Daniel K Tarullo: Dodd-Frank Act implementation
Testimony by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 6 June 2012.
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Chairman Johnson, Ranking Member Shelby, and other members of the committee, thank
you for the opportunity to testify on the Federal Reserve's implementation of the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).
As we approach the second anniversary of the Dodd-Frank Act, implementation of the
financial reforms enacted by the Congress remains a formidable task. At the Federal
Reserve, staff teams with a wide range of expertise continue to contribute to Dodd-Frank Act
projects, many as part of joint rule-making efforts with other federal agencies. We have been
working to put final Dodd-Frank Act rules in place and to negotiate and implement
international reforms compatible with various Dodd-Frank Act provisions; these include
enhanced capital requirements for systemically important banks, liquidity requirements,
resolution mechanisms, and margining requirements for over-the-counter derivatives.
As we continue rule implementation and the related international initiatives, we are trying to
provide as much clarity as possible to financial markets and the public about the post-crisis
financial regulatory landscape, and are also taking the time to consider comments and
alternatives carefully. In addition, the Federal Reserve continues to work cooperatively with
other supervisors to ensure that prudential supervision is conducted in a manner that
supports these important reforms.
As a final introductory point, it bears noting that both the Dodd-Frank Act reforms and the
international regulatory reforms share an important feature - a strong focus on the largest,
most complex, and most interconnected financial firms and the systemic risks posed by
those firms. This effort reflects the provenance of both the Dodd-Frank Act and international
reform initiatives, which were motivated largely by the failure or near failure of a number of
major financial firms and the significant public policy problems created by the market
perception that such firms are "too big to fail." As the Federal Reserve implements reforms,
we have maintained this core focus on the largest firms by proposing rules that try to mitigate
the systemic risks posed by those firms and minimize the burden on smaller entities,
particularly community banks. Similarly, we seek to implement reforms in a manner that is
faithful to statutory requirements and that maximizes financial stability and other economic
benefits at the least cost to credit availability and economic growth.
This morning I will briefly describe the Federal Reserve's progress on several important
Dodd-Frank Act rules and recent reforms to the international bank regulatory framework. I
will also describe briefly the Federal Reserve's role in supervising and examining the largest
financial firms in cooperation with other federal and state supervisors.
Enhanced capital standards
While robust bank capital requirements alone cannot ensure the safety and soundness of our
financial system, they are central to good financial regulation precisely because capital is
available to absorb all kinds of potential losses - unanticipated as well as anticipated.
Indeed, the best way to safeguard against taxpayer-funded bailouts in the future is for our
large financial institutions to have capital buffers commensurate with their own risk profiles
and the damage that would be done to the financial system if such institutions were to fail.
Recent events serve to remind us that the presence of substantial amounts of high-quality
capital is the best way to ensure that significant losses at individual firms are borne by their
shareholders, and not by depositors or taxpayers. Ensuring the capital adequacy of financial
firms requires both improvement of the traditional, firm-based approach to capital regulation
and the creation of a more systemic, or macroprudential, component of capital regulation.
With respect to improving the traditional approach to capital regulation, the Federal
Reserve's work has principally involved the development of stronger regulatory capital
standards in cooperation with other supervisors in the Basel Committee on Banking
Supervision. This work includes the so-called Basel 2.5 reforms that strengthened the
market-risk capital requirements of Basel II. This work also includes the Basel III reforms,
which improve the quality of regulatory capital, increase the quantity of required minimum
regulatory capital, require banks to maintain a capital conservation buffer and, for the first
time internationally, introduce a minimum leverage ratio. The Federal Reserve and other U.S.
banking agencies are moving to finalize regulations to implement Basel 2.5 in the United
States and soon will be proposing regulations to implement Basel III.
These significant changes to the international regulatory capital framework have been
supplemented by an important element of the Dodd-Frank Act known as the "Collins
Amendment." The Collins Amendment provides a safeguard against declines in minimum
capital requirements in the Basel II capital regime based on bank internal modeling. The
Federal Reserve and other U.S. banking agencies issued final rules to implement this
provision in June 2011.
Capital surcharges for systemically important financial firms
The recent financial crisis also made clear that the existing international regulatory capital
framework was not sufficiently responsive to macroprudential concerns, such as the threat to
financial stability posed by systemically important financial institutions. Accordingly, in Basel
Committee deliberations, the Federal Reserve advocated for capital surcharges on the
world's largest, most interconnected banking organizations based on their global systemic
importance. Last year, an international agreement was reached on a framework for such
surcharges, to be implemented during the same 2016-2019 transition period for the capital
conservation buffers in Basel III. This initiative is consistent with the Federal Reserve's
obligation under section 165 of the Dodd-Frank Act to impose more stringent capital
standards on systemically important financial institutions, including the requirement that
these additional standards be graduated based on the systemic footprint of the institution.
Both the Dodd-Frank Act provision and the Basel framework are motivated by the fact that
the failure of a systemically important firm would have dramatically greater negative
consequences on the financial system and the economy than the failure of other firms.
Stricter capital requirements on systemically important firms should also help offset any
funding advantage these firms derive from any remaining perceived status as too-big-to-fail
and provide an incentive for such firms to reduce their systemic footprint. The Federal
Reserve's aim has been to fashion the enhanced capital requirements of section 165 and
work toward an associated international framework in a simultaneous and congruent manner.
Stress testing and capital planning
Recent improvements to the regulatory capital framework have important supervisory
complements in the Federal Reserve's development of firm-specific stress testing and capital
planning requirements. These supervisory tools serve two related functions. First, they make
capital regulation more forward-looking by testing whether firms would have enough capital
to remain viable financial intermediaries if they sustained hypothetical losses in asset values
and earnings in an adverse macroeconomic scenario. Second, they contribute to the
macroprudential dimension of supervision by enabling simultaneous examination of the risks
faced by all large financial institutions in a hypothetical adverse economic scenario.
The Dodd-Frank Act creates two forms of stress-testing requirements. These requirements
mirror the Supervisory Capital Assessment Program model, a 2009 effort led by the Federal
Reserve that helped restore confidence in the viability of the banking system during the
financial crisis. First, the act mandates that the Federal Reserve conduct annual stress tests
on all bank holding companies with $50 billion or more in assets to determine whether they
have the capital needed to absorb losses in hypothetical baseline, adverse, and severely
adverse economic conditions. Second, the act requires both these companies and certain
other regulated financial firms with assets between $10 billion and $50 billion to conduct
internal stress tests. The Federal Reserve must publish a summary of results of the
supervisory stress tests and issue regulations requiring firms to publish a summary of the
company-run stress tests.
Regular and rigorous stress testing provides regulators with knowledge that can be applied
to both microprudential and macroprudential supervision efforts. Disclosure of the general
methodology and firm-specific results of our stress testing has additional regulatory benefits.
First, the release of certain details about assumptions, methods, and conclusions exposes
the supervisory approach to greater external scrutiny and discussion. Such discussions will
almost surely help us improve our assumptions and methodology over time. Second,
because bank portfolios are difficult to value without a great deal of detailed information, the
stress test results should be very useful to investors in and counterparties of the largest
banking firms. Further, I believe the demands of supervisors for well-specified data and
projections from firms have improved risk management at these firms. The stress testing that
the Federal Reserve has instituted during the past few years has become an important part
of our horizontal, interdisciplinary approach to supervising the largest bank holding
companies.
Firm-specific capital planning has also become an important supervisory tool. In November
2011, the Federal Reserve issued a new regulation requiring large banking organizations to
submit an annual capital plan. This tool serves multiple purposes. First, it provides a regular,
structured, and comparative way to promote and assess the capacity of large bank holding
companies to understand and manage their capital positions. Second, it provides supervisors
with an opportunity to evaluate any capital distribution plans against the backdrop of the
firm's overall capital position, a matter of considerable importance given the significant
distributions that some firms made in 2007 even as the financial crisis gathered momentum.
Third, at least for the next few years, it will provide a regular assessment of whether large
bank holding companies will readily meet the Basel 2.5 and Basel III capital requirements as
they take effect in the United States.
A stress test is a critical part of the annual capital plan review. But, as these three different
purposes indicate, the capital plan review is about more than using a stress test to determine
whether a firm's capital distribution plans are consistent with remaining a viable financial
intermediary in adverse economic conditions. As indicated during our capital plan reviews in
both 2011 and 2012, the Federal Reserve may object to a capital plan because of significant
deficiencies in a firm's capital planning process, as well as because one or more relevant
capital ratios would fall below required levels under the assumptions of stress and planned
capital distributions. Likewise, the stress test is relevant not only for its role in the capital
planning process. As noted earlier, it also serves other important purposes, not least of which
is increased transparency of both bank holding company balance sheets and the supervisory
process of the Federal Reserve.
Enhanced liquidity standards
As with capital, the financial crisis also brought attention to defects in the liquidity
riskmanagement practices of large financial firms. As seen during the crisis, a financial firm -
particularly one with significant amounts of short-term funding - can become illiquid before it
becomes insolvent, as creditors run in the face of uncertainty about the firm's viability. While
higher levels and quality of capital can mitigate some of this risk, it was widely agreed that
quantitative liquidity requirements should be developed. The Basel Committee generated two
liquidity standards: one, a Liquidity Coverage Ratio (LCR) with a 30-day time horizon; the
other, a Net Stable Funding Ratio (NSFR) with a one-year time horizon. However, insofar as
this was the first-ever effort to specify such requirements, the Governors and Heads of
Supervision of the countries represented on the Basel Committee determined that
implementation of both frameworks should be delayed while they are subject to further
examination and possible revision. As is the case with enhanced capital standards for the
largest banking firms, the Basel Committee's liquidity initiatives are consistent with the
Federal Reserve's obligation under section 165 of the Dodd-Frank Act to impose more
stringent liquidity standards on the largest bank holding companies as well as other
systemically important nonbank financial firms.
The LCR has been actively reconsidered within the Basel Committee over the last year or so.
As this work proceeds, four types of changes appear particularly ripe for consideration. First,
the LCR's definition of high-quality liquid assets should be broadened. In this regard, we
support efforts to move away from the current credit risk-based approach and toward a
quantitative liquidity-based approach. Second, some of the assumptions embedded in the
LCR about run rates of liabilities and the liquidity of assets might be grounded more firmly in
actual experience during the crisis, as the LCR may overstate in particular the liquidity risks
of commercial banking activities. Third, additional consideration needs to be given to the
liquidity risks inherent in trading activities that rely upon large amounts of short-term
wholesale funding. Fourth, the LCR could be better adapted to ensure usability of the
highquality liquid asset buffer in appropriate circumstances: for example, by making credibly clear
that ordinary minimum liquidity levels need not be maintained in the midst of a crisis. As
currently constituted, the LCR may have the unintended effect of exacerbating a period of
stress by forcing liquidity hoarding. The Basel Committee will likely suggest a set of changes
to the LCR later this year, with a goal of introducing the LCR in 2015. Work on the NSFR is
on a considerably slower track; the current plan is for implementation in 2018.
Enhanced prudential standards for the largest financial firms
Sections 165 and 166 of the Dodd-Frank Act require the Federal Reserve to establish a
broad set of enhanced prudential standards, both for bank holding companies with total
consolidated assets of $50 billion or more and for nonbank financial companies designated
by the Financial Stability Oversight Council (Council). In addition to enhanced risk-based
capital and liquidity requirements and stress testing, the required standards also include
single-counterparty credit limits, an early remediation regime, and risk-management and
resolution-planning requirements. Sections 165 and 166 also require that these prudential
standards become more stringent as the systemic footprint of a firm increases.
In December, the Federal Reserve issued a package of proposed rules to implement
sections 165 and 166 of the Dodd-Frank Act. The Federal Reserve's proposed rules would
apply the same set of enhanced prudential standards to covered companies that are bank
holding companies and to covered companies that are nonbank financial companies
designated by the Council. As we made clear in the proposal, however, the Federal Reserve
expects to tailor the application of the enhanced standards to different companies individually
or by category, taking into consideration each company's capital structure, riskiness,
complexity, financial activities, size, and any other risk-related factors that the Federal
Reserve deems appropriate. The comment period for our enhanced prudential standards
proposal closed on April 30. Nearly 100 comment letters were received. The Federal
Reserve is currently reviewing those comments carefully as we work to develop final rules.
The Volcker Rule
Section 619 of the Dodd-Frank Act, commonly known as the "Volcker Rule," generally
prohibits banking entities from engaging in proprietary trading or acquiring an ownership
interest in, sponsoring, or having certain relationships with a hedge fund or private equity
fund. In October, the Federal Reserve joined the Office of the Comptroller of the Currency
(OCC), the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange
Commission in seeking public comment on a proposal to implement the Volcker Rule. The
Commodities Futures Trading Commission issued its substantially similar proposal for
comment shortly thereafter. Because of the importance and complexity of the issues raised
by the statutory provisions that make up the Volcker Rule, the Federal Reserve and other
agencies provided the public with a 120-day opportunity to submit comments. The comment
period is now closed, and nearly 19,000 public comments were received. The agencies are
now working together to review and consider these comments and put final implementing
rules in place as soon as practicable.
In April, after consultation with the other agencies, the Federal Reserve issued guidance on a
Volcker Rule conformance period that was intended to help limit any confusion about when
banking entities will need to comply with the final rules once issued. The Federal Reserve's
statement clarified that a banking entity has the full two-year period provided by the statute
(i.e., until July 21, 2014), unless that period is extended by the Board, to fully conform its
activities and investments to the requirements of the Volcker Rule, including any final
implementing rules adopted by the agencies.
Prudential supervision of large financial firms
In the wake of the Dodd-Frank Act, the prudential supervision of the largest, most complex
financial firms remains a cooperative effort. As before, the law mandates that a variety of
federal and state supervisors execute particular supervisory and examination responsibilities
for certain parts of a firm. This allocation of supervisory oversight among different agencies
reflects, among other factors, the historical development of various types of financial
intermediaries in the United States and a series of legislative decisions about regulatory and
supervisory structure.
As the regulator and supervisor of bank holding companies, the Federal Reserve's role in
this statutory arrangement is typically that of consolidated regulator and supervisor of the
parent holding company. Accordingly, our supervisory program for such firms generally takes
a broad view of the activities, risks, and management of the consolidated firm, with a
particular focus on the capital adequacy, governance, and risk-management practices and
competencies of the firm as a whole.
Many of the principal business activities of the largest financial firms are conducted through
the functionally regulated subsidiaries of those firms, such as insured depository institutions,
broker-dealers, and insurance companies. As required by section 5 of the Bank Holding
Company Act, the Federal Reserve generally relies to the fullest extent possible on the
examination and supervision of those subsidiaries by the functional regulators. Together, the
Federal Reserve and other functional regulators work to discharge the supervisory and
examination responsibility given to each agency for particular parts of a large financial firm in
a way that maximizes the expertise and resources of each agency and best ensures the
safety and soundness of the consolidated firm and each of its constituent parts.
Just as the financial crisis revealed the need for change in the prudential standards
applicable to financial firms and activities, so too did it make clear that important changes in
supervisory practices were needed to improve both the microprudential and macroprudential
oversight of banks and bank holding companies. To that end, even before passage of the
Dodd-Frank Act, the Federal Reserve began to reorient its supervisory structure and
strengthen its supervision of the largest, most complex financial firms.
The most important change has been creation of the Large Institution Supervision
Coordinating Committee (LISCC). The LISCC is founded on several principles: that large
institution supervision should be more centralized; that it should conduct regular,
simultaneous, horizontal (cross-firm) supervisory exercises; and that it should be more
interdisciplinary than it has been in the past. Thus, the LISCC includes senior Federal
Reserve staff from research, legal and other divisions at the Board, from the markets and
payments systems groups at the Federal Reserve Bank of New York, and senior bank
supervisors from the Board and relevant reserve banks. Relative to previous practices, this
approach to supervision relies more on quantitative methods for evaluating the performance
and vulnerabilities of firms.
To date, the LISCC has developed and administered various horizontal supervisory
exercises, notably the capital stress tests and the related comprehensive capital reviews of
the nation's largest bank holding companies, and is now extending its activities to coordinate
other supervisory processes more effectively. It also has focused its attention on potential
implications for financial stability in the United States from stresses arising in Europe.
Review of JPMorgan Chase & Co. trading loss
In response to the significant trading losses that were recently announced by JPMorgan
Chase & Co. (JPMorgan) as a result of trading operations at the London branch of its
national bank, the Federal Reserve - in its capacity as consolidated supervisor of the bank
holding company - is working with the OCC, the regulator of the national bank, to review the
firm's response and remedial actions. In particular, the Federal Reserve has been assisting
in the oversight of JPMorgan's efforts to manage and de-risk the portfolio in question. As this
process proceeds, we anticipate also working with the OCC and FDIC to identify the changes
in risk measurement, management and governance that will be necessary to improve
riskcontrol practices surrounding the firm's trading activities and to address trading strategies
that led to these losses.
In addition, the Federal Reserve has been looking at other parts of the holding company to
determine if governance, risk management and control weaknesses - similar to those
exposed by this incident - are present elsewhere. While we have, to date, found no evidence
that they are, this review is not yet complete.
Conclusion
The recent financial crisis disrupted the financial system and the broader economy on a
scale and scope not seen since the 1930s. Some of the world's largest financial firms
collapsed or required government assistance to stay afloat, sending shock waves through
the highly interconnected global financial system. Asset prices fell sharply, flows of credit to
American families and businesses slowed dramatically, and millions of people lost their jobs.
Extraordinary actions by governments around the world helped to provide stability, but more
than four years after the onset of the crisis, the recovery is far from complete. It is critical that
we complete the implementation of capital and other prudential measures to prevent another
crisis and protect taxpayers from having again to recapitalize financial firms.
Thank you very much for your attention. I would be pleased to answer any questions you
may have.