Daniel K Tarullo: International cooperation to modernize financial
regulation
Testimony of Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, before the Subcommittee on Security and International Trade and Finance,
Committee on Banking, Housing, and Urban Affairs, Washington DC, 30 September 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Chairman Bayh, Ranking Member Corker, and other members of the Subcommittee, I
appreciate the opportunity to testify today on the role of international cooperation in
modernizing financial regulation. International cooperation is important for the interests of the
United States because, as has been graphically illustrated in the past two years, financial
instability can spread rapidly across national boundaries. Well-devised international financial
regulatory standards can help encourage all nations to maintain effective domestic regulatory
systems. Coordinated international supervisory arrangements can help ensure that every
large, internationally active financial institution is effectively supervised. Both these forms of
international cooperation can, at the same time, promote at least a roughly equivalent
competitive environment for U.S. financial institutions with those from other nations.
In my testimony this afternoon, I will review the responses of key international regulatory
groups to the financial crisis, including both substantive policy responses and the
organizational changes in membership and working methods in some of those groups. Next I
will describe specifically the role of the Federal Reserve's participation and priorities in these
international regulatory groups. I will conclude with some thoughts on the challenges for
international regulatory cooperation as we move forward from the G-20 Pittsburgh Summit
and the exceptionally active international coordination process that has preceded it.
The response of international regulatory groups to the crisis
Over the past few decades, international cooperation in financial regulation has generally
been pursued in a number of groups that bring together national authorities with
responsibility for regulating or supervising in a particular area, or that served as venues for
informal discussion. Several of the functional regulatory groups have undertaken initiatives in
response to the recent financial crisis. During this period, the Financial Stability Board (FSB)
shifted from being more of a discussion forum to serving as a coordinator of these initiatives.
The FSB was also the direct line of communication between these groups and the G-20.
The Federal Reserve actively participates in the FSB as well as in the following international
groups:
- In the Committee on Payment and Settlement Systems, we work with other central
banks to promote sound and efficient payment and settlement systems.
- In the Committee on the Global Financial System, we work with other central banks
to monitor developments in global financial markets, reporting to the central bank
governors of the G-10 countries.
- In the Basel Committee on Banking Supervision (Basel Committee), we and the
other U.S. bank supervisors work with other central banks and bank supervisory
agencies to promote sound banking supervision by developing standards for bank
capital requirements and bank risk management, and by promulgating principles for
effective bank supervision. The Basel Committee, which doubled its membership
earlier this year, now includes supervisors from 27 jurisdictions, including both
advanced and emerging markets.1
- In the Joint Forum, we and other U.S. financial regulators - including bank,
securities, and insurance regulators - work with financial regulators from other
countries to enhance financial regulation that spans different financial sectors.
- In the Senior Supervisors Group, we and other U.S. supervisors have worked over
the past few years with the supervisors of other major financial firms to share
information and sponsor joint reviews of risk management and disclosure.
- In bilateral and regional supervisory groups, we have discussed regulatory issues
with Europe, China, India, Japan and other supervisors from the Western
Hemisphere.
Some of these groups have quite a long history. Both the Committee on the Global Financial
System and the Basel Committee date back to the 1970s. These groups are not formal
international organizations. They have operated with only a modest support staff - often
provided, along with a location for meetings, by the Bank for International Settlements (BIS).
The bulk of their activity is conducted by officials from the national regulators themselves.
The FSB is a relatively new group, established in the wake of the Asian financial crisis in
1999 as the Financial Stability Forum, with a broad mandate to promote global financial
stability. The FSB is an unusual combination of international standard-setting bodies
(including those mentioned above) and a range of national authorities responsible for
financial stability: treasury departments and ministries of finance, central banks, and financial
supervisory agencies.2 Major international organizations such as the BIS and the
International Monetary Fund (IMF) also participate.3 At the request of the G-20 in April 2009,
the Financial Stability Forum's name was changed to the Financial Stability Board, its
membership was expanded to add the emerging market countries from the G-20, and its
mandate was strengthened.
The financial crisis has underscored the importance of the original motivation for creating
what is now the FSB. The connections among financial market sectors, and between
macroeconomic policy and financial markets, mean that efforts to ensure international
financial stability must incorporate a breadth of perspectives and include communication
among the various international groups in which regulatory cooperation takes place. In its
work to increase international financial stability and to promote financial regulatory reform,
the FSB has tried to identify priorities and agree upon high-level principles. It has then
requested that the relevant standard-setting bodies formulate detailed proposals and report
back to the FSB.
All these international groups, including the FSB, operate by consensus. Although this
institutional feature can create significant challenges in reaching agreement on complex
1
The Basel Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France,
Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands,
Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and
the United States.
2
International standard-setting bodies participating in the FSB are the Basel Committee, the Committee on the
Global Financial System, the Committee on Payment and Settlement Systems, the International Association of
Insurance Supervisors, the International Accounting Standards Board, and the International Organization of
Securities Commissions.
The jurisdictions represented on the FSB are: Argentina, Australia, Brazil, Canada, China, France, Germany,
Hong Kong SAR, India, Indonesia, Italy, Japan, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore,
South Africa, South Korea, Spain, Switzerland, Turkey, the United Kingdom, and the United States.
3
International organizations in the FSB are the BIS, the European Central Bank, the European Commission,
the IMF, the Organisation for Economic Co-operation and Development, and The World Bank.
BIS Review 118/2009
topics, it also serves as a check on potentially undesirable policy directions. The process of
developing proposals in the standard-setting bodies allows a variety of ideas to be explored
and exposed to critical examination by expert staff. Like any other process, alternative
viewpoints emerge and dissenting opinions are voiced. Once a consensus is reached, it is
then up to individual members to implement any statutory changes, administrative rules, or
guidance under local law.
As already noted, the FSB has played a leading role in guiding the official response to the
crisis. In April 2008, it made a range of recommendations to increase the resiliency of
financial markets and institutions. These recommendations are broadly consistent with
similar principles articulated by the President's Working Group on Financial Markets here in
the United States. The FSB has acted upon priorities identified by the G-20 leaders and has
delivered to those leaders a series of proposals that have been adopted by them, most
recently at the Pittsburgh summit last week. With its role now expanded and in the process of
being formalized in a charter, the FSB will have the ongoing mandate of identifying and
addressing emerging vulnerabilities in the financial system.
The activities of some other groups have also broadened in response to the crisis. The Basel
Committee was formed in 1974 in an effort by national authorities to fill supervisory gaps
exposed by problems in a number of internationally active banks. Beginning in the late
1980s, its focus shifted to setting capital standards for internationally active banks. That
emphasis continues today, notably with respect to strengthening capital requirements for
securitization exposures and trading book exposures as well as disclosure requirements
related to these areas. The Basel Committee has now begun to address a wider range of
issues aimed at improving standards for capital, liquidity, cross-border bank resolution,
leverage, and macroprudential supervision.
In March 2008, the Senior Supervisors Group released its first report on risk-management
practices.4 The report, based on extensive discussions with large financial institutions,
provided near-real-time analysis of the major failures in risk management and internal
controls that led to outsized losses at a number of firms, and highlighted distinctions in
practices that may have enabled some other institutions to better withstand the crisis. The
group is now in the final phases of preparing a second report that will focus on the
challenges that emerged as particularly critical last year, notably related to management of
liquidity risk, and present the results of the self-assessments by the largest financial
institutions regarding their responses to the risk-management and internal control issues
highlighted by the crisis.
International regulatory and supervisory bodies have been actively engaged in addressing a
wide range of issues, many of which have been highlighted by the recent financial crisis. Let
me now discuss in more detail a few of the areas that are most important from the
perspective of the Federal Reserve.
Capital
The financial crisis has left little doubt that capital levels of many financial firms, including
many in the United States, were insufficient to protect them and the financial system as a
whole. The FSB has called for significantly stronger capital standards, to be agreed upon
now and phased in as financial and economic conditions improve. The communiqué issued
Friday by the G-20 leaders echoed and amplified the need for improvements in both the
quantity and quality of capital.
One critical area for improvement is that of increasing capital requirements for many forms of
traded securities, including some securitized assets. Some work has already been
completed. We place a high priority on undertaking a comprehensive review and reform of
these requirements. The Basel Committee is also working on proposals for an international
leverage ratio to act as a supplement to risk-based capital ratios. The FSB has also devoted
considerable energies to exploring sources of procyclicality in the financial system, which are
those practices and structures that tend to amplify rather than dampen the cycles
characteristic of financial markets, and to identifying possible strategies to reduce their
effects, which were often quite visible during the recent crisis. One such strategy is to include
a countercyclical capital buffer in the capital requirements for financial firms. Work on such a
buffer is under way, though the technical challenges of devising an effective buffering
mechanism are significant.
It will be important for the international regulatory community to carefully calibrate the
aggregate effect of these initiatives to ensure that they protect against future crises while not
raising capital requirements to such a degree that the availability of credit to support
economic growth is unduly constrained. The Basel Committee plans a study of the overall
calibration of these changes for early next year.
Liquidity
Liquidity risk is another key international agenda item. Although the Basel Committee had
historically focused on capital standards, the crisis clearly demonstrated that adequate
capital was a necessary but not always sufficient condition to ensure the ability of a financial
institution to withstand market stress. We were reminded that the liquidity of a firm's assets is
critical to its ability to meet its obligations in times of market dislocation. In particular, access
to wholesale financing very quickly became severely constrained for many institutions that
had grown quite dependent on it. The Basel Committee promulgated general guidance on
liquidity risk management in June 2008 and is now in the process of incorporating those
broad principles into specific quantitative requirements.
Cross-border bank resolution
In the area of cross-border resolution authority, there is broad international agreement that
existing frameworks simply do not allow for the orderly resolution of cross-border failures of
large complex banking organizations and that changes are needed. Current frameworks
focus on individual institutions rather than financial groups or the financial systems at large.
These frameworks have proven problematic even at the national level. Policy differences and
legal obstacles can magnify these shortcomings at the international level.
The Basel Committee's Cross-Border Bank Resolution Group has developed 10
recommendations for national authorities.5 The recommendations, which aim at greater
convergence of national resolution frameworks, should help strengthen cross-border crisis
management. One key recommendation requires systemically important firms to have
contingency plans that will allow for an orderly resolution should that prove necessary.
Implementation of these recommendations is likely to require heightened cooperation
throughout the international community.
Accounting standards for financial institutions
The FSB and the Basel Committee have an important role in supporting improved accounting
standards for financial institutions. For example, the FSB has developed recommendations
for improving the accounting for loan loss provisions. The Basel Committee consults
frequently with those who set international accounting standards on these and other topics
and provides comments on important accounting proposals affecting financial institutions.
Future initiatives
A number of other initiatives are at an earlier stage of policy development. A good deal of
attention right now is focused on mitigating the risks of systemically important financial firms.
Two of the more promising ideas are particularly worth mentioning. One is for a requirement
for contingent capital that converts from debt to equity in times of stress or for comparable
arrangements that require firms themselves to provide for back-up sources of capital. The
other is for a special capital or other charge to be applied on firms based on their degree of
systemic importance. Many of these initiatives still require much work at the technical level
before policy proposals will be ready for a thorough vetting in the national and international
regulatory community.
How the Federal Reserve pursues our objectives in international groups
The Federal Reserve promotes U.S. interests in these international groups by actively
participating and by coordinating with other U.S. participants.
The international groups that I mentioned earlier all hold regular meetings. The FSB meets at
least twice a year, and the Basel Committee typically meets four times a year. Between
meetings of the main groups, subgroups of technical experts meet to discuss proposals and
lay the groundwork for issues to be discussed at the main groups. The Federal Reserve
actively participates in both the main groups and the subgroups. For practical purposes, not
all members of a group can sit on each subgroup, although the United States is well
represented on all major topics and chairs important subgroups.
We have found that success in pursuing our objectives in these groups depends upon having
well-developed ideas. One important basis for leadership in international groups is the quality
of the intellectual and policy contributions that an organization can offer. To this end, we
have tried to use the extensive economic and research resources of the Federal Reserve, as
well as our regulatory experience, to produce well-considered proposals and useful feedback
on the proposals of others.
International groups operate on the basis of consensus. Policies are endorsed only when all
members voice their support. This approach can make it challenging to come to agreement
on complex topics. But international groups are made up of regulatory agencies or central
banks, and they have particular responsibilities based on their own national laws.
International groups are not empowered to create enforceable law, and agreements need to
be implemented by member countries in the form of statutory changes, administrative rules,
or supervisory guidance. Thus, the consensus orientation of the international policy
development process is necessary to respect the domestic legal structures within which the
various regulatory agencies operate.
The President's Working Group on Financial Markets is the primary forum in which regulatory
issues are discussed among the principals of the U.S. financial regulatory agencies. These
discussions often cover the same issues being discussed in international groups. We strive
to maintain a degree of intellectual rigor and collegiality in these discussions where
consensus is again the norm, despite the sometimes different perspectives of the various
agencies. In the past, there were some notable instances of significant disagreement among
the U.S. agencies, but my observation since being appointed to the Federal Reserve is that
the coordination process is working quite well. Indeed, it can sometimes be an advantage to
have multiple U.S. agencies involved in international processes because of the
complementary expertise we each bring to bear. In addition, at the international level, having
multiple U.S. agencies at the table provides an appropriate counterweight to our European
counterparts, who for historical reasons are usually overrepresented in international groups
relative to their weight in the global financial system.
Like other central banks, the Federal Reserve did not participate in the G-20 summit, which
is attended by heads of state and finance ministers. However, we are involved in a significant
part of the relevant preparatory and follow-up work, both through the FSB and in joint
meetings of the G-20 finance ministers and central banks.6 In preparation for the Pittsburgh
summit, as well as for the previous G-20 summits in London and Washington, the Federal
Reserve has also collaborated with other U.S. financial regulatory agencies in considering
the financial regulatory issues on the agendas for these meetings.
Challenges for international financial cooperation
The testimony that my colleagues and I have offered this afternoon reflects the breadth and
depth of the tasks associated with improved regulation and supervision of financial markets,
activities, and firms. An ambitious agenda has been developed through the interactions of
the G-20, the FSB, and international standard-setting bodies, and much work toward
completing that agenda is already under way. At the same time, there will inevitably be
challenges as we all intensify and reorient the work of these groups. I will now discuss four of
those challenges.
First, for all the virtues of the consensus-based approach involving the relevant national
authorities, some subjects will simply be very difficult to handle fully in this fashion.
Crossborder resolution may prove to be one such issue. Although there is undoubtedly potential for
achieving improvement in the current situation through the international processes I have
described, the complexities involved because of the existence of differing national
bankruptcy and bank resolution laws may limit what can be achieved.
Second, there will likely be a period of working out the relationships among the various
international bodies, particularly in light of the increased role of the FSB. We will need to
determine how extensively the FSB and its newly constituted committees should themselves
develop standards, particularly where an existing international standards-setting body has
the expertise and mandate to address the topic. Similarly, while simultaneous consideration
of the same issue in multiple international bodies can sometimes be a useful way to develop
alternative proposals, there may also be potential for initiatives that are at odds with one
another.
Third, the significant expansion in membership of many of the more important of these
bodies may require some innovation in organizational approaches in order to maintain the
combination of flexibility and effectiveness that the FSB and some of the other groups have,
at their best, possessed in the past. The substitution of the G-20 for the G-8 at the level of
heads of government is the most visible manifestation of the salutary trend toward involving a
number of emerging market economies in key international financial regulatory
arrangements. As I mentioned earlier, the FSB and the Basel Committee have recently
expanded their membership to the entire G-20. Important as this expansion is for the goal of
global financial stability, the greater number of participants does have an impact upon the
operation of those groups, and we will need to adapt accordingly. I hasten to add that this is
not at all a comment on the capacities of the new members. On the contrary, I have been
impressed with the quality of the participation from the new emerging market members.
Finally, the financial crisis has understandably concentrated the attention and energies of
many of these international regulatory groups on the new standards that will be necessary to
protect financial stability in the future. Combined with the enlarged memberships of these
groups, however, this focus on negotiating standards may unintentionally displace some of
the traditional attention to fostering cooperative supervisory practices by the national
regulators who participate in these international bodies. It is important that, even as we
represent our national interests in these bodies, we also promote the shared interests we
have in effective financial supervision.
Conclusion
Participating in international regulatory groups has helped the Federal Reserve and other
U.S. agencies begin to shape an effective global regulatory response to the financial crisis.
We look forward to continuing our collaboration in pursuit of effective, efficient financial
regulation.
Thank you for inviting me to present the Board's views on this very important subject. I look
forward to continuing dialogue with the subcommittee on these issues. I would be pleased to
answer any questions you may have.