Ben S Bernanke: Remarks on The Squam Lake Report - fixing the
financial system
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Squam Lake Conference, New York, 16 June 2010.
* * *
The Squam Lake Report - the centerpiece of this conference - is a valuable contribution to
the ongoing analysis of the causes of the financial crisis and the appropriate policy
responses.1 I commend the organizers for bringing together an impressive group of scholars
both to produce the report and to continue the discussion of these important policy issues at
this meeting.
I think we all agree on the key questions facing financial regulators: How do we strengthen
the financial system and its oversight so as to minimize the risk of a replay of the recent
financial crisis? And should a crisis occur, how can we limit its economic costs? The report
identifies two core principles that should be among those that guide us in answering these
questions. First, financial policymakers and supervisors must consider more than the safety
and soundness of individual financial institutions, as important as that is; they should also
consider factors, including interactions of institutions and markets, that can affect the stability
of the financial system as a whole. In the jargon of economists and regulators, supervisors
need a macroprudential as well as a microprudential perspective.
The second core principle put forth in the report is that the stakeholders in financial firms
- including shareholders, managers, creditors, and counterparties - must bear the costs of
excessive risk-taking or poor business decisions, not the public. The perception that some
institutions are "too big to fail" - and its implication that, for those firms, profits are privatized
but losses are socialized - must be ended.
The Federal Reserve strongly agrees with both of these principles, and both have been
important in shaping our views on regulatory reform. We also broadly agree with the
narrative of the crisis offered in the report, which discusses, among other things, the role of
subprime lending in the housing boom and bust; the structural weaknesses in the shadow
banking system, including insufficient transparency and investor overreliance on rating
agencies; inadequate risk management by many financial institutions; and a flawed
regulatory framework that allowed some large financial firms to escape strong consolidated
supervision and gave no regulator the mandate or powers needed to effectively evaluate and
respond to risks to the financial system as a whole. Weaknesses in both the private sector
and the public sector, in the framework for regulation, and in supervisory execution all
contributed to the crisis. The crisis in turn led to a severe tightening of credit, a collapse in
confidence, and a sharp global economic downturn.
The Squam Lake recommendations
What, then, is to be done? The Squam Lake Report provides a substantial set of
recommendations. Among these are the adoption of a more systemic approach to the
supervision and regulation of financial firms and markets; enhanced capital and liquidity
regulation for financial firms, particularly for systemically important institutions; improved
information collection by regulators and, where possible, the public release of such
information; development of a resolution regime that would allow the authorities to manage
the failure of a systemically important financial firm in an orderly manner while imposing
losses on shareholders and creditors; and significant strengthening of the financial
infrastructure, particularly for derivatives contracts. The Federal Reserve has supported
legislative changes in all of these areas, and, where possible under current law, has initiated
changes along these lines within its own operations. In the remainder of my remarks I will
elaborate briefly on these recommendations, with particular attention to how they are
currently helping shape regulatory reform and the Fed's own regulatory and supervisory
activities.
The systemic approach to supervision
The report correctly notes that most financial regulatory systems throughout the world are
designed primarily to ensure the soundness of individual institutions. While this is an
important mission, we agree with the authors of the report that it is not sufficient. The failure
of large, complex, and interconnected financial firms can disrupt the broader financial system
and the overall economy, and such firms should be regulated with that fact in mind. Likewise,
the costs of the failure of critical financial infrastructures, such as payments and settlements
systems, are likely to be much greater and more widely felt than the costs imposed directly
on the owners of and participants in those systems. Regulatory agencies must thus
supervise financial institutions and critical infrastructures with an eye toward overall financial
stability as well as the safety and soundness of each individual institution and system.
Indeed, the crisis has demonstrated that a too-narrow focus on the safety and soundness of
individual institutions or systems can result in a failure to detect and thwart emerging threats
to financial stability that cut across many firms or markets.
A critical building block of a successful systemic, or macroprudential, approach to
supervision is a requirement that all systemically important financial firms be subject to
consolidated supervision. That is, one regulator must be responsible and able to review the
full range of activities of such firms. Before the recent financial crisis, many major financial
firms - including investment banks like Bear Stearns and Lehman Brothers and large
insurance companies like American International Group - were able to avoid robust
comprehensive supervision. In the future, all firms that present systemic risks - regardless of
whether they happen to own an insured depository institution - must be subject to a
common, comprehensive framework of supervision and regulation. The financial reform bills
that were passed in both the House and the Senate would expand and strengthen
consolidated supervision of firms whose failure would pose risks to the financial system.
The report recommends that a single systemic regulator be assigned responsibility for
overseeing the health of the overall financial system and, in particular, that this duty be
assigned to the central bank. We agree that the central bank - in the United States, the
Federal Reserve - should be extensively involved in the collective effort to promote financial
stability. The reasons for this involvement include the central bank's breadth of expertise and
its traditional roles in promoting financial stability and serving as a backstop liquidity provider
to the financial system. However, giving all macroprudential responsibilities to a single
agency risks creating regulatory blind spots, as - in the United States, at least - the skills
and experience needed to oversee the many parts of our complex financial system are
distributed across a number of regulatory agencies. Rather than concentrating all
macroprudential authorities in a single agency, we prefer that all regulators be required to
routinely factor macroprudential considerations into their supervision, thus helping ensure
that risks to financial stability can be addressed wherever they arise.
For similar reasons, we have supported the creation of a Systemic Risk Council made up of
the financial supervisors. Such a council would provide a forum for agencies with differing
responsibilities and perspectives to share information and approaches, and would facilitate
identification and mitigation of emerging threats to financial stability. At the same time,
consistent with the report's recommendation that the lines of accountability for systemic
oversight be clearly drawn, we believe the council should not be directly involved in
rulewriting and supervision. Rather, those functions should remain with the relevant supervisors,
with the council in a coordinating role.
Even as the legislative process moves forward, at the Federal Reserve we have already
taken a number of steps to reorient and strengthen our supervision of the largest, most
complex financial firms that we oversee and to broaden our field of vision to incorporate
macroprudential concerns. For example, in my view a critical feature of a successful
systemic approach to supervision is a multidisciplinary perspective. Our experience a year
ago with the Supervisory Capital Assessment Program, or the SCAP (popularly known as the
bank stress tests), demonstrated the feasibility and benefits of employing such a perspective.
We are working to ensure that our supervision of large banking organizations and financial
market utilities makes use of the wide range of skills of Federal Reserve staff, including those
of economists, financial market specialists, payments systems experts, accountants, and
others, as well as bank supervisors. The SCAP also showed how much can be learned by
simultaneous evaluations and comparisons of the practices and portfolios of different firms,
rather than focusing on only one firm at a time, as was the supervisory approach often taken
in the past. Thus, we are increasing our use of cross-firm, horizontal examinations. And we
are implementing a quantitative surveillance mechanism and enhanced data collection to
further strengthen our supervision of systemic firms.
Enhanced capital and liquidity regulation
As the report notes, minimizing the risk of future financial crises will require tougher
prudential standards for financial firms, especially systemically important financial firms, as
well as more intensive supervision. Stronger capital and liquidity standards and
morestringent risk-management requirements for larger and more interconnected firms are
necessary to reduce the probability that a systemic firm will experience financial distress and
so harm the financial system and the economy. Enhanced prudential standards for the
largest firms should also reduce the incentive of firms to grow or otherwise expand their
systemic footprint in order to become perceived as too big to fail.
At the Federal Reserve, we are already working both domestically and internationally to
increase the quantity and quality of regulatory capital that banks are required to hold, to
better link capital standards to the risks that banks face, and to reduce the pro-cyclicality of
the regulatory capital and accounting frameworks. All of these changes will enable firms to
better withstand adverse systemwide shocks. To be sure, reasonable transition periods will
be necessary to allow banks to meet these more demanding standards without unduly
constricting credit or endangering the recovery.
In addition to enhanced capital standards, we are also working with domestic and
international colleagues on toughening liquidity requirements. A prominent feature of the
crisis was the inadequate liquidity risk-management practices of some major financial firms.
Some firms, notably the independent investment banks, relied excessively on volatile,
wholesale, short-term funding sources and were overly exposed when those funding markets
were disrupted. To better prevent excessive levels of liquidity risk, major financial firms
should be subject to explicit, internationally consistent liquidity standards.
Systemically important firms also should be subject to stronger risk-management standards,
supported by high-quality management information systems. In addition, supervisors should
require major financial firms to structure their incentive compensation programs to promote
long-term financial performance and avoid excessive risk-taking.
An improved information infrastructure
Both regulation and market discipline have important roles to play in constraining risk-taking
in financial markets; the best outcomes are achieved when these two forms of oversight work
effectively together. The report recommends a better system of data collection and
aggregation to enhance this partnership. Better data collection would enable regulators to
more accurately assess and compare risks across firms, markets, and products. A regulatory
requirement to track and report timely, consistent, and fully aggregated data on risk
exposures could also promote better risk management by the firms themselves. And
increased public disclosure of such data would provide investors and analysts with a more
complete picture of individual firms' strengths and vulnerabilities, as well as of potential risks
to the system as a whole, thereby facilitating more effective market discipline.
Consistent with this recommendation, and in preparation for possible changes in the
regulatory framework, the Federal Reserve is expanding its already-extensive commitment to
the collection and analysis of financial data. For example, efforts are under way to construct
better measures of counterparty credit risk and interconnectedness among systemically
critical firms. In particular, to better identify potential channels of financial contagion,
supervisors are working to improve their understanding of banks' largest exposures to other
banks, nonbank financial institutions, and corporate borrowers. We are also collecting data
on banks' trading and securitization exposures, as well as their liquidity risks, as part of an
internationally coordinated effort to improve regulatory standards in these areas. Importantly,
attention is being paid not only to the risks to individual firms, but also to potential systemic
risks arising from firms' common exposures or sensitivity to common shocks.
Resolution regime
A clear lesson from the events of the past few years - and a recommendation in the report
with which we strongly agree - is that the government must not be forced to choose between
the unattractive alternatives of bailing out a systemically important firm or having it fail in a
disorderly and disruptive manner. The government instead must have the tools to resolve a
failing firm in a manner that preserves market discipline - by ensuring that shareholders and
creditors incur losses and that culpable managers are replaced - while at the same time
cushioning the broader financial system from the possibly destabilizing effects of the firm's
collapse. Having a method to resolve failing firms safely is necessary if commitments to allow
failure are to be credible, which in turn is essential to reverse the perception that some firms
are too big to fail.
The financial reform legislation in both the House and the Senate would provide for such a
resolution regime. In both versions, the Federal Deposit Insurance Corporation would be
given the authority to manage the resolution of systemically important nonbank financial
institutions in a manner broadly similar to the authority it uses for banks under current law. As
noted in the report, a key challenge would be fostering the international cooperation needed
to manage the cross-border aspects of such a resolution regime.
To help ensure the efficacy of this resolution authority, the financial reform legislation under
consideration in the Congress usefully requires each systemically important financial firm to
prepare a "living will" that sets out a plan for winding down the firm's operations in an orderly
manner - another recommendation in the report. The creation and supervisory review of
these plans would require firms and their regulators to confront the difficulties posed by
complex legal structures well in advance of the firm's financial distress, and in some cases
could lead firms to simplify their internal structures. While these contingency plans might not
actually serve as templates for the resolution of firms that reach the brink of failure, the
preparation and periodic review of the plans could be a valuable supervisory tool in preparing
firms to withstand distress.
Financial infrastructure
The report also addresses the importance of a strong financial market infrastructure that
includes well-functioning and appropriately regulated central counterparties. Strong
infrastructure helps reduce systemic risk and guards against contagion in times of stress; by
contrast, weak infrastructure can increase risk and spawn contagion.
The Federal Reserve has long supported efforts to improve the infrastructure for the clearing
and settlement of derivatives. For example, the Federal Reserve Bank of New York was a
leader in improving the documentation, settlement, and transparency of credit default swaps.
The Federal Reserve has also encouraged the development of industry warehouse utilities
for the collection of trade information on derivatives.
Although individually customized derivatives still have an important place in the financial
marketplace, we believe that systemic risk can be reduced in derivative markets by
increasing the standardization of contracts and by requiring standardized derivatives to be
cleared through well-regulated central counterparties. In addition, it is also critical that
relevant financial regulators have access to detailed information on the derivatives markets
- including both standardized and customized transactions - so that they can assess the
extent to which derivatives trades might concentrate risk or transmit localized or regional
shocks throughout the financial system.
The market for repurchase agreements, or repos, also played a prominent role in transmitting
risk during the crisis. The Federal Reserve is working to improve the infrastructure
arrangements in the triparty repo market and is exploring what other steps should be taken to
improve the stability of this key funding market.
Given the important role played by financial market infrastructures, we support the current
legislative provisions that would help ensure that payment, clearing, and settlement systems
- including central counterparties - are subject to robust and consistent risk-management
standards and do not pose dangers to the financial system as a whole.
Status of legislation
The Congress has made significant progress in each of the substantive areas I have
discussed today as well as many others. Indeed, it appears that final legislation that
addresses in some way the great majority of the recommendations in The Squam Lake
Report could be enacted in the next few weeks. Like you, we will be following legislative
developments closely as we continue to plan for and implement reform.
Once again, I appreciate the valuable contribution this group has made to articulating an
intellectual framework for transforming the lessons of the recent financial crisis into practical
recommendations. I look forward to discussing these issues with many of you in the future.