Daniel K Tarullo: Dodd-Frank 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, 11 July 2013.
* * *
Chairman Johnson, Ranking Member Crapo, and other members of the Committee, thank
you for the opportunity to testify on the Federal Reserve's activities in mitigating systemic risk
and implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(Dodd-Frank Act).
With the third anniversary of the Dodd-Frank Act upon us, it is a good time to reflect on what
has been accomplished, what still needs to be done, and how the work on the Dodd-Frank
Act fits with other regulatory reform projects. Indeed, the deliberate pace and multi-pronged
nature of the implementation of the act - occasioned as it is by complicated issues and
decisionmaking processes - may be obscuring what will be far-reaching changes in the
regulation of financial firms and markets. Indeed, the Federal Reserve and other banking
supervisors have already created a very different supervisory environment than what was
prevalent just a few years ago.
Today, I will review recent progress in key areas of financial regulatory reform, with special -
though not exclusive - attention to implementation of the Dodd-Frank Act, including how that
law affects the regulation of community banks. I will also highlight areas in which proposals
are still outstanding and, in a few cases, in which we intend to make new proposals in the
relatively near future.
Implementation of Basel III capital rules
Let me begin by noting the completion of our major rulemakings on capital regulation.
Although most of the provisions in these rules do not directly implement provisions of the
Dodd-Frank Act, implementation of that law is occurring against the backdrop of
implementation of the Basel III framework.
This month, the Federal Reserve, the Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation (FDIC) approved final rules implementing the Basel
III capital framework, as well as certain related changes required by the Dodd-Frank Act.1
The rules establish an integrated regulatory capital framework designed to ensure that U.S.
banking organizations maintain strong capital positions, enabling them to absorb substantial
losses on a going-concern basis and to continue lending to creditworthy households and
businesses even during economic downturns.
The rules increase the quantity and improve the quality of regulatory capital of the U.S.
banking system by setting strict eligibility criteria for regulatory capital instruments, by raising
the minimum tier 1 capital ratio from 4 percent to 6 percent of risk-weighted assets, and by
establishing a new minimum common equity tier 1 capital ratio of 4.5 percent of risk-weighted
assets. The rules also require a capital conservation buffer of 2.5 percent of risk-weighted
assets to ensure that banking organizations build capital during benign economic periods so
that they can withstand serious economic downturns and still remain above the minimum
capital levels. In addition, the rules improve the methodology for calculating risk-weighted
assets to enhance risk sensitivity and incorporate certain provisions of the Dodd-Frank Act,
such as sections 171 and 939A.2 The rules also contain certain provisions, including a
supplementary leverage ratio and a countercyclical capital buffer, that apply only to large and
internationally active banking organizations, consistent with their systemic importance and
their complexity. The rules will have several important consequences.
First, they consolidate the progress made by banks and regulators over the past four years in
improving the quality and quantity of capital held by banking organizations. Second, they
remedy shortcomings in our existing generally applicable risk-weighted asset calculations
that became apparent during the financial crisis. In so doing, they also enhance the
effectiveness of the Collins Amendment, the scope of which we have extended through these
rules by applying standardized floors to capital buffer, as well as minimum requirements.
Third, adoption of these rules meets international expectations for U.S. implementation of the
Basel III capital framework. This gives us a firm position from which to press our expectations
that other countries implement Basel III fully and faithfully.
In crafting these rules, the banking agencies made a number of changes to the 2012
proposals, mostly to address concerns by community banks. For example, the new rules
maintain current practice on risk weighting residential mortgages and provide community
banking organizations the option of maintaining existing standards on the regulatory capital
treatment of "accumulated other comprehensive income" (AOCI) and pre-existing trust
preferred securities. These changes from the proposed rule are meant to reduce the burden
and complexity of the rules for community banks while preserving the benefits of more
rigorous capital standards. Most banking organizations already meet the higher capital
standards, and the rules will help preserve the benefits of the stronger capital positions
banks have built under the oversight of regulators since the financial crisis.
The capital rules also apply risk-based and leverage capital requirements to certain savings
and loan holding companies for the first time. In another change from the proposal, savings
and loan holding companies with significant commercial and insurance underwriting activities
will not be subject to the final rules at this time. During the comment period, these firms
raised significant concerns regarding the appropriateness of the proposed regulatory capital
framework for their business models. To address these concerns, the Federal Reserve will
take additional time to evaluate the appropriate regulatory capital framework for these
entities.
All financial institutions subject to the new rules will have a significant transition period to
meet the requirements. The phase-in period for smaller, less complex banking organizations
will not begin until January 2015, while the phase-in period for larger institutions begins in
January 2014.
Stress testing and capital planning requirements for large banking firms
Important as higher capital requirements and a better quality of capital are to the safety and
soundness of financial institutions, conventional capital requirements are by their nature
somewhat backward-looking. First, they reflect loss expectations based on past experience.
Second, losses that actually reduce reported capital levels are often formally taken by
institutions well after the likelihood of losses has become clear. Rigorous stress testing helps
compensate for these shortcomings through a forward-looking assessment of the losses that
would be suffered under stipulated adverse economic scenarios, so that capital can be built
and maintained at levels high enough for the firms to withstand such losses and still remain
viable financial intermediaries. In the middle of the financial crisis, the Federal Reserve
created and applied a stress test to the nation's largest financial firms. The next year,
Congress mandated stress tests for a larger group of firms in the Dodd-Frank Act. This fall,
we will extend the full set of stress testing requirements to the dozen or so banking
organizations with greater than $50 billion in assets covered in the Dodd-Frank Act but not
fully covered in our previous stress tests.
Regular, comprehensive stress testing, with published results, has already become a key
part of both capital regulation and overall prudential supervision. In the annual
Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve requires each
large bank holding company to demonstrate that it has rigorous, forward-looking capital
planning processes that effectively account for the unique risks of the firm and maintains
sufficient capital to continue to operate through times of extreme economic and financial
stress. CCAR and Dodd-Frank Act stress tests have shown the significant supervisory value
of conducting coordinated cross-firm analysis of the major risks facing large banks.
The Federal Reserve has used stress testing and its broader supervisory authority to prompt
a doubling over the past four years of the common equity capital of the nation's 18 largest
bank holding companies, which collectively hold more than 70 percent of the total assets of
all U.S. bank holding companies. Specifically, the aggregate tier 1 common equity ratio -
which is based on the strongest form of loss-absorbing capital - at the 18 firms covered by
the stress test has more than doubled, from 5.6 percent at the end of 2008 to 11.3 percent at
the end of 2012. That reflects an increase in tier 1 common equity from $393 billion to
$792 billion during the same period.
Enhanced prudential requirements for large banking 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) as systemically important. The required
standards include capital requirements, liquidity requirements, stress testing,
singlecounterparty credit limits, an early remediation regime, and risk-management and
resolutionplanning requirements. The sections also require that these prudential standards become
more stringent as the systemic footprint of a firm increases.
The Federal Reserve has issued proposed rules to implement sections 165 and 166 for both
large U.S. banking firms and foreign banks operating in the United States. In addition, earlier
this week the federal banking agencies jointly issued a proposal to implement higher
leverage ratio standards for the largest, most systemically important U.S. banking
organizations. We have already finalized the rules on resolution planning and stress testing,
and we are working diligently this year toward finalization of the remaining standards.
On liquidity, we will also be implementing the Basel III quantitative liquidity requirements for
large U.S. banking firms. We expect that the federal banking agencies will issue a proposal
later this year to implement the Basel Committee's Liquidity Coverage Ratio for large U.S.
banking firms. These quantitative liquidity requirements would complement the stricter set of
qualitative liquidity standards that the Federal Reserve has already proposed pursuant to
section 165 of the Dodd-Frank Act.
On capital, we will be proposing risk-based capital surcharges on the most systemically
important U.S. banking firms. The proposal will be based on the risk-based capital surcharge
framework developed by the Basel Committee for global systemically important banks, under
which the size of the surcharge will increase with a banking firm's systemic importance.
These surcharges are a critical element of the Federal Reserve's efforts to force the most
systemic financial firms to internalize the externalities caused by their potential failure and to
reduce any residual subsidies such firms may enjoy as a result of market perceptions that
they may be too big to fail. We anticipate issuing a proposed regulation on these capital
surcharges around the end of this year.
With one exception, we expect to finalize the remaining proposed enhanced prudential
standards around the end of the year as well. The one exception is single-counterparty credit
limits. We are conducting a quantitative impact study (QIS) on the effects of the counterparty
credit limits included in the proposed rule. Based on the comments received and ongoing
internal staff analysis, we concluded that a QIS was needed to help us better assess the
optimal structure of the rule. Moreover, since the Federal Reserve issued its
singlecounterparty credit limit proposal, the Basel Committee began developing a similar large
exposure regime that would apply to all global banks. We are coordinating our
singlecounterparty credit limit rule with this effort.
A core element of the Federal Reserve's proposed enhanced prudential standards for large
banking firms is our December 2012 foreign bank proposal. The foreign bank proposal
responds to fundamental changes over the last 15 years in the scope and scale of the U.S.
operations of foreign banking organizations, many of which have moved beyond their
traditional lending activities to engage in substantial capital markets activities and, in some
cases, have become more reliant on short-term wholesale U.S. dollar funding. The proposed
rule would increase the resiliency of the U.S. operations of foreign banks and help protect
U.S. financial stability. The proposal would also promote competitive equality for all large
banking firms - domestic and foreign - operating in the United States and would, in many
respects, result in greater harmony between how the U.S. operations of foreign banking
organizations and the foreign operations of U.S. bank holding companies are regulated.
The foreign bank proposal generally would require foreign banks with a large U.S. presence
to organize their U.S. subsidiaries under a single U.S. intermediate holding company that
would serve as a platform for consistent supervision and regulation. The U.S. intermediate
holding companies of foreign banks would be subject to the same risk-based capital and
leverage requirements as U.S. bank holding companies. In addition, U.S. intermediate
holding companies and the U.S. branches and agencies of foreign banks with a large U.S.
presence would be required to meet liquidity requirements similar to those applicable to large
U.S. bank holding companies. Importantly, however, the foreign bank proposal does not
entail full subsidiarization - foreign banks generally will continue to be allowed to directly
branch into the United States on the basis of their consolidated capital. The comment period
for this proposal closed at the end of April, and we are now carefully reviewing comments.
Improving resolvability of large banking firms
An important reform included in the Dodd-Frank Act was the creation of the Orderly
Liquidation Authority (OLA). Under OLA, the FDIC can resolve a systemic financial firm by
imposing losses on the shareholders and creditors of the firm and replacing its management,
while preserving the operations of the sound, functioning parts of the firm. This authority
gives the government a real alternative to the Hobson's choice of bailout or disorderly
bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under
development in other countries, and the Basel Committee and the Financial Stability Board
have devoted considerable attention to developing new international standards for statutory
resolution frameworks. Although much work remains to be done by all countries, the
DoddFrank Act reforms have paved the way for the United States to be a leader in shaping the
development of international policy on effective resolution regimes for systemic financial
firms.
In implementing OLA, the FDIC is developing the single-point-of-entry (SPOE) resolution
approach. SPOE is designed to focus losses on the shareholders and long-term unsecured
debt holders of the parent holding company of the failed firm. It aims to produce a
wellcapitalized bridge holding company in place of the failed parent by converting long-term debt
holders of the parent into equity holders of the bridge. The critical operating subsidiaries of
the failed firm would be re-capitalized by the parent, to the extent necessary, and would
remain open for business. The SPOE approach should reduce incentives for creditors and
customers of the operating subsidiaries to run and, as financial stress increases, for
hostcountry regulators to engage in ring-fencing or other measures disruptive to an orderly,
global resolution of the failed firm.
Successful execution by the FDIC of its preferred SPOE approach in OLA depends on the
availability of a sufficient combined amount of equity and loss-absorbing debt at the parent
holding company of the failed firm. Accordingly, in consultation with the FDIC, the Federal
Reserve is working on a regulatory proposal that requires the largest, most complex U.S.
banking firms to maintain a minimum amount of outstanding long-term unsecured debt on top
of their regulatory capital requirements. Such a requirement could have a number of public
policy benefits. Most notably, it would increase the prospects for an orderly resolution under
OLA by ensuring that shareholders and long-term debt holders of a systemic financial firm
can bear potential future losses at the firm and sufficiently capitalize a bridge holding
company in resolution. In addition, by increasing the credibility of OLA, a minimum long-term
debt requirement could help counteract the moral hazard arising from taxpayer bailouts and
improve market discipline of systemic firms.
The Dodd-Frank Act also requires that all large bank holding companies develop, and submit
to supervisors, resolution plans. The Federal Reserve has been working with the FDIC to
review resolution plans submitted by the largest U.S. bank holding companies and foreign
banks. The largest firms - generally those with $250 billion or more in total nonbank assets -
submitted their first annual resolution plans to the Federal Reserve and the FDIC in the third
quarter of 2012. These "first-wave" resolution plans yielded valuable information that is being
used to identify, assess, and mitigate key challenges to resolvability under the Bankruptcy
Code and to support the FDIC's development of backup resolution plans under OLA. These
plans also are very useful supervisory tools that have helped the Federal Reserve and the
subject firms focus on opportunities to simplify corporate structures and improve
management systems in ways that will help the firms be more resilient and efficient, as well
as easier to resolve.
Further work is being done on resolution plans this year. On July 1, bank holding companies
in the second group - generally those with between $100 billion and $250 billion in total
nonbank assets - submitted their initial plans to the Federal Reserve. The public portions of
these resolution plans were made available on the FDIC and Federal Reserve websites on
July 2.3
The first-wave filers will submit updated plans in October that reflect further guidance
from the FDIC and the Federal Reserve.
Structural reform of banking firms
The Dodd-Frank Act also includes provisions calling for structural reform of the U.S. banking
system. Key elements are the Volcker Rule in section 619 of the act and the derivatives
push-out provision in section 716 of the act.
The Volcker Rule generally prohibits a banking entity from engaging in proprietary trading or
acquiring an ownership interest in, sponsoring, or having certain relationships with a hedge
fund or private equity fund. The federal banking agencies and the Securities and Exchange
Commission (SEC) jointly proposed a rule to implement the Volcker Rule in October 2011.
The Commodity Futures Trading Commission issued a substantially similar proposal a few
months later.
The rulemaking agencies have carefully analyzed the nearly 19,000 public comments on the
proposal and have made steady and significant progress toward crafting a final rule that
attempts to maximize bank safety and soundness and financial stability while minimizing cost
to the liquidity of the financial markets, credit availability, and economic growth. The
implementation of the Volcker Rule has taken a significant amount of time for a variety of
reasons - the interpretive and policy issues implicated by the rule are complex, the
completion of the Volcker Rule requires negotiations among a variety of banking and market
regulators, and the potential costs of getting the Volcker Rule wrong are high. But I think
most observers would agree that the agencies need to provide firms, markets, and the public
with the product of all this work, so that they can begin to adjust their plans and expectations
accordingly. During this Committee's last oversight hearing in February, I expressed the
hope that we would complete the Volcker Rule by the end of this year. Since that time, there
has been good interagency progress, and I maintain both the hope and expectation of five
months ago.
The derivatives push-out provision in section 716 of the Dodd-Frank Act generally prohibits
the provision of federal assistance, such as FDIC deposit insurance or Federal Reserve
discount window credit, to swap dealers and major swap participants. The provision
becomes effective on July 16, 2013, although the statute provides insured depository
institutions the right to request a two-year extension from their primary federal supervisor.
Last month, the Federal Reserve issued an interim final rule that clarified that uninsured U.S.
branches and agencies of foreign banks will be treated in the same manner as insured
depository institutions under section 716 and, as a result, will qualify for the same
exemptions and two-year transition period available by statute to U.S. insured depository
institutions. The interim final rule also establishes the process for state member banks and
uninsured state branches or agencies of foreign banks to apply to the Federal Reserve for
transition relief.4 Although the rule is already effective, we are seeking comments on it and
will revise the rule, as necessary, in light of comments received.
Oversight of community banks
In addition to overseeing large banking firms, the Federal Reserve supervises approximately
800 state-chartered community banks that are members of the Federal Reserve System.5
Community banks play an important role in extending credit in local economies across the
country - particularly, though by no means only, in their lending to small and medium-sized
businesses. Recognizing the disproportionate burden that regulatory compliance can impose
on smaller institutions, the Federal Reserve has put in place special processes for taking
account of the circumstances and more limited compliance resources of community banks,
while still achieving safety-and-soundness aims. We created a special subcommittee of our
regulatory and supervisory oversight committee to review all proposals with an eye to their
effects on community banks. We have also established a Community Depository Institutions
Advisory Council to enable community bankers to comment on the economy, lending
conditions, supervisory policies, and other matters of interest.
The changes we will be seeing in the financial regulatory architecture as a result of the
DoddFrank Act and Basel III are principally directed at our largest and most complex financial
firms. Many of the Basel III requirements will not apply to smaller banks - including the
countercyclical capital buffer, supplementary leverage ratio, trading book reforms, AOCI flow
through, higher capital requirements for counterparty credit risk on derivatives, and
disclosure requirements. In fact, most of the significant changes from the proposed capital
rules published by the three banking agencies last year that we made in the final version of
the rules issued earlier this month were in response to concerns expressed by smaller
banks. Community banking organizations also will not be subject to the Federal Reserve's
additional enhanced prudential standards that larger banking firms face or will face, such as
capital plans, stress testing, resolution plans, single-counterparty credit limits, and capital
surcharges for systemically important financial firms. In addition, most of the major systemic
risk and prudential provisions of the Dodd-Frank Act - such as the Volcker Rule, derivatives
push-out, derivatives central clearing requirements, and the Collins Amendment - will have a
far smaller impact on community banks than on large banking firms.
Constraining systemic risk outside the banking sector
While strengthening the regulation and improving the resolvability of banking firms is of
paramount importance, we should not forget that one of the key elements of the recent
financial crisis was the precipitous unwinding of large amounts of short-term wholesale
funding that had been made available to highly leveraged and maturity-transforming financial
firms, many of which were clearly outside of the traditional banking sector. Nonbank financial
intermediaries can provide substantial benefits to an economy, but a complete financial
reform program must address financial stability risks that emanate from the shadow banking
system. Particularly as we tighten the oversight of the regulated banking system, it will
become more and more essential that we are able to monitor and constrain the build-up of
systemic risks in the nonbank financial sector.
Among other things, financial stability depends on strong consolidated supervision and
regulation of all financial firms whose failure could pose a threat to the financial system -
whether or not they own a bank. One of the key lessons of the financial crisis was the
prodigious amount of systemic risk that was concentrated in several nonbank financial firms.
To mitigate these risks, the Dodd-Frank Act gave the Council authority to bring systemically
important financial firms that are not already bank holding companies within the perimeter of
Federal Reserve supervision and regulation. Last month, the Council made three proposed
designations of nonbank financial firms, and earlier this week the Council made final
designations of two of these firms. The Federal Reserve already supervises these two firms
as savings and loan holding companies and we will now begin the process of applying
relevant enhanced prudential regulatory and supervisory standards. We remain committed to
applying a supervisory and regulatory framework to such firms that is tailored to their
business mix, risk profile, and systemic footprint - consistent with the Collins Amendment
and other legal requirements under the Dodd-Frank Act.
The threats to financial stability from the shadow banking system do not reside solely in a
few individual nonbank financial firms with large systemic footprints. Significant threats to
financial stability emanate from systemic classes of nonbank financial firms and from
vulnerabilities intrinsic to short-term wholesale funding markets. Many of the key problems
related to shadow banking and their potential solutions are still being debated domestically
and internationally, but some of the necessary steps are already clear.
First, we need to increase the transparency of shadow banking markets so that authorities
can monitor for signs of excessive leverage and unstable maturity transformation outside
regulated banks. Since the financial crisis, the ability of the Federal Reserve and other
regulators to track the types of transactions that are core to shadow banking activities has
improved markedly. But there remain several areas, notably involving transactions organized
around an exchange of cash and securities, where gaps still exist. For example, many
repurchase agreements and securities lending transactions can still only be monitored
indirectly. Improved reporting in these areas would better enable regulators to detect
emerging risks in the financial system.
Second, we need to reduce further the risk of runs on money market mutual funds. Late last
year, the Council issued a proposed recommendation on this subject that offered three
reform options. Last month, the SEC issued a proposal that includes a form of the floating
net asset value (NAV) option recommended by the Council.
Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market
are successfully completed. These marketwide efforts have been underway for some time
and have already reduced discretionary intraday credit extended by the clearing banks by
approximately 25 percent. Market participants, with the active encouragement of the Federal
Reserve and other supervisors, are on track to achieve the practical elimination of all such
intraday credit in the triparty settlement process by the end of 2014.
Completing these three reforms would represent a strong start to the job of reducing
systemic risk in the short-term wholesale funding markets that are key to the functioning of
securities markets. Still, important work would remain. For example, a major source of
unaddressed risk emanates from the large volume of short-term securities financing
transactions (SFTs) in our financial system, including repos, reverse repos, securities
borrowing, and lending transactions. Regulatory reform has mostly passed over these
transactions because SFTs appear to involve minimal risks from a microprudential
perspective. But SFTs, particularly large matched books of SFTs, create sizable
macroprudential risks, including vulnerabilities to runs and asset fire sales. Although the
Dodd-Frank Act provides additional tools to address the failure of a systemically important
broker-dealer, the existing bank and broker-dealer regulatory regimes have not been
designed to materially mitigate these systemic risks. Continued attention to these potential
vulnerabilities is needed, both here in the United States and abroad.
Conclusion
As I hope is apparent from this review of progress on the implementation of regulatory
reforms, we are at the beginning of the end of the rulemaking process for most of the major
Dodd-Frank Act provisions. Some regulations already finalized are now in effect. Others
provide a transition period for firms and markets to prepare for the new rules of the road. Still
others will be completed in the coming months. With respect to all three sets of regulations,
the emphasis will soon be shifting from rule-writing to rule compliance, interpretation, and
enforcement. Here, the benchmarks for progress and performance are less visible, at least
until something goes wrong. For that reason, it is all the more important that the regulatory
agencies put in place institutional mechanisms to assure strong, sensible oversight of the
new regulatory framework.
Thank you for your attention. I would be pleased to answer any questions you might have.
List of Rules, Notices, and Reports of the Federal Reserve Board under the Dodd-Frank Act
as of July 2, 2013