, supplemented by assessments on financial firms over
an extended period of time if necessary. We believe this approach provides a path to
resolution for financial firms in a way that both mitigates risk to the financial system and
protects taxpayers. The availability of a workable resolution regime with appropriate funding
would eliminate the need for the Federal Reserve to use its emergency lending authority
under section 13(3) of the Federal Reserve Act to prevent the disorderly failure of specific
failing institutions.
It is important, however, that the Federal Reserve, as the nation's central bank, retain our
long-standing authority to address broader liquidity needs within the financial system under
section 13(3) when necessary to maintain financial stability. During the recent crisis, our
ability to establish broad-based liquidity facilities proved critical in containing the severe
pressures that threatened the financial system as a whole and in reopening key financial
markets. We used this authority only when the need for action was evident to both the
Federal Reserve and the Treasury, a practice that could be formalized by the Congress.
Payment, clearing, and settlement arrangements
As I mentioned at the outset, in revising the financial regulatory system, we must look
beyond the causes of the current crisis and seek to address areas of potential systemic risk
in the future. Such areas include critical payment, clearing, and settlement arrangements,
which are the foundation of the nation's financial infrastructure. These arrangements include
centralized market utilities for clearing and settling payments, securities, and derivatives
transactions, as well as the decentralized activities through which financial institutions clear
and settle such transactions bilaterally. While these arrangements can create significant
efficiencies and promote transparency in the financial markets, they also may concentrate
substantial credit, liquidity, and operational risks. In addition, many of these arrangements
have direct and indirect financial or operational linkages and, absent strong risk controls, can
themselves be a source of contagion in times of stress. Thus, it is critical that systemically
important payment, clearing, and settlement systems and activities be subject to strong and
consistent prudential standards designed to ensure the identification and sound management
of credit, liquidity, and operational risks.
Unfortunately, the current regulatory and supervisory framework for systemically important
payment, clearing, and settlement arrangements is fragmented, creating the potential for
inconsistent standards to be adopted or applied. In light of the increasing integration of global
financial markets, it is important that these arrangements be viewed from a systemwide
perspective, and that they be subject to strong and consistent prudential standards and
supervisory oversight.
The Federal Reserve has direct supervisory responsibility for some of the largest and most
critical systems in the United States and has a role in overseeing several other systemically
important systems. But a coherent framework for supervision of these systems does not
exist, and our current authority depends to a considerable extent on the specific
organizational form of these systems. Chairman Frank's discussion draft would provide the
Federal Reserve with additional authorities to ensure that appropriate standards and
oversight are applied to systemically important payment, clearing, and settlement
arrangements.
Improving the securitization process
The financial crisis revealed a number of significant shortcomings in the securitization
process that contributed importantly to the stresses experienced by the markets as well as to
the outsized losses some firms faced once markets began to deteriorate. The ability of
brokers and lenders to readily securitize and sell to third parties loans that they were making,
regardless of their risks, contributed to the overall decline in underwriting standards in the
years leading up to the crisis. Moreover, capital requirements failed to provide adequate
incentives for firms to maintain capital and liquidity buffers sufficient to absorb extreme
systemwide shocks without taking actions that could tend to amplify the effects of the shocks.
In addition, institutional investors of all sorts - including financial institutions, pension funds,
and overseas investors - put excessive reliance on the rating agencies' assessment of the
risks associated with a range of structured products. In part, investors' reliance on ratings
reflected the lack of transparency of many structured products, which made independent
assessments of risk difficult. However, it subsequently became clear that the rating agencies
had not themselves understood the extent of the risks associated with complex structured
instruments, particularly those related to subprime mortgages. Once those risks were
realized, the ratings of many of these securities were downgraded sharply, with investors
taking very large and unexpected losses.
Addressing these weaknesses will require action on several fronts. As I noted earlier, the
Basel Committee has announced improvements to bank capital standards for
securitizationrelated exposures, thereby better aligning these standards with the risks presented by
securitizations. Improved transparency regarding the individual loans backing a
securitization, as well as regarding the originators of such loans, also is needed to reduce the
opacity that has impeded effective discipline in the market for asset-backed securities (ABS)
and encouraged undue reliance on credit rating agencies. Chairman Frank's discussion draft
would advance this goal by authorizing the Securities and Exchange Commission (SEC) to
develop enhanced disclosure requirements for ABS, including loan-level information and
information identifying the originators or brokers of the underlying loans.6 Using authority
granted by the Congress in 2006, the SEC already has adopted or proposed several rules to
improve the transparency, quality, and integrity of the credit rating process for securitizations
and other structured finance products.7
Requiring that originators or securitizers of loans packaged for securitization retain some
exposure to the credit risk associated with the loans also could help restore confidence in the
securitization market and encourage the application of sound underwriting criteria to all
loans, including those intended for securitization. The details of such a requirement are
probably best left to rulemaking by the implementing agencies. Complexities are created by
the broad range of assets that are, or may be, securitized, as well as by the different
approaches that may be taken to securitization. A credit exposure retention requirement may
thus need to be implemented somewhat differently across the full spectrum of securitizations
in order to properly align the interests of originators, securitizers, and investors without
unduly restricting the availability of credit or threatening the safety and soundness of financial
institutions.
Charter conversions and regulatory arbitrage
Finally, I am pleased to note that one potential gap, which I know is of interest to this
Committee, already has been addressed by the joint efforts of the banking agencies. The
dual banking system and the existence of different federal supervisors create the opportunity
for insured depository institutions to change charters or federal supervisors. While institutions
may engage in charter conversions for a variety of sound business reasons, conversions that
are motivated by hopes of escaping current or prospective supervisory actions by the
institutions' existing supervisors undermine the efficacy of the prudential supervisory
framework.
Accordingly, the Federal Reserve welcomed and immediately supported an initiative led by
the Federal Deposit Insurance Corporation to address such regulatory arbitrage. This
initiative resulted in a recent statement of the Federal Financial Institutions Examination
Council reaffirming that a charter conversion or other action by an insured depository
institution that would result in a change in its primary supervisor should occur only for
legitimate business and strategic reasons.8 Importantly, this statement also provides that
not
conversion requests should be entertained by the proposed new chartering authority or
supervisor while serious or material enforcement actions are pending with the institution's
current chartering authority or primary federal supervisor. In addition, it provides that the
examination rating of an institution and any outstanding corrective action programs should
remain in place when a valid conversion or supervisory change does occur.
Conclusion
In closing, let me reiterate the importance of moving ahead with the elements of the
administrative and legislative reform agenda that I have discussed. These reforms, taken
together, will enhance financial stability, increase market discipline in transactions involving
large financial firms, and reduce both the probability and severity of future crises. The
Federal Reserve looks forward to continuing work with the Congress and the Administration
as the legislative process moves forward.