Daniel K Tarullo: Bank supervision
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 4 August 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Chairman Dodd, Ranking Member Shelby, and other members of the Committee, thank you
for your invitation to testify this morning. The financial crisis had many causes, including
global imbalances in savings and capital flows, the rapid integration of lending activities with
the issuance, trading, and financing of securities, the existence of gaps in the regulatory
structure for the financial system, and widespread failures of risk management across a
range of financial institutions. Just as the crisis had many causes, the response of
policymakers must be broad in scope and multifaceted.
Improved prudential supervision - the topic of today's hearing - is a necessary component of
the policy response. The crisis revealed supervisory shortcomings among all financial
regulators, to be sure. But it also demonstrated that the framework for prudential supervision
and regulation had not kept pace with changes in the structure, activities, and growing
interrelationships of the financial sector. Accordingly, it is essential both to refocus the
regulation and supervision of banking institutions under existing authorities and to augment
those authorities in certain respects.
In my testimony today, I will begin by suggesting the elements of an effective framework for
prudential supervision. Then I will review actions taken by the Federal Reserve within its
existing statutory authorities to strengthen supervision of banks and bank holding companies
in light of developments in the banking system and the lessons of the financial crisis. Finally,
I will identify some gaps and weaknesses in the system of prudential supervision. One
potential gap has already been addressed through the cooperative effort of federal and state
banking agencies to prevent insured depository institutions from engaging in "regulatory
arbitrage" through charter conversions. Others, however, will require congressional action.
Elements of an effective framework for prudential supervision
An effective framework for the prudential regulation and supervision of banking institutions
includes four basic elements.
First, of course, there must be sound regulation and supervision of each insured depository
institution. Applicable regulations must be well-designed to promote the safety and
soundness of the institution. Less obvious, perhaps, but of considerable importance, is the
usefulness of establishing regulatory requirements that make use of market discipline to help
confine undue risk-taking in banking institutions. Supervisory policies and techniques also
must be up to the task of enforcing and supplementing regulatory requirements.
Second, there must be effective supervision of the companies that own insured depository
institutions. The scope and intensity of this supervision should vary with the extent and
complexity of activities conducted by the parent company or its nonbank subsidiaries. When
a bank holding company is essentially a shell, with negligible activities or ownership stakes
outside the bank itself, holding company regulation can be less intensive and more modest in
scope. But when material activities or funding are conducted at the holding company level, or
when the parent owns nonbank entities, the intensity of scrutiny must increase in order to
protect the bank from both the direct and indirect risks of such activities or affiliations and to
ensure that the holding company is able to serve as a source of strength to the bank on a
continuing basis. The task of holding company supervision thus involves an examination of
the relationships between the bank and its affiliates as well as an evaluation of risks
associated with those nonbank affiliates. Consolidated capital requirements also play a key
role, by helping ensure that a holding company maintains adequate capital to support its
group-wide activities and does not become excessively leveraged.
Third, there cannot be significant gaps or exceptions in the supervisory and regulatory
coverage of insured depository institutions and the firms that own them. Obviously, the goals
of prudential supervision will be defeated if some institutions are able to escape the rules and
requirements designed to achieve those goals. There is a less obvious kind of gap, however,
where supervisors are restricted from obtaining relevant information or reaching activities
that could pose risks to banking organizations.
Fourth, prudential supervision - especially of larger institutions - must complement and
support regulatory measures designed to contain systemic risk and the too-big-to-fail
problem, topics that I have discussed in previous appearances before this Committee.1 One
clear lesson of the financial crisis is that important financial risks may not be readily apparent
if supervision focuses only on the exposures and activities of individual institutions. For
example, the liquidity strategy of a banking organization may appear sound when viewed in
isolation but, when examined alongside parallel strategies of other institutions, may be found
to be inadequate to withstand periods of financial stress.
Strengthening prudential supervision and regulation
The crisis has revealed significant risk-management deficiencies at a wide range of financial
institutions, including banking organizations. It also has challenged some of the assumptions
and analysis on which conventional supervisory wisdom has been based. For example, the
collapse of Bear Stearns, which at the end was unable to borrow privately even with U.S.
government securities as collateral, has undermined the widely held belief that a company
can readily borrow against high-quality collateral, even in stressed environments. Moreover,
the growing co-dependency between financial institutions and markets - evidenced by the
significant role that investor and counterparty runs played in the crisis - implies that
supervisors must pay closer attention to the potential for financial markets to influence the
safety and soundness of banking organizations. These and other lessons of the financial
crisis have led to changes in regulatory and supervisory practices in order to improve
prudential oversight of banks and bank holding companies, as well as to advance a
macroprudential, or systemic, regulatory agenda.
Working with other domestic and foreign supervisors, the Federal Reserve has taken steps
to require the strengthening of capital, liquidity, and risk management at banking
organizations. There is little doubt that, in the period before the crisis, capital levels were
insufficient to serve as a needed buffer against loss, particularly at some of the largest
financial institutions, both in the United States and elsewhere. Measures to strengthen the
capital requirements for trading activities and securitization exposures - two areas where
banking organizations have experienced greater losses than anticipated - were recently
announced by the Basel Committee on Banking Supervision. Additional efforts are under
way to improve the quality of the capital used to satisfy minimum capital ratios, to strengthen
the capital requirements for other types of on- and off-balance-sheet exposures, and to
establish capital buffers in good times that can be drawn down as economic and financial
conditions deteriorate. Capital buffers, though not easy to design or implement in an
efficacious fashion, could be an especially important step in reducing the procyclical effects
of the current capital rules. Further review of accounting standards governing valuation and
loss provisioning also would be useful, and might result in modifications to the accounting
rules that reduce their procyclical effects without compromising the goals of disclosure and
transparency.
The Federal Reserve also helped lead the Basel Committee's development of enhanced
principles of liquidity risk management, which were issued last year.2 Following up on that
initiative, on June 30, 2009, the federal banking agencies requested public comment on new
Interagency Guidance on Funding and Liquidity Risk
Management, which is designed to
incorporate the Basel Committee's principles and clearly articulate consistent supervisory
expectations on liquidity risk management.3 The guidance re-emphasizes the importance of
cash flow forecasting, adequate buffers of contingent liquidity, rigorous stress testing, and
robust contingent funding planning processes. It also highlights the need for institutions to
better incorporate liquidity costs, benefits, and risks in their internal product pricing,
performance measurement, and new product approval process for all material business
lines, products, and activities.
With respect to bank holding companies specifically, the supervisory program of the Federal
Reserve has undergone some basic changes. As everyone is aware, many of the financial
firms that lay at the center of the crisis were not bank holding companies; some were not
subject to mandatory prudential supervision of any sort. During the crisis a number of very
large firms became bank holding companies - in part to reassure markets that they were
subject to prudential oversight and, in some cases, to qualify for participation in various
government liquidity support programs. The extension of holding company status to these
firms, many of which are not primarily composed of a commercial bank, highlights the degree
to which the traditional approach to holding company supervision must evolve.
Recent experience also reinforces the value of holding company supervision in addition to,
and distinct from, bank supervision. Large organizations increasingly operate and manage
their businesses on an integrated basis with little regard for the corporate boundaries that
typically define the jurisdictions of individual functional supervisors. Indeed, the crisis has
highlighted the financial, managerial, operational, and reputational linkages among the bank,
securities, commodity, and other units of financial firms.
The customary focus on protecting the bank within a holding company, while necessary, is
clearly not sufficient in an era in which systemic risk can arise wholly outside of insured
depository institutions. Similarly, the premise of functional regulation that risks within a
diversified organization can be evaluated and managed properly through supervision focused
on individual subsidiaries within the firm has been undermined further; the need for greater
attention to the potential for damage to the bank, the organization within which it operates,
and, in some cases, the financial system generally, requires a more comprehensive and
integrated assessment of activities throughout the holding company.
Appropriate enhancements of both prudential and consolidated supervision will only increase
the need for supervisors to be able to draw on a broad foundation of economic and financial
knowledge and experience. That is why we are incorporating economists and other experts
from non-supervisory divisions of the Federal Reserve more completely into the process of
supervisory oversight. The insights gained from the macroeconomic analyses associated
with the formulation of monetary policy and from the familiarity with financial markets derived
from our open market operations and payments systems responsibilities can add enormous
value to holding company supervision.
The recently completed Supervisory Capital Assessment Program (SCAP) heralds some of
the changes in the Federal Reserve's approach to prudential supervision of the largest
banking organizations. This unprecedented process involved, at its core, forward-looking,
cross-firm, and aggregate analyses of the 19 largest bank holding companies, which together
control a majority of the assets and loans within the financial system. Bank supervisors in the
SCAP defined a uniform set of parameters to apply to each firm being evaluated, which
allowed us to evaluate on a consistent basis the expected performance of the firms under
both a baseline and more-adverse-than-expected scenario, drawing on individual firm
information and independently estimated outcomes using supervisory models.
Drawing on this experience, we are prioritizing and expanding our program of horizontal
examinations to assess key operations, risks, and risk-management activities of large
institutions. For the largest and most complex firms, we are creating an enhanced
quantitative surveillance program that 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 impact of
adverse changes in the operating environment on individual firms and on the system as a
whole. This work will be performed by a multi-disciplinary group composed of our economic
and market researchers, supervisors, market operations specialists, and accounting and
legal experts. This program will be distinct from the activities of on-site examination teams so
as to provide an independent supervisory perspective as well as to complement the work of
those teams.
Capital serves as an important bulwark against potential unexpected losses for banking
organizations of all sizes, not just the largest ones. Accordingly, internal capital analyses of
banking organizations must reflect a wide range of scenarios and capture stress
environments that could impair solvency. Earlier this year, we issued supervisory guidance
for all bank holding companies regarding dividends, capital repurchases, and capital
redemptions.4 That guidance also reemphasized the Federal Reserve's long-standing
position that bank holding companies must serve as a source of strength for their subsidiary
banks.
Commercial real estate (CRE) is one area of risk exposure that has gained much attention
recently. We began to observe rising CRE concentrations earlier this decade and, in light of
the central role that CRE lending played in the banking problems of the late 1980s and early
1990s, led an interagency effort to issue supervisory guidance directed at the risks posed by
CRE concentrations. This guidance, which generated significant controversy at the time it
was proposed, was finalized in 2006 and emphasized the need for banking organizations to
incorporate realistic risk estimates for CRE exposures into their strategic- and
capitalplanning processes, and encouraged institutions to conduct stress tests or similar exercises
to identify the impact of potential CRE shocks on earnings and capital. Now that weaker
housing markets and deteriorating economic conditions have, in fact, impaired the quality of
CRE loans at many banking organizations, we are monitoring carefully the effect that
declining collateral values may have on CRE exposures and assessing the extent to which
banking organizations have been complying with the CRE guidance. At the same time, we
have taken actions to ensure that supervisory and regulatory policies and practices do not
inadvertently curtail the availability of credit to sound borrowers.
While CRE exposures represent perhaps an "old" problem, the crisis has newly highlighted
the potential for compensation practices at financial institutions to encourage excessive
risktaking 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. The Federal
Reserve worked closely with other supervisors represented on the Financial Stability Board
to develop principles for sound compensation practices, which were released earlier this
year.5 The Federal Reserve expects to issue soon our own guidance on this important
subject to promote compensation practices that are consistent with sound risk-management
principles and safe and sound banking.
Finally, I would note the importance of continuing to analyze the practices of financial firms
and supervisors that preceded the crisis, with the aim of fashioning additional regulatory tools
that will make prudential supervision more effective and efficient. One area that warrants
particular attention is the potential for supervisory agencies to enlist market discipline in
pursuit of regulatory ends. For example, supervisors might require that large financial firms
maintain specific forms of capital so as to increase their ability to absorb losses outside of a
bankruptcy or formal resolution procedure. Such capital could be in contingent form,
converting to common equity only when necessary because of extraordinary losses. While
the costs, benefits, and feasibility of this type of capital requires further study, policymakers
should actively seek ways of motivating the private owners of banking organizations to
monitor the financial positions of the issuing firms more effectively.
Addressing gaps and weaknesses in the regulatory framework
While the actions that I have just discussed should help make banking organizations and the
financial system stronger and more resilient, the crisis also has highlighted gaps and
weaknesses in the underlying framework for prudential supervision of financial institutions
that no regulatory agency can rectify on its own. One, which I will mention in a moment, has
been addressed by the banking agencies working together. Others require congressional
attention.
Charter conversions and regulatory arbitrage
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 a hope of escaping current or prospective
supervisory actions by the institution's existing supervisor 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 (FDIC) to address such regulatory arbitrage. This
initiative resulted in a recent statement of the Federal Financial Institutions Examination
Council reaffirming that charter conversions or other actions by an insured depository
institution that would result in a change in its primary supervisor should occur only for
legitimate business and strategic reasons.6 Importantly, this statement also provides that
conversion requests should not 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.
Systemically important financial institutions
The Lehman experience clearly demonstrates that the financial system and the broader
economy can be placed at risk by the failure of financial firms that traditionally have not been
subject to the type of consolidated supervision applied to bank holding companies. As I
discussed in my most recent testimony before this Committee, the Federal Reserve believes
that all systemically important financial firms - not just those affiliated with a bank - should
be subject to, and robustly supervised under, a statutory framework for consolidated
supervision like the one embodied in the Bank Holding Company Act (BHC Act).
Doing so would help promote the safety and soundness of these firms individually and the
stability of the financial system generally. Indeed, given the significant adverse effects that
the failure of such a firm may have on the financial system and the broader economy, the
goals and implementation of prudential supervision and systemic risk reduction are
inextricably intertwined in the case of these organizations. For example, while the strict
capital, liquidity, and risk-management requirements that are needed for these organizations
are traditional tools of prudential supervision, the supervisor of such firms will need to
calibrate these standards appropriately to account for the firms' systemic importance.
Industrial loan companies and thrifts
Another gap in existing law involves industrial loan companies (ILCs). ILCs are
statechartered banks that have full access to the federal safety net, including FDIC deposit
insurance and the Federal Reserve's discount window and payments systems; have virtually
all of the deposit-taking powers of commercial banks; and may engage in the full range of
other banking services, including commercial, mortgage, credit card, and consumer lending
activities, as well as cash management services, trust services, and payment-related
services, such as Fedwire, automated clearinghouse, and check-clearing services.
A loophole in current law, however, permits any type of firm - including a commercial
company or foreign bank - to acquire an FDIC-insured ILC chartered in a handful of states
without becoming subject to the prudential framework that the Congress has established for
the corporate owners of other full-service insured banks. Prior to the crisis, several large
firms - including Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley, GMAC,
and General Electric - took advantage of this opportunity by acquiring ILCs while avoiding
consolidated supervision under the BHC Act.
The Federal Reserve has long supported closing this loophole, subject to appropriate
"grandfather" provisions for the existing owners of ILCs. Such an approach would prevent
additional firms from acquiring a full-service bank and escaping the consolidated supervision
framework and activity restrictions that apply to bank holding companies. It also would
require that all firms controlling an ILC, including a grandfathered firm, be subject to
consolidated supervision. For reasons of fairness, the Board believes that the limited number
of firms that currently own an ILC and are not otherwise subject to the BHC Act should be
permitted to retain their nonbanking or commercial affiliations, subject to appropriate
restrictions to protect the federal safety net and prevent abuses.
Corporate owners of savings associations should also be subject to the same regulation and
examination as corporate owners of insured banks. In addition, grandfathered commercial
owners of savings associations should, like we advocate for corporate owners of ILCs, be
subject to appropriate restrictions to protect the federal safety net and prevent abuses.
Strengthening the framework for consolidated supervision
Consolidated supervision is intended to provide a supervisor the tools necessary to
understand, monitor, and, when appropriate, restrain the risks associated with an
organization's consolidated or group-wide activities. Risks that cross legal entities and that
are managed on a consolidated basis cannot be monitored properly through supervision
directed at any one, or even several, of the legal entity subdivisions within the overall
organization.
To be fully effective, consolidated supervisors need the information and ability to identify and
address risks throughout an organization. However, the BHC Act, as amended by the
socalled Fed-lite provisions of the Gramm-Leach-Bliley Act, places material limitations on the
ability of the Federal Reserve to examine, obtain reports from, or take actions to identify or
address risks with respect to both nonbank and depository institution subsidiaries of a bank
holding company that are supervised by other agencies. Consistent with these provisions, we
have worked with other regulators and, wherever possible, sought to make good use of the
information and analysis they provide. In the process, we have built cooperative relationships
with other regulators - relationships that we expect to continue and strengthen further.
Nevertheless, the restrictions in current law still can present challenges to timely and
effective consolidated supervision in light of, among other things, differences in supervisory
models - for example, between the safety and soundness approach favored by bank
supervisors and the approaches used by regulators of insurance and securities subsidiaries
- and differences in supervisory timetables, resources, and priorities. Moreover, the growing
linkages among the bank, securities, insurance, and other entities within a single
organization that I mentioned earlier heighten the potential for these restrictions to hinder
effective group-wide supervision of firms, particularly large and complex organizations. To
ensure that consolidated supervisors have the necessary tools and authorities to monitor and
address safety and soundness concerns in all parts of an organization on a timely basis, we
would urge statutory modifications to the Fed-lite provisions of the Gramm-Leach-Bliley Act.
Such changes, for example, should remove the limits first imposed in 1999 on the scope and
type of information that the Federal Reserve may obtain from subsidiaries of bank holding
companies in furtherance of its consolidated supervision responsibilities, and on the ability of
the Federal Reserve to take action against subsidiaries to address unsafe and unsound
practices and enforce compliance with applicable law.
Limiting the costs of bank failures
The timely closing and resolution of failing insured depository institutions is critical to limiting
the costs of a failure to the deposit insurance fund.7 The conditions governing when the
Federal Reserve may close a failing state member bank, however, are significantly more
restrictive than those under which the Office of the Comptroller of the Currency may close a
national bank, and are even more restrictive than those governing the FDIC's backup
authority to close an insured depository institution after consultation with the appropriate
primary federal and, if applicable, state banking supervisor. The Federal Reserve generally
may close a state member bank only for capital-related reasons. The grounds for which the
OCC or FDIC may close a bank include a variety of non-capital-related conditions, such as if
the institution is facing liquidity pressures that make it likely to be unable to pay its obligations
in the normal course of business or if the institution is otherwise in an unsafe or unsound
condition to transact business. We hope that the Congress will consider providing the
Federal Reserve powers to close a state member bank that are similar to those possessed
by other federal banking agencies.
In view of the number of bank failures that have occurred over the past 18 months and the
resulting costs to the deposit insurance fund, policymakers also should explore whether
additional triggers - beyond the capital ratios in the current Prompt Corrective Action
framework - may be more effective in promoting the timely resolution of troubled institutions
at lower cost to the insurance fund. Capital is a lagging indicator of financial difficulties in
most instances, and one or more additional measures, perhaps based on asset quality, may
be worthy of analysis and consideration.
Conclusion
Thank you for the opportunity to testify on these important matters. We look forward to
working with the Congress, the Administration, and the other banking agencies to ensure that
the framework for prudential supervision of banking organizations and other financial
institutions adjusts, as it must, to meet the challenges our dynamic and increasingly
interconnected financial system.