Daniel K Tarullo: 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 Phoenix Metropolitan Area Community Leaders' Luncheon, Phoenix,
Arizona, 8 October 2009.
* * *
I am pleased to be here in Phoenix at the invitation of President Yellen. Having come across
the country to speak to you today, I thought I would not confine myself to a single subject, but
would instead address a number of areas about which I have been thinking. Lest you fear
that means a potpourri of unrelated observations, let me assure you that there is at least
some thematic unity in my remarks - namely, the challenges we face in the wake of the
financial crisis. So, with your indulgence, let me strike that rather grand theme by covering
the current state of the economy, the task of financial regulatory reform, and some broader
comments on credit markets.1
The economic outlook
Turning first to the economic outlook, let me begin by stating the obvious: After a period in
which there seemed to be only two plausible scenarios - very bad and even worse -
financial and economic conditions have steadied. A year ago the world financial system was
profoundly shaken by the failures of large financial institutions here and abroad. Significant
liquidity problems that had been building since early 2007 turned into a full-blown liquidity
crisis. The economy deteriorated at a pace that was both rapid and sustained. The period
ending in the second quarter of this year was the first time the United States had suffered
negative GDP growth in four consecutive quarters since the Great Depression.2
As we closed out the third quarter last week, it was apparent that economic growth was back
in positive territory. Financial markets continued to stabilize and, in some respects, improved.
Consumer spending was showing signs of firming. Housing-related economic indicators have
turned positive. Industrial production rose significantly in the summer, and not just for the
auto industry, which was effectively restarting after the disruption caused by the bankruptcies
of General Motors and Chrysler. Growth in foreign markets, particularly emerging Asia, has
been encouraging.
This turnaround is certainly welcome, but it should not be overstated. Although we can
expect positive growth to continue beyond the third quarter, economic activity remains
relatively weak. The upturns in industrial production and residential investment, for example,
follow startling declines in the first half of the year. Improvement is gradual and beginning
from very low levels.
The employment situation continues to be dismal. While the pace of job losses has slowed
from the extraordinary levels of early 2009, the economy has recently still been losing on
average about a quarter of a million jobs each month. Hopes for a steady reduction in the
pace of job losses were once again confounded last Friday with release of the September
employment report, which showed net job declines well above the consensus expectation of
economic forecasters. The unemployment rate has risen to 9.8 percent. Decomposing this
figure, we see that the only demographic group whose unemployment rate appears less than
awful is that for college graduates - at 4.9 percent. A look behind even that figure gives little
reason for comfort, insofar as it has nearly doubled from the level of 2.6 percent at which it
stood just a year earlier. Rates for many race or age-based demographic groups remain
downright discouraging.3
Indicators apart from the unemployment rate underscore the weakness of labor markets. The
percentage of working-age people with jobs has fallen to a point not seen in a quarter
century.4 Average hours worked have not increased through the spring and summer from
what were, by historic standards, unusually low levels. The number of part-time workers who
want full-time jobs jumped nearly 50 percent last fall and winter and has remained elevated
since.5 The average duration of unemployment has risen almost 10 weeks since the
recession began, to more than six months.
The labor market conditions I have just described reflect the low level of resource utilization
in the economy as a whole. In this context, with inflation expected to remain subdued for
some time, the Federal Open Market Committee indicated after our meeting two weeks ago
that exceptionally low interest rates are likely to be warranted for an extended period. Indeed,
with the effects of the February stimulus package diminishing next year, bank lending that is
still declining, and continued dysfunction in some parts of capital markets, there is
considerable uncertainty as to how robust growth will be in 2010. At the same time, the
unconventional policies pursued by the Federal Reserve in order to halt the crisis have
produced levels and types of reserves that will eventually require use of the unconventional
exit tools discussed on numerous occasions by Chairman Bernanke and Vice Chairman
Kohn.
The coincidence of a weak economy and an unusually large balance sheet at the Federal
Reserve will require some judgments by the Federal Open Market Committee of a sort for
which there are not many historical precedents. Still, just as with conventional monetary
policy, decisions on the timing and pace for removing accommodation should and will
depend on our ongoing analysis and forecasts of all relevant economic factors.
Reforming financial regulation
In one sense, the financial crisis that began in 2007 is an old and familiar tale of explosive
growth in leverage built on assumptions of ever-rising asset prices. Financial crises are, as
the economist Charles Kindleberger put it, a "hardy perennial."6 Instead of tulips in the
seventeenth century Dutch Republic, South Sea Company stock in eighteenth century
England, or the Nikkei and real estate in late twentieth century Japan, we had subprime
mortgages and securitizations. However, like most recurring stories in human history, each
financial crisis has its own plot twists and themes interwoven with elements common to most
crashes. To fashion an effective and sensible response, it is necessary to understand both
the unique and shared features of our own experience.
The financial crisis revealed that systemic risk was very much built into our financial system.
As shown by the intervention of the government when Bear Stearns and AIG 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 extended beyond the perimeter of traditional safety and soundness
regulation. During the years immediately preceding the crisis, there were both private and
public sector mistakes. Within many financial firms there was a massive failure of risk
management. Within government there were serious shortcomings in the regulation of both
firms and markets.
In truth, though, the origins of the financial crisis lay deeper. In the preceding decades our
regulatory system had accommodated the growth of capital market alternatives to traditional
financing by relaxing many restrictions on the type and geographic scope of bank activities
and virtually all restrictions on affiliations between banks and non-bank financial firms. These
changes, in turn, enabled a series of acquisitions that resulted in a number of very large,
highly complex financial holding companies centered on a large commercial bank. These
firms were subject to prudential supervision to be sure, but it was a kind of supervision that
had not kept pace with the far-reaching changes in the industry. At the same time, there was
a group of very large, much higher leveraged financial firms that were not subject to
mandatory prudential regulation.
Many firms of both types relied for a considerable portion of their financing on short-term
capital market sources that were often poorly matched with the maturity structure of a firm's
assets. Securitization markets played a major role in these complex, tightly wound financial
arrangements, which for a time seemed to promise ever-increasing credit availability. But
when questions arose about the quality of the assets on which this system was based -
notably poorly underwritten subprime mortgages - a classic adverse feedback loop ensued.
With lenders increasingly unwilling to extend credit against these assets, liquidity-strained
institutions made increasingly distressed asset sales, which placed additional downward
pressure on asset prices, thereby leading to margin calls for leveraged actors and
mark-tomarket losses for all holders of the assets. The margin calls and booked losses would start
another round in the adverse feedback loop.
The causes of the crisis were thus embedded in the very nature of the financial services
industry as it had evolved since the 1980s, and with the failure of the regulatory system to
adapt to the new sources of financial risk. An adequate post-crisis program of regulatory
reform must be equally concerned with the fundamentals of leverage and too-big-to-fail.
There must be improvement in traditional, firm-centered regulation, sometimes referred to as
microprudential regulation. We must also develop a macroprudential regulatory outlook - that
is, an approach that considers linkages among firms and markets that could threaten the
financial system as a whole, and that watches for the emergence of risks that might not be
apparent solely through examination of specific financial institutions.
Both objectives will require changes by the financial regulatory agencies acting under their
existing authority, as well as new legislation to ensure that there is sufficient authority and
accountability for the regulatory agencies in adapting their policies. I believe that a reform
program is, in fact, taking shape, though important components remain the subject of debate
within Congress, the Administration, and the financial regulatory agencies. While I do not
have time today to cover everything that the Federal Reserve is doing, much less the
activities of other financial regulators, let me describe some of our initiatives and identify
some of the more important areas in which I believe that Congressional action could be
helpful.
The Federal Reserve has worked with other U.S. and foreign supervisors to strengthen
capital, liquidity, and risk-management requirements for banking organizations. There is little
doubt that capital levels prior to the crisis were insufficient to serve their functions as an
adequate constraint on leverage and a buffer against loss. Higher capital requirements for
trading activities and securitization exposures have already been agreed internationally.
Efforts to improve the quality of capital have made considerable progress, with a particular
emphasis on the need for higher levels of common equity, which ultimately provides the
greatest protection against losses for creditors or the deposit insurance fund. We are also
working with our domestic and international counterparts to deal with the procyclical
tendencies that characterize important areas of financial regulation, including capital and
accounting standards.
We must also adopt new regulatory mechanisms to counteract the systemic and
too-big-tofail problems that became so embedded in our financial system. One possible approach is a
special charge - possibly a special capital requirement - that would be calibrated to the
systemic importance of a firm. Needless to say, developing a metric for such a requirement is
a new, and not altogether straightforward, exercise. Another proposal, which strikes me as
having particular promise, is that large financial institutions be required to have specified
forms of "contingent capital." One form of this proposal would have firms regularly issue
special debt instruments that would convert to equity during times of financial stress. If well
devised, such instruments would not only provide an increased capital buffer at the moment
when it is most needed. They would also inject an additional element of market discipline into
large financial firms, since the price of those instruments would reflect market perceptions of
the stability of the firm.
In addition to changing the regulations under which banking organizations function, the
Federal Reserve is adapting the methods by which we supervise those organizations. For
the largest and most complex firms, we are implementing closer coordination among our
onsite examiners of those firms and with Federal Reserve Board staff in Washington. We will
expand our use of so-called horizontal reviews of these large firms, a process involving
cross-firm analysis of key practices and circumstances that gives all supervisory participants
a broader perspective on the state of the financial industry.
We are also creating a quantitative surveillance mechanism that will use supervisory
information, firm-specific data analysis, and market-based indicators to identify developing
strains and imbalance that may affect multiple institutions. This program will be distinct from
the activities of supervisors, so as to provide an independent assessment of the conditions in
major firms, as well as to provide additional information to on-site examination teams. It will
also provide a good starting point for the macroprudential regulatory perspective I mentioned
earlier.
There is, then, much to be done under existing supervisory authority. But there are limits. For
example, under present law, our capital and other regulatory requirements apply only to firms
that own a commercial bank. And yet, as became evident last year, systemic problems can
arise from the activities of non-banking firms as well. Indeed, there is an incentive to shift
riskier activities to such firms. For this reason, the Federal Reserve supports proposals that
Congress extend the reach of the regulatory system so that every systemically important firm
is subject to consolidated supervision.
A second important legislative initiative would be creation of a special resolution process for
systemically important financial firms. At present we have such a process for banks, but not
for the holding companies of which they are part or for other financial firms. A regime that
raised the real prospect of losses for shareholders and creditors would add a third alternative
to the unattractive existing options of bailout or disorderly bankruptcy. The consequent
increase in market discipline before severe financial distress arises could provide another
way to help contain the too-big-to-fail problem.
A third relevant proposal for Congressional action is creation of an oversight council
composed of the financial regulatory agencies. This council, which should be given access to
a wide range of information from regulators and market actors, would be charged with
identifying emerging risks to stability and regulatory gaps across the entire financial system,
and coordinating agency responses to potential systemic risk. It could also play a useful role
in identifying financial firms that may deserve designation as systemically important and thus
subject to consolidated supervision, as suggested above.
These and other actions by Congress and the regulatory agencies, completed and proposed,
offer a real and welcome prospect of broad reform in the financial regulatory system. Still, as
the reform process proceeds and people inevitably become involved in detailed debates on
the merits of particular ideas, I would suggest that there are two basic norms that should
guide the outcome of this process.
First, there is some danger that reforms and restrictions on financial activity will simply be
piled on one another, with insufficient attention to their cumulative or interactive effects.
Reforms must reflect the social and economic desirability of ensuring access to credit on
risk-sensible terms for businesses and consumers alike, even as policymakers strive to
ensure that methods of credit allocation are consistent with financial stability.
Second, the reform process cannot be judged a success until it substantially reduces
systemic risk and the too-big-to-fail problem. While it is unrealistic to think that these
concerns can be eliminated, it is critical that they be addressed head-on. We cannot know for
certain that the regulatory, supervisory, and legislative changes to which I have already
alluded will be up to these tasks. Accordingly, as I have said before, all participants in the
reform process must continue to explore other possibilities - including potentially quite
innovative possibilities - even as we work to shape and implement the current batch of
worthwhile proposals to these ends.
A "new normalcy" for credit markets
Thus far I have spoken exclusively from the perspective of a member of the Board of
Governors of the Federal Reserve in thinking about the economy, monetary policy, financial
supervision, and regulatory reform. Before closing, I want to make a few more general
comments on changes, actual or potential, in credit markets. These remarks are prompted in
part by the conversations I often have with bankers, business people, and consumers.
During these discussions I have realized that just about everyone understands we will never
return to the credit markets of the middle part of this decade, but very few people believe
they understand what the "new normal" will look like once the crisis has fully passed and the
economy is on a sustained recovery path. I suspect that this uncertainty is itself an
impediment to stronger growth, since it makes financial planning more difficult.
There are some features of the pre-crisis credit world with little to be said for them, whose
apparent demise we should welcome. For example, mortgage lending at high rates with little
or no down payment and non-existent underwriting is not something we want to see again,
for both consumer protection and financial stability reasons. Likewise, a business model for
credit cards based upon low interest rates and high, frequent penalty fees seems at odds
with responsible allocation and use of credit.
But what of securitization? There were undoubtedly many imprudent, even reckless,
practices associated with the securitization process, particularly with respect to some exotic
instruments whose risk could not be understood even by their creators. There is little to
lament in their disappearance. But securitization is not in and of itself a bad thing. On the
contrary, a well-functioning system for securitizing well-underwritten loans can make capital
available at lower cost to businesses, homeowners, and retail consumers. The failure of
many relatively straightforward securitization markets to revive without government support
may be explained simply as a hangover from the excesses and still-encumbered assets of
the pre-crisis period. Just as some have restarted, perhaps others will follow as markets for
the underlying assets improve. But I will confess to some concern that there has not already
been greater activity.
Beyond specific financial instruments, there are clearly fundamental behavioral and
macroeconomic adjustments in the offing. The habit of building personal savings
predominantly through appreciation of one's home is one that many Americans will have to
change. Similarly, the growth models of emerging market countries dependent on
unshakeable American consumption and ever-increasing borrowing will not be sustainable
even as recovery becomes more established. And, needless to say, major fiscal reform here
at home will very likely be the central issue of U.S. economic policy in the years following
recovery from the present crisis.
Conclusion
My focus today on what follows in the wake of the crisis might itself be read as a touch of
optimism, signifying that the crisis itself looks to be over. The sobering counterpoint is my
argument that some rather substantial adjustments will be needed by individuals, financial
firms, businesses, regulators, and nations. That there will be adjustments is not something
we can choose. How deftly we adjust is the question whose answer will weigh heavily in our
nation's economic performance over the next decade.