Daniel K Tarullo: Financial regulatory reform
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the annual US Monetary Policy Forum, University of Chicago Booth School of
Business, New York, 26 February 2010.
* * *
It is a pleasure to participate in this year's U.S. Monetary Policy Forum. To begin the
discussion of regulatory reform, I will first explain my view that the imperative for financial
regulatory reform has much deeper roots than the imprudent mortgage lending, tightly wound
wholesale financing channels, and other factors that were direct contributors to the recent
financial crisis. Next, I will summarize the status of the reform proposals to address systemic
risk, as well as the changes that are already in train, before ending with a few observations
on the relationship between the scope of the systemic risk problem and the reform agenda.
The roots of the financial crisis
It is interesting and important to inquire carefully into the immediate causes of the financial
crisis. But an appropriately tailored response must begin by recognizing that the crisis arose
following profound changes in both the organization and regulation of financial markets that
began in the 1970s.
Starting in 1933, the New Deal established a regulatory system that largely confined
commercial banks to traditional lending activities within a circumscribed geographic area,
with attendant limits on price competition and a federal deposit insurance backstop meant to
forestall bank runs. This approach fostered a commercial 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.
The turbulent macroeconomic developments of the 1970s, along with technological and
business innovations, helped produce an increasingly tight squeeze on the traditional
commercial banking business model. The squeeze came on both the liability side of bank
balance sheets, in the form of more-attractive savings vehicles such as money market
mutual funds, and on the asset side, with the growth of public capital markets and
international competition. Large commercial banks reacted, among other ways, by seeking
removal or relaxation of the regulations that confined bank activities, affiliations, and
geographic reach - a request to which supervisory agencies and legislators were generally
sympathetic because of the potential threat to the viability of the traditional commercial
banking system.
The period of relative legal and industry stability that followed the New Deal legislation thus
gave way in the 1970s to a nearly 30-year period during which many prevailing restrictions
on banks were relaxed, both through administrative action by the bank regulatory agencies
and through a series of legislative changes culminating in the Gramm-Leach-Bliley Act of
1999. By the turn of the century, the Depression-era cluster of restrictions on commercial
banks had been replaced by a regulatory environment in which they could operate nationally,
conduct a much broader range of activities, and affiliate with virtually any kind of financial
firm.
These changes enabled a series of acquisitions that resulted in a number of very large,
highly complex financial holding companies centered on large commercial banks. At the
same time, independent investment banks had grown into a group of very large, complex,
and highly leveraged firms. Of course, financial engineering had been rapidly changing the
character of the financial services sector as a whole. Among other things, securitization and
associated derivative instruments were merging capital markets and traditional lending
activities, thereby fueling the growth of the shadow banking system.
The regulatory system had also evolved, notably through progressively more detailed capital
requirements and increasing demands that banking organizations enhance their own
riskmanagement systems. Supervisors counted on capital and risk management to be supple
tools that could ensure stability even as financial activities changed rapidly. Truthfully,
though, there was no wholesale transformation of financial regulation to match the dramatic
changes in the structure and activities of the financial industry. In particular, the regulatory
system did not come close to adequately accounting for the effects of securitization and
other capital market activities on both traditional banking and systemic risk.
Meanwhile, as shown by the intervention of the government when Bear Stearns and
American International Group were failing, and by the repercussions from the failure of
Lehman Brothers, the universe of financial firms that appeared too big to fail during periods
of stress included more than insured depository institutions and, indeed, reached beyond the
circle of firms subject to mandatory prudential regulation. The extension of funds by the
Treasury Department from the Troubled Asset Relief Program and of guarantees by the
Federal Deposit Insurance Corporation (FDIC) from the Temporary Liquidity Guarantee
Program to each of the nation's largest institutions revealed the government's conclusion in
the fall of 2008 that a very real threat to the nation's entire financial system was best
addressed by shoring up the largest financial firms.
Regulatory reform: the consensus to date
The crisis thus arose against the backdrop of a regulatory system that had not adjusted to
the extensive integration of traditional lending with capital market activities, which had
created new sources of systemic risk. The already significant too-big-to-fail problem was
further amplified by the government's actions in 2008 to prevent a complete collapse of the
financial system. The internal information and risk-management systems of many financial
firms were revealed as inadequate to the task of identifying the scope of market and credit
risks, much less ensuring the soundness of those firms, in a period of severe stress.
Proposed reforms to counteract systemic risk should, both individually and as a whole, be
evaluated by reference to these quite fundamental deficiencies in the regulatory system.
Despite substantial disagreements over some reform proposals - such as the creation of an
independent consumer financial services protection agency and the possible reallocation of
responsibilities among the regulatory agencies - a fair degree of consensus has been
reached on some elements of a legislative reform package. Accordingly, and with full
recognition that there are still important differences on the specifics of the legislation, my
summary of the reform agenda as it has evolved to this point will include some proposed
legislative elements, as well as various administrative measures being pursued by the
regulatory agencies under existing statutory authority.
It is perhaps instructive to organize this agenda by reference to the "three pillars" of financial
regulation enunciated by the Basel Committee on Banking Supervision - minimum prudential
requirements, supervisory oversight, and market discipline. Although the Basel Committee
formulated the three-pillar approach in the context of the Basel II arrangement for capital
requirements, this frame of reference can also be applied to the broader set of reform
measures.
As to minimum prudential rules, U.S. banking agencies are joining with our international
counterparts in the Basel Committee to modify capital and liquidity requirements. Increased
capital requirements for trading activities and securitization exposures have already been
agreed. A consultative paper issued late last year advances additional capital proposals,
including improvements in the quality of capital used to satisfy minimum capital rules, with a
particular emphasis on the importance of common equity, and a first set of measures
designed to reduce the traditional pro-cyclicality of capital requirements.1 Additional work on
capital requirements for market risk is also under way. Finally, the bank regulatory agencies
are implementing strengthened guidance on liquidity risk management and weighing
proposals for quantitative liquidity requirements.
To a considerable extent, these changes strengthen rules that existed prior to the crisis and
thus build on existing approaches, even as they underscore the problems with the pre-crisis
regulatory regime. Several potential regulatory devices with a more direct systemic focus
have also garnered substantial interest, both here and abroad. Prominent among them are
proposals to (1) impose special taxes or capital charges on firms based on their systemic
importance, (2) require systemically important firms to issue or maintain contingent capital
instruments that would convert to common equity in periods of stress, and (3) reduce
procyclical tendencies by establishing special capital buffers that would be built up in boom
times and drawn down as conditions deteriorate. Each of these ideas has substantial appeal,
but, as has become clear, each also presents considerable challenges in the transition from
a good idea to a fully elaborated regulatory mechanism.
Many legislative proposals would extend the perimeter of regulation so that rules designed to
promote financial stability would apply to firms that currently are not subject to prudential
regulation because they do not own a commercial bank. The legislation passed by the
House, for example, would subject any firm whose failure could have serious systemic
consequences to consolidated supervision, including minimum capital and liquidity
requirements.
Supervisory oversight is being reoriented in several notable ways. As I mentioned earlier, the
crisis revealed the serious shortcomings in the risk-management systems of many large
firms. As we found during the Supervisory Capital Assessment Program that the Federal
Reserve led early last year, the risk-management prerequisite of good information
management was simply lacking at many firms. Accordingly, we are placing increased
emphasis on the ability of firms to assess their own capital needs, particularly in periods of
stress, both to supplement minimum capital requirements and to ensure that relevant
information on firm risks is readily available to supervisors.
More fundamentally, the supervisory perspective of the Federal Reserve has been refocused
by modifying the scope of consolidated supervision and by coordinating much more closely
the supervision of our largest financial institutions. In the years preceding the crisis,
supervision of bank holding companies was principally focused on protecting the commercial
banks within a holding company. Too little attention was paid to the risks faced, and created,
by the entire holding company, including in affiliates principally involved in trading and other
capital market activities. Supervisory attention is now focused on the risks that may develop
anywhere within large holding companies, regardless of whether there is an immediate threat
to the federally insured bank. Legislative proposals to remove the Gramm-Leach-Bliley
constraints placed on the Federal Reserve's ability to obtain information from, and address
unsafe and unsound practices in, the subsidiaries of bank holding companies would make
this supervisory reorientation more effective.
We are also instituting a more closely coordinated system for supervising some of the largest
holding companies that will, in effect, establish a cross-firm, horizontal perspective as an
ongoing organizing supervisory principle. This new approach will have a macroprudential
dimension as well. To advance both macroprudential and microprudential goals, we are
instituting a quantitative surveillance mechanism (QSM) for large, complex financial
organizations. The QSM will use supervisory information, firm-specific data analysis, and
market-based indicators to identify developing strains and imbalances that may affect
multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses
across large firms will enhance our understanding of the potential effects of adverse changes
in the operating environment on individual firms and on the system as a whole.
Market discipline has been an underdeveloped policy tool despite numerous ideas put forth
over the years. Yet it is hard to imagine a practical counterstrategy to the undesirable
consequences of too-big-to-fail perceptions that does not include a credible alternative to the
current Hobson's choice of bailout or disorderly bankruptcy. Consequently, most regulatory
reform proposals have prominently featured a special resolution mechanism that would raise
the real prospect of losses for investors and counterparties of even the largest failing
institutions. At present, of course, the law provides the FDIC with authority to resolve failed
insured depository institutions, but there is no parallel authority for the holding companies of
which these banks are a part or for other systemically important financial firms.
Regulatory reform: the ongoing debate
The rough consensus around the reform elements just described has hardly meant an end to
the debate for at least three reasons. First, as already noted, there is considerable continuing
disagreement over the key features of some of these proposals, even when the basic idea is
accepted. The significant differences over the best form of resolution mechanism provide one
example. Second, as also mentioned earlier, some ideas that may be promising ideas in
concept - such as special charges calibrated to the systemic importance of a firm - are not
easy to develop and put into practice effectively. Until more-detailed proposals are
generated, judgments on the likely efficacy of these ideas will obviously be difficult to make.
Third, many participants in the public policy debate who would agree with some form of this
consensus agenda nonetheless believe that it falls short of what is needed to ensure
financial stability.
Those who believe that additional regulatory measures are necessary have mostly turned to
structural measures, as distinguished from the prudential requirements, supervisory
initiatives, and market discipline proposals that constitute the bulk of the consensus reform
agenda. One approach is to reverse the 30-year trend that allowed progressively more
financial activities within commercial banks and more affiliations with nonbank financial firms.
The idea, promoted by former Federal Reserve Chairman Paul Volcker and now endorsed by
the Administration, is to insulate insured depository institutions from proprietary trading or
similar capital market activities that are thought to pose unusually high risks for institutions
or, more precisely, for the federal safety net provided to insured banks.
A second approach is to directly regulate more financial products and practices, whether or
not the firms involved in the transactions are subject to prudential supervision. To an extent,
this approach is reflected in the House bill and other proposals that would require
standardized over-the-counter derivatives to be cleared through central counterparties or
traded on exchanges. Some proponents favor going beyond this market requirement to
prohibit or significantly constrain the use of other products or practices.
A third approach is to attack the bigness problem head-on by limiting the size or
interconnectedness of financial institutions. The more muscular forms of this approach would
break up some existing institutions in a manner somewhat reminiscent of breakups of AT&T
in 1982 or Standard Oil in 1911 under the antitrust laws. A somewhat less sweeping variant
would prevent firms from growing beyond a certain size or in a way that would significantly
increase their systemic importance, including through acquisitions. The Administration's
recent proposals contain an example of the second form, with a cap on the percentage of
total financial industry liabilities that could be held by any one firm. The House bill has
examples of both forms, as it grants authority to a newly created council of financial
regulators to dismantle a firm that poses a "grave threat" to systemic stability and to
individual banking regulators to prevent acquisitions that would increase systemic risk.
Regulatory reform in perspective
Let me now offer a few observations on the overall effort to revamp our financial regulatory
system. First, the reform process cannot be judged a success unless it substantially reduces
systemic risk generally and, in particular, the too-big-to-fail problem. In using the Basel II
three-pillar metaphor to classify the consensus reform agenda, I meant to underscore that
this agenda is in many respects a program to build out and improve the regulatory
approaches that prevailed before the crisis. The important intellectual question is whether the
limitations of these approaches that have been revealed in the past can be sufficiently
overcome, either within each pillar or through their combination.
The fact that support for reforms of the structural variety has been growing during the past
year's policy debate suggests to me that many thoughtful people have given at least a
tentative negative answer to that question. Of course, the specifics of a good number of
these proposals have yet to be formulated, and judgment of the merits must await their
further development, insofar as the details will determine whether a proposal is likely both to
be effective and to have manageable unintended consequences. Speaking personally,
however, I think that we should not become unrealistically demanding in seeking
specification of such proposals, particularly when a proposal itself provides for ongoing
refinement. For example, my sense is that the provision in the House bill that would empower
banking regulators to prevent acquisitions that would increase systemic risk could be
sensibly and effectively elaborated over time. We should also be thinking more seriously
about ensuring that safety and soundness requirements for some types of activities
- residential mortgage lending comes to mind - apply throughout the financial system,
without regard to the regulated status of the lender.
Second, having just noted the promise of measures beyond what I have termed the
consensus agenda, I also want to emphasize the importance of its elements. Without better
capital requirements, a horizontal approach to supervising the largest financial institutions,
and a sophisticated macroprudential complement to traditional bank and bank holding
company supervision, the regulatory system is unlikely to deliver on a promise of greater
financial stability. Similarly, legislative proposals to make a workable resolution mechanism
and prudential regulation applicable to all systemically important firms are necessary to
achieving the same goal. Indeed, the resolution mechanism is critical to strengthening
market discipline sufficiently so that it can truly take its place alongside rules and supervisory
oversight as a strong third pillar of the financial regulatory system.
Third, having made the case for extensive change, I want to add a cautionary note. Even as
we improve and reorient regulation, we must not lose sight of the ultimate goal. Today we are
all mindful of the economic devastation that can ensue when a financial system goes badly
awry. But financial stability alone is not the aim of financial regulation. It is instead a stable
financial system within which capital is efficiently directed to creditworthy consumers and
businesses who need it, as well as a system that offers good savings and investment
vehicles for individuals and organizations.
The implications of this caution are several. I will mention two. One, which we regulators
have already taken to heart, is that the effect of new capital and liquidity requirements on
lending, and thus on economic recovery and growth, must be carefully taken into account.
This is why we urged - successfully, I am pleased to say - that the Basel Committee analyze
the whole package of capital changes under consideration from a macroeconomic, as well as
a microprudential, perspective before those changes are finalized. Another implication is that
it will be unnecessary to apply some regulatory changes to the smaller financial institutions
that are far from being able to create systemic risk on their own.
Conclusion
In closing, let me say that regulatory reform will not come to a close once we have enacted
our new regulations and legislation. The work of containing systemic risk and the
too-big-tofail problem will need to be adaptive. The perspectives, ideas, and criticisms of those outside
the regulatory agencies will remain essential to this work, even if they can sometimes cause
some discomfort for those of us within.