Christine M Cumming: Reform in a time of rapid change
Remarks by Ms Christine M Cumming, First Vice President of the Federal Reserve Bank of
New York, at the Standard and Poor's Ratings Services Global Bank Conference, New York
City, 27 March 2014.
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It is a pleasure to speak at this program on global banks. Since your agenda covers many
dimensions of transformation and adaptation of global financial institutions, I thought I'd
frame my remarks around the theme of reform in a time of rapid change. Change involves
both long-wave and short-wave components. Reform can be driven by both the public and
the private sectors. My thesis is that the most effective reform involves both the public and
private sectors and takes account of both the proximate needs for reform and the long-term
trends that drive long-term transformation. The views I will express are my own and not
necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.
Let me highlight two kinds of change. So much of the immediate regulatory agenda has been
framed around addressing the failings in the run-up to the global financial crisis - the failings
as we understand them today. The resulting lessons learned often focus on developments
between 2003 and 2007: poor underwriting in the U.S. residential mortgage market, the rapid
expansion of leverage in the household and the financial sectors, and the packaging and
repackaging of risks from mortgages into increasingly complicated securities.
Alongside those immediate forces driving reform, I want to highlight a second kind of change
- the no less major impetus for transformation in the financial services business that stems
from larger macroeconomic and technological change. As we think about public sector and
private sector reform, I submit that we need to address and adapt to both types of change.
What are some of those longer run forces that have been transforming the financial system?
Let's start with two macroeconomic trends that reflect the result of successes in global
economic policy. One is the rapid rise in wealth in much of the world and with it, new or
greatly expanded institutions to concentrate and manage that wealth. The function of the
banking system in the 19th and early 20th century was to intermediate scarce capital on one
side and a large supply of ambitious projects on the other, projects such as the building of
the transcontinental railroad. By contrast, today we live in a capital-rich world where the
financial system's problem to solve is effective deployment of abundant capital, not gathering
sufficient savings to meet capital needs.
Another long-run macroeconomic force has gathered substantial momentum in the last
decade: the shift of income, wealth and economic energy from the so-called advanced
economies of the United States, Japan and Europe to the so-called emerging economies.
Ten years ago, the emerging market countries accounted for about 20 percent of world GDP
- the advanced economies 80 percent. Today the proportion is 40/60, and the emerging
market countries continue to grow substantially faster than the large advanced economies.
Yes, China is an important component of that growth, but the trend reflects strong
performance in recent years in many regions of the world outside the advanced economies.
A further long-run force, seen as the most disruptive, is technology. At one time, the financial
system, perhaps until the 1970s or 1980s, played an important role in searching for
savers/investors to contribute to financing those major investments. Much of the work of
identifying and linking the sources and the uses of funds has been facilitated or even taken
over by technology - just think of the ubiquity of trading platforms, screens, and financial
news and, beyond that, the increasing automation and artificial intelligence applied to credit
evaluation, financial analysis, and trading activities.
I mention these three long-run forces because the financial industry has been and still is
adapting to these trends. Indeed, the major transformation in the U.S. financial industry that
occurred in the course of the 1980s and 1990s - the development of over-the-counter
derivatives markets, the shift toward a larger role for securities markets relative to banking
markets - was just such an adaptation to the long-run forces of change. The shift reflected
the growth of institutional wealth and the power of technology, ubiquitous information and
expanded financial know-how.
In 1986, the derivatives markets were still nascent and securitization had just begun to
spread outside the mortgage markets in the United States. At that time, a task force of
central bankers, the precursor to today's Committee of the Global Financial System, which
reports to the Global Economy Meeting of 31 central bank governors, published a volume
titled Recent Innovations in International Banking.1 The report was notable for being among
the first to describe what was then a set of new financial instruments, such as
over-thecounter derivatives and the expanded use of financial options. The study noted the
tremendous momentum behind the 1980s wave of financial innovation, the likelihood of
those forces continuing, and the changes already occurring in the financial system,
especially the shift of financial activities from traditional banking markets to securities and
derivatives markets.
The really noteworthy aspect of the report is the study group's effort to identify - really,
anticipate - the risks and concerns that could emerge in the transforming financial system. In
a section that anticipates current policy language with the cutting-edge title "Macro-prudential
policy", the report enumerates these concerns:
• The risk that credit vigilance would decline in the financial system, and with it,
overall credit quality.
• The potential that the transformed financial system could encourage and enable
leverage.
• The risk of sudden loss of liquidity as markets come under pressure, especially
because the banking system would no longer be capable of backstopping the
nonbank financial sector and the broader private sector.
• Concern that instrument complexity and transaction volume could overwhelm
settlement systems.
Post 2008, these issues sound all too familiar, of course.
Of particular note, the report stated that:
A major source of concern derives from the difficulties in pricing new instruments and the
possibility that many new instruments appear to be, at least to some degree, underpriced,
that is, that gross income from the transactions is insufficient, on average, to compensate
fully for their inherent risks. Since it may be necessary to accumulate experience over a
variety of circumstances and cyclical conditions in order for market participants fully to
understand and assess all elements of risk, this problem may appear especially before the
market for a new product has reached maturity.
The recent financial crisis in many ways represented the realization of many of these
concerns. Some observations:
• The crisis demonstrated how the combination of poor underwriting, financial
engineering, and leverage could transform what had been viewed as relatively safe
markets for US residential mortgages, magnify risks in those instruments through
securitization and leverage, and transmit the risks around large parts of the globe.
• The speed at which liquidity deterioration, market dysfunction and financial
institution distress set in was breathtaking - far faster than experienced in earlier
crises.
• Capital and liquidity buffers in place through regulatory minimums and firms' own
economic capital calculations, once viewed as robust, proved in many cases to be
inadequate to absorb mounting losses during the crisis. In addition, the supervisory
apparatus proved slow to recognize and address the full dimension of the problem,
and when some large, systemically important firms approached failure, the public
sector lacked the tools to resolve them.
Difficulties arose in winding down large derivatives portfolios because of their size
•
and complexity, the back office logistics and settlement risks associated with
derivatives portfolios, and the lack of a sufficiently harmonized international legal
framework to handle counterparty default or failure.
• At least some business models in place before the crisis proved to be
unsustainable. At many large institutions, the heavy reliance on generating
mortgage-related revenues, whether through flawed underwriting or creating highly
complex securities, proved a vulnerability; some institutions lacked stable revenue
streams robust to macroeconomic conditions; some relied heavily on funding from
short-term markets such as the tri-party repo market.
Regulatory reform
The wave of regulatory reform, of course, corresponds to a considerable degree with the
problems observable during the crisis. Take, for example, solving the Too Big to Fail
problem. The regulatory and financial stability agenda being advanced by the Financial
Stability Board and the Basel Committee on Banking Supervision is intended both to reduce
the probability that large, systemically important firms could fail and to mitigate the costs of
their failure, should that occur. Measures to raise both the quantity and quality of capital at
the large, systemically important firms, known as G-SIFIs, such as Basel III and enhanced
prudential standards, are aimed at reducing the probability of failure. The work on recovery
and resolution planning, as set out in the Key Attributes for Effective Resolution Regimes, a
new global standard published in 2011, aims at mitigating the cost of failure by developing
the institutional arrangements and concrete plans to place a failing G-SIFI into resolution.
These initiatives at the global level have been mirrored at the national level in many
countries.
I'd draw special attention to stress testing in its role in reducing the probability of failure and
to resolution planning in reducing failure's social cost, because both represent an important
shift of focus for the supervisory community. Both processes focus attention on the far
adverse tail of the probability distribution of outcomes for a firm. Technology, financial
modeling, and risk management theory and practice have greatly expanded and enhanced
the supervisors' ability to analyze and address those severe adverse outcomes.
Another part of the regulatory reform agenda addresses weaknesses in short-term funding
markets. Efforts here include seeking to reduce the reliance on intraday credit in the tri-party
repo market, to strengthen risk management in the repo and other short-term funding
markets, and to make progress toward developing a collateral liquidation mechanism to
prevent fire sales of collateral in distressed markets. Reforms also are being considered for
money market mutual funds, where the inherent run risk in the event that a money market
mutual fund "breaks the buck" continues to be a significant vulnerability.
Yet a third set of initiatives in the reform agenda seeks to strengthen the clearance and
settlement infrastructure for over the counter derivatives. In addition to creating incentives to
move derivative transactions into trade repositories and central counterparties, which provide
the benefits of risk management mechanisms and encouragement of standardization of
contract terms, the reform efforts extend to improving the international legal framework for
derivatives transactions in the event of default and failure or resolution.
Regulatory reform can create guardrails for the financial system, but in my view, those
reforms are far more effective if accompanied by similar reform efforts in the private sector.
Private sector reform can take the form of enhancing internal governance, re-evaluating
strategy and business models, and strengthening risk management and internal controls
within individual firms. It can also take the form of industry collective action to improve market
structure and practice, to invest in financial infrastructure and to recommend best practices.
In the U.S., the combination of public sector - and private sector - driven reform has
historically played an important role in our financial system and should play a role today.
I experienced the interplay of public and private sector efforts in the early 1990s, in the wake
of the commercial real estate and leveraged buyout downturn in the US Northeast. In the
public sector, the supervisors pursued an aggressive program of remediation for troubled
banks with three major elements. Because the problems at that time were simpler, the
remediation program imposed by supervisors was easy to understand and it was effective.
The three principal actions were: a troubled bank had to raise additional capital and
strengthen its liquidity; it needed to fully identify its problem assets and exposures, isolate
them and place them in workout; and it needed to develop a new business plan.
At the same time, Congress passed the Federal Deposit Insurance Corporation Improvement
Act, otherwise known as FDICIA in 1992; for its time, it contained a large number of
provisions to guide supervisory and market practice. Its lasting contributions were the prompt
corrective action framework escalating the intensity of supervision as capital levels fall in a
bank culminating in the ability to close banks before capital is fully depleted and a
management attestation about the quality of internal controls that foreshadowed
SarbanesOxley. Today, however, much of FDICIA has been forgotten.
The reason? At many financial firms, bankers struck the theme of "never again". That
conviction spurred them to identify lessons learned and institute stronger controls on
commercial real estate lending and buyout lending and maintain them. One sign that the
effort mattered appeared as the commercial real estate market heated up later in the 1990s
and lending terms started to loosen. Deal flow came to a near-standstill as the controls
established in the early 1990s kicked in. The market only resumed when underwriting
standards retraced their way back to higher ground.
So, as we benchmark progress in the recovery of financial institutions from the recent
financial crisis, one area stands out. The early 1990s supervisory program comprised
strengthening capital and liquidity, identifying problem exposures and placing them in
workout, and developing a new business plan - there is one area where more progress will
need to be made. The international community of supervisors has done a great deal to
address the need for more and better quality capital through new capital standards. The
identification and workout of troubled assets has made significant progress, which we can
observe in the recovery of markets for some troubled assets. But global financial firms are
still working on the new business plan. From the financial press, it's clear that many large
financial companies have been rethinking their strategies, often along the lines of increasing
the focus on nonfinancial businesses and households and reducing the focus on expanding
capital markets businesses. But I believe we are more at the beginning than toward the end
of that process of reconsideration.
In my personal view, the reconsideration of business plans needs to incorporate the
longterm macroeconomic and technology trends even as they incorporate the lessons learned
from the financial crisis. Those business plans need to look ahead five years or more to
position the financial firms and, with them, the financial system for the opportunities and risks
that lie ahead. We will need to meet the long-term challenges of changes in the global
macroeconomy, the distribution of growth opportunities and the distribution of wealth, and the
speed and power of technological change.
Since so much opportunity has developed elsewhere in the world, how will the public sector
reform agenda impact the global banking activities of financial institutions? We do not know
yet how the reform agenda will affect the international activities of G-SIFIs, although we can
see some early indications. Higher capital requirements and more stringent prudential
standards are causing some firms to re-examine their correspondent and business
relationships and make new cost-benefit assessments. The greater focus on stress testing
and resolution planning may lead to more discussion of firm structure, including the number
of subsidiaries, the alignment of the corporate structure with the firm's business activities, the
management of intragroup exposures, the use of parent guarantees, and the correlation of
the firm's capital and liquidity structure with the firm's business and legal entity structure.
In my personal view, discussion will no doubt lead to action, in the best scenario, by the
large, systemically important financial firms themselves. The issues reflect areas where the
true costs of managing a large, complex, internationally active firm have not yet been fully
internalized by the firms. Said differently, the cost of international financial activity has
probably been too low, and as it rises, some readjustment of those activities will be
necessary.
The forces of change continue strong, as strong as they were in the peak years of innovation
more than 25 years ago. Now, as then, financial institutions will need to adapt and transform
themselves. This time, however, we have the sobering experiences of the financial crisis to
guide us. We all have an interest in moving forward, given the pace of change in the world
and in technology.
Thank you for your attention.