Ben S Bernanke: Financial regulation and supervision after the crisis -
the role of the Federal Reserve
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Boston 54th Economic Conference,
Chatham, Massachusetts, 23 October 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The theme of the Federal Reserve Bank of Boston's Economic Conference this year -
reevaluating regulatory, supervisory, and central banking policies in the wake of the crisis -
is certainly timely. Not much more than a year ago, we and our international counterparts
faced the most severe financial crisis since the Great Depression. Fortunately, forceful and
coordinated policy actions averted a global financial collapse, and since then, aided by a
range of government programs, financial conditions have improved considerably. However,
even though we avoided the worst financial and economic outcomes, the fallout from the
crisis has nonetheless been very severe, as reflected in the depth of the global recession
and the deep declines in employment both here and abroad. With the financial turmoil
abating, now is the time for policymakers to take action to reduce the probability and severity
of any future crises.
Although the crisis was an extraordinarily complex event with multiple causes, weaknesses
in the risk-management practices of many financial firms, together with insufficient buffers of
capital and liquidity, were clearly an important factor. Unfortunately, regulators and
supervisors did not identify and remedy many of those weaknesses in a timely way.1
Accordingly, all financial regulators, including of course the Federal Reserve, must take a
hard look at the experience of the past two years, correct identified shortcomings, and
improve future performance.
Supervisors in the United States and abroad are now actively reviewing prudential standards
and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal
Reserve is participating in a range of joint efforts to ensure that large, systemically critical
financial institutions hold more and higher-quality capital, improve their risk-management
practices, have more robust liquidity management, employ compensation structures that
provide appropriate performance and risk-taking incentives, and deal fairly with consumers.
On the supervisory front, we are taking steps to strengthen oversight and enforcement,
particularly at the firmwide level, and we are augmenting our traditional microprudential, or
firm-specific, methods of oversight with a more macroprudential, or systemwide, approach
that should help us better anticipate and mitigate broader threats to financial stability.
Although regulators can do a great deal on their own to improve financial regulation and
oversight, the Congress also must act. We have seen numerous instances when
weaknesses and gaps in the regulatory structure itself contributed to the crisis, many of
which can only be addressed by statutory change. Notably, to promote financial stability and
to address the extremely serious problem posed by firms perceived as "too big to fail,"
legislative action is needed to create new mechanisms for oversight of the financial system
as a whole; to ensure that all systemically important financial firms are subject to effective
consolidated supervision; and to establish procedures for winding down a failing,
systemically critical institution without seriously damaging the financial system and the
economy. In the rest of my remarks, I will elaborate on each of these areas.
Strengthening regulations and guidance
First, I would like to report on changes already under way to strengthen the regulatory
standards that limit the risks taken by financial firms and establish the capital and liquidity
buffers that they must hold. Through the course of the crisis, it became increasingly clear that
many firms lacked adequate capital and liquidity to protect themselves as well as the
financial system as a whole. These problems became apparent not just in the United States
but around the world, necessitating an internationally coordinated response. The Federal
Reserve has played a key part in the international effort, working through organizations such
as the Basel Committee on Bank Supervision and the Financial Stability Board. For example,
we were extensively involved in the Basel Committee's recent decisions to strengthen capital
requirements for trading activities and securitizations, and we continue to work with domestic
and foreign supervisors to raise capital requirements for other types of on- and
off-balancesheet exposures.2
By conducting the Supervisory Capital Assessment Program, popularly known as the stress
test, U.S. supervisors took a significant step toward ensuring that our banks hold adequate
levels of high-quality capital.3 Led by the Federal Reserve, the program evaluated the capital
needs of 19 of the largest U.S. banking organizations by estimating their expected losses
and earnings capacity through the end of 2010 under a more-adverse-than-expected
macroeconomic scenario. Firms that were not projected to have enough high-quality capital
under this scenario were required to raise additional capital within six months. The release of
the assessment results last spring increased investor confidence in the banking system and
helped open the public equity markets to these institutions. Since January 1, the 19
participating firms have raised more than $150 billion of incremental Tier 1 common equity,
primarily through share issuances, exchanges, and asset sales, increasing their average Tier
1 Common ratios from 5.3 percent at the end of last year to 7.5 percent on June 30 of this
year.4 As one indication of improved market confidence in those firms, their subordinated
debt spreads have fallen by nearly one-half since the completion of the assessment.
Additional steps are necessary to ensure that all banking organizations hold adequate
capital. Internationally, the Financial Stability Board has called for significantly stronger
capital standards, and the Group of Twenty has committed to develop rules to improve both
the quantity and quality of bank capital.5 The Federal Reserve supports these initiatives. The
structure of capital requirements should also be reviewed. For example, to reduce the
tendency of current capital requirements to promote credit growth in booms and to restrict
credit during downturns, the Federal Reserve has supported international efforts to develop
capital standards that would be countercyclical. Countercyclical standards would require
firms to build larger capital buffers in good times and allow them to be drawn down - but not
below prudent levels - during more-stressed periods. We also are working with our domestic
and international counterparts to develop capital and prudential requirements that take
account of the systemic importance of large, complex firms whose failure would pose a
significant threat to overall financial stability. Options under consideration include assessing
a capital surcharge on these institutions or requiring that a greater share of their capital be in
the form of common equity. For additional protection, systemically important institutions could
be required to issue contingent capital, such as debt-like securities that convert to common
equity in times of macroeconomic stress or when losses erode the institution's capital base.
The crisis also highlighted weaknesses in liquidity management by major firms. Short-term
secured funding of long-term, potentially illiquid assets - through repurchase agreements
and asset-backed commercial paper conduits, for example - became unavailable or
prohibitively costly during the worst phases of the crisis, both here and abroad. In response,
the Federal Reserve helped lead the Basel Committee's development of revised principles
for sound liquidity risk management, which in the United States are being incorporated into
new interagency guidance that reemphasizes the importance of rigorous stress testing to
determine adequate liquidity buffers.6 Together with our domestic and international
counterparts, we are also considering quantitative standards for liquidity exposures similar to
those for capital adequacy, with the goal of ensuring that internationally active firms can fund
themselves even during periods of severe market instability. With supervisory
encouragement, large banking organizations have, for the most part, already significantly
increased their liquidity buffers and are strengthening their management of liquidity risk.
In addition to insufficient capital and inadequate liquidity risk management, flawed
compensation practices at financial institutions also contributed to the crisis. Compensation,
not only at the top but throughout a banking organization, should appropriately link pay to
performance and provide sound incentives. In particular, compensation plans that
encourage, even inadvertently, excessive risk-taking can pose a threat to safety and
soundness. The Federal Reserve has just issued proposed guidance that would require
banking organizations to review their compensation practices to ensure they do not
encourage excessive risk-taking, are subject to effective controls and risk management, and
are supported by strong corporate governance including board-level oversight.7
A fundamental element of effective financial regulation is protecting consumers from unfair
and deceptive practices. The recent crisis clearly illustrated the links between consumer
protection and the safety and soundness of financial institutions. We have seen that flawed
financial instruments can both harm families and impair financial stability. Strong consumer
protection helps to preserve household savings and to provide families access to credit on
terms that are fair and well matched with their financial needs and resources. At the same
time, effective consumer protection promotes healthy competition in the financial
marketplace, supports sound lending practices, and increases confidence in the financial
system as a whole.
The Federal Reserve has taken several important steps to strengthen the protections
provided consumers and ensure that these protections effectively respond to market
changes and emerging risks. As well-informed consumers are better able to make decisions
in their own best interest, effective disclosures are the first line of defense against improper
lending. The Federal Reserve has pioneered the use of extensive consumer testing to
improve the clarity of disclosures, notably for mortgages and credit cards. However, we have
learned that even the best disclosures may not always sufficiently protect consumers from
unfair practices. Accordingly, we have written rules providing strong substantive protections
for mortgage borrowers and credit card users. For example, last year the Board adopted new
regulations under the Home Ownership and Equity Protection Act to better protect
consumers with higher-priced mortgages. These rules strengthen underwriting, restrict
prepayment penalties, and require escrow accounts for property taxes and insurance. The
rules also address deceptive mortgage advertisements and unfair practices related to real
estate appraisals and mortgage servicing. More recently, the Board adopted new credit card
rules to increase transparency and protect consumers from a variety of unfair and deceptive
acts and practices, rules that were largely incorporated into subsequent legislation. We are
currently working on rulemakings in the areas of overdraft protection, reverse mortgages,
and gift cards.
Making supervision more effective
Let me turn from regulation (the development of rules and standards that govern banks'
practices) to supervision (ongoing oversight and enforcement to ensure that the rules are
being followed). As I noted earlier, the events of the past two years revealed serious failures
in risk management at regulated financial firms that, in turn, underscored the need for
supervisors to identify weaknesses in a more timely way and to more effectively ensure
financial institutions remedy the problems. The nature and causes of these failures have
been outlined in reports issued by a variety of domestic and international groups in which we
participate.8 As a complement to those efforts, we at the Federal Reserve set up a number of
working groups, drawing on expertise from throughout the Federal Reserve System, to
evaluate all aspects of our oversight of banking organizations and to develop strategies to
improve the quality of our supervision.
Two important themes have emerged from these efforts. First, they have reaffirmed the
importance of effective consolidated supervision, particularly at large, complex organizations,
so that supervisors can properly understand risks and exposures that cross legal entities and
business lines. Second, we must combine a systemwide, or macroprudential, perspective
with firm-specific risk analysis to better anticipate problems that may arise from the
interactions of firms and markets. To support these approaches, we are strengthening our
supervisory processes to include analyses that draw on multiple disciplines, updated
surveillance tools, and more timely information so that supervisors can identify emerging
risks sooner and respond more effectively. I will address each of these themes in turn.
First, recent experience confirms the value of supervision of financial holding companies -
especially the largest, most complex, and systemically critical institutions - on a consolidated
basis, supplementing the supervision that takes place at the level of the holding company's
subsidiaries. Large financial institutions manage their businesses in an integrated manner
with little regard for the corporate or national boundaries that define the jurisdictions of
functional supervisors in the United States and abroad. For example, a nonbank subsidiary
of a financial holding company may originate a mortgage loan, sell it to an investment
banking affiliate to be packaged and distributed as a security, which in turn may be
purchased by an investment vehicle supported by a liquidity facility from a bank affiliate.
Because financial, operational, and reputational linkages span large and complex financial
firms, the risks borne by such firms cannot be adequately evaluated through supervision
focused on individual subsidiaries alone. Instead, effective supervision must involve greater
coordination among consolidated and functional supervisors and an integrated assessment
of risks across the holding company and its subsidiaries.
In recognition of these points, the Federal Reserve Board issued guidance a year ago that
updated our approach to consolidated supervision, tying it more explicitly to the systemic
significance of individual holding companies and their business lines, such as core clearing
and settlement activities and activities in critical financial markets.9 Strengthened
consolidated supervision also supports improved oversight of institutions' compliance with
consumer protections. Indeed, building on a pilot project we launched in 2007, we recently
announced a consumer compliance examination program for nonbank subsidiaries of bank
holding companies, as well as of foreign banking organizations.10
Second, our supervisory approach should better reflect our mission, as a central bank, to
promote financial stability. The extraordinary pressure on financial firms last fall underscored
how profoundly interconnected firms and markets are in our complex, global financial
system. Thus, any effort to address systemic risks will require a more systemwide, or
macroprudential, approach to the supervision of systemically critical firms. More generally,
supervisors must go beyond their traditional focus on individual firms and markets to try to
identify possible channels of financial contagion and other risks to the system as a whole.
To improve consolidated supervision and increase the macroprudential focus of our
oversight, we are improving existing supervisory tools and developing new ones. For
example, drawing on our experience with the recent capital assessment program, we have
increased our emphasis on horizontal reviews, which focus on particular risks or activities
across a group of banking organizations. Although we have conducted horizontal reviews
before, the Supervisory Capital Assessment Program of the past spring was both broader in
scope and conducted differently than many previous horizontal reviews. It involved a broad
simultaneous review of several types of risk exposures at the included banking
organizations, covering a majority of the assets of the U.S. banking system. Examiners
applied the same stress parameters to each firm, highlighting the relative strengths and
weaknesses among them. Because we simultaneously evaluated potential credit exposures
across all the firms, we were also better able to consider the systemic implications of
financial stress under adverse economic scenarios. Building on the success of this initiative,
we will conduct more frequent, broader, and more comprehensive horizontal examinations,
evaluating both the overall risk profiles of institutions as well as specific risks and
riskmanagement issues.
The increased complexity of the firms we supervise and the need to consider the systemic
implications of problems at individual firms underscore the importance of increased
collaboration within the Federal Reserve System itself among examiners and other
specialists. The Federal Reserve's ability to draw on expertise from a range of disciplines
was essential to the success of the Supervisory Capital Assessment Program, and it will be a
central feature of our supervision in the future. For example, we are using a multidisciplinary
approach to develop an enhanced quantitative surveillance program for systemically critical
institutions. This program will incorporate supervisory information, firm-specific data analysis,
and market-based indicators to identify developing strains and imbalances that may affect
multiple institutions, as well as specific firms. Our economic and market researchers will work
in concert with examiners, market operations specialists, and other experts within the
Federal Reserve System. Their efforts will incorporate periodic scenario analysis so we can
better understand the consequences of economic shocks for both individual firms and the
financial system. Off-site quantitative analysis will complement our traditional on-site
supervision, but will be independently conducted to provide an alternative perspective to
traditional examination findings.
To support and complement these initiatives, we are working with the other federal banking
agencies to develop more-comprehensive information-reporting requirements for the largest
firms. Traditional bank regulatory reports have not been sufficiently complete or timely to
support continuous monitoring and analysis of the dynamic and diverse business activities of
the largest, most complex organizations. These firms should report systematic, frequent, and
consistent information on material firm-wide exposures, funding and liquidity profiles, and
operating performance. Enhanced reporting requirements should not only help supervisors
identify potential vulnerabilities at individual institutions and in the banking sector more
broadly, but should also prompt institutions to better track their own risks.
When risk-management shortcomings are identified, even if losses have not yet materialized,
supervisors must hold management accountable and make sure that weaknesses receive
proper attention at senior levels and are resolved promptly. We will ensure that important
supervisory concerns are communicated promptly and at a high level, with more frequent
involvement of senior bank management and boards of directors and senior Federal Reserve
officials. This approach proved especially effective during the recent Supervisory Capital
Assessment Program and in other circumstances where clear expectations for prompt
remediation were forcefully communicated to large banking organizations. Of course, we will
use the full range of enforcement tools at our disposal as necessary to achieve important
supervisory objectives.
Need for legislative action
Though the Federal Reserve and other supervisors in the United States and abroad are
strengthening the existing regulatory and supervisory framework, it remains critical for the
Congress to close regulatory gaps and provide supervisors with additional tools for
anticipating and managing systemic risks. The recent financial crisis clearly demonstrated
that risks to the financial system can arise not only from banks, but also from other financial
firms - such as investment banks or insurance companies - that traditionally have not been
subject to the type of regulation and consolidated supervision applied to bank holding
companies. To close this gap, the Congress should ensure that all systemically important
financial institutions are subject to a robust regime for consolidated prudential supervision.
Large, complex financial firms that do not own a bank, but that nonetheless pose risks to the
overall financial system, must not be permitted to avoid comprehensive and effective
supervisory oversight. Consolidated supervision of systemically important institutions,
together with tougher capital, liquidity, and risk-management requirements for those firms, is
needed not only to protect the firms' stability and the stability of the financial system as a
whole, but also to reduce firms' incentive to grow very large in order to be perceived as too
big to fail.
To further ameliorate the too-big-to-fail problem, the Congress should create a new set of
authorities to facilitate the orderly resolution of failing, systemically important financial firms.
In most cases, federal bankruptcy laws work appropriately for the resolution of nonbank
financial institutions. However, the bankruptcy code does not always protect the public's
strong interest in avoiding the disorderly collapse of a nonbank financial firm that could
destabilize the financial system and damage the economy. In light of the experience of the
past year, it is clear that we need an option other than bankruptcy or bailout for such firms.
A new resolution regime for nonbanks, analogous to the regime currently used by the
Federal Deposit Insurance Corporation for banks, would permit the government to wind down
a failing systemically important firm in a way that reduces the risks to financial stability and
the economy. Importantly, to restore a meaningful degree of market discipline and to address
the too-big-to-fail problem, it is essential that there be a credible process for imposing losses
on the shareholders and creditors of the firm. Any resolution costs incurred by the
government should be paid through an assessment on the financial industry and not borne
by the taxpayers.
Beyond strengthening and extending consolidated supervision and making provisions for the
safe unwinding of failing, systemically important firms, there remains the broader objective of
monitoring and addressing emerging systemic risks. Because of the size, diversity, and
complexity of our financial system, that task may exceed the capacity of any individual
supervisor. The Federal Reserve supports the creation of a systemic oversight council, made
up of the principal financial regulators. By combining the expertise and information of all the
relevant agencies and departments, the council would be in the best position to identify
developments that threaten the stability of the system as a whole. The council could be
charged, among other things, with monitoring risk exposures that cut across firms and
markets; analyzing potential spillovers among financial firms or between firms and markets
that could lead to financial contagion; identifying regulatory gaps; coordinating the responses
of its member agencies to emerging systemic risks; identifying systemically important firms;
and periodically reporting to the Congress and the public about emerging systemic risks and
recommended approaches for dealing with those risks. In addition, to further encourage a
more comprehensive and holistic approach to financial oversight, all federal financial
supervisors and regulators - not just the Federal Reserve - should be directed and
empowered to take account of risks to the broader financial system as part of their normal
oversight responsibilities.
Conclusion
As we work together to build on the progress already made toward securing a sustained
economic recovery, we cannot lose sight of the need to reorient our supervisory approach
and to strengthen our regulatory and legal framework to help prevent a recurrence of the
events of the past two years. As I have described today, the Federal Reserve has been
actively engaged in this process. We are working with our domestic and international
counterparts to strengthen the standards governing bank capital, liquidity, risk management,
incentive compensation, and consumer protection, among other areas. We are also
improving supervision, and giving it a greater macroprudential focus, through enhanced
consolidated supervision and through the development of new supervisory tools - including
comprehensive horizontal reviews, off-site quantitative evaluations, and more extensive
information gathering. We are moving quickly to bring unresolved issues to the attention of
senior management and requiring prompt responses.
Regulators and supervisors can do a great deal, but comprehensive financial reform requires
action by the Congress. Strengthening consolidated supervision, setting up a mechanism
(such as a systemic oversight council) to identify and monitor risks to financial stability, and
creating a framework that allows for the safe unwinding of failing, systemically critical firms
are among the essential ingredients of a new system that will reduce the probability of future
crises and greatly mitigate the severity of any that occur. We at the Federal Reserve look
forward to working closely with the Congress as the legislative process evolves.