Daniel K Tarullo: The international agenda for financial regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the American Bar Association Banking Law Committee Fall Meeting,
Washington DC, 4 November 2011.
* * *
Long before the recent financial crisis, banking regulation had acquired an important
international dimension. The crisis renewed attention to the interconnectedness among
national financial markets. In its aftermath, accordingly, the international focus on banking
regulation has grown even more extensive. Today I will discuss three subjects germane to
the increasingly significant international regulatory agenda.
First are the steps needed to complete the reform agenda on capital and liquidity standards,
including some implementation issues in the United States. Second are areas that I believe
should be priorities for international work in 2012 - cross-border resolution of financial firms,
wholesale funding markets, and over-the-counter (OTC) derivatives reform. And third are
some institutional changes that will be required in the relevant international bodies to assure
that they fulfill their promise of promoting a safe and efficient international financial system.
Before turning to these topics, I think it important to state the goals that should inform U.S.
involvement in international financial regulatory efforts. In recognition of the fact that financial
distress can quickly and dramatically cross national borders, we seek to protect our own
financial system by promoting the adoption of strong, common regulatory standards and
effective supervisory practices for large financial firms and important financial market
infrastructures around the world. Such standards and practices can also help prevent major
competitive disadvantage for U.S. firms.
Completing the agenda on minimum capital and liquidity standards
Strong capital and liquidity standards are central to these goals and to the overall reform
agenda for financial regulation. The crisis showed that liquidity problems can be an
independent source of severe stress, perhaps even for firms that might otherwise have
remained solvent. But it also confirmed that capital standards themselves had been wholly
inadequate in a number of respects: Required capital levels were much too low, particularly
trading book capital requirements. In evaluating the condition of financial firms at the height
of the crisis, markets focused on common equity ratios and virtually ignored the Tier 1 ratio
enshrined by Basel I and Basel II. Moreover, markets and supervisors both used a much
more forward-looking capital calculation than under prevailing regulatory requirements -
subtracting losses that they estimated would be sustained in an adverse scenario to
determine whether firms would have enough capital to remain viable financial intermediaries.
Finally, the significant interconnectedness among globally active firms, and the high degree
of correlation in their assets, underscored the vulnerability of the entire international financial
system to the potential failure of these firms.
In response to these revealed regulatory shortcomings, the Basel Committee has announced
four sets of changes to minimum prudential standards for internationally active banks: First,
in 2009 it revised and strengthened the market risk requirements of Basel II, in what has
become known as Basel 2.5. Second, last year it issued Basel III, which improved the quality
and increased the quantity of minimum capital requirements, created a capital conservation
buffer, and introduced an international leverage ratio requirement. Third, and coincident with
Basel III, the committee issued a framework for quantitative liquidity requirements. Fourth, it
has just today released the rules text of its assessment methodology for determining an
additional capital requirement for global systemically important banks (G-SIBs) - popularly
referred to as a "capital surcharge."
In the Basel Committee itself, work on Basel 2.5 and Basel III has been essentially complete
for some time. As reported recently by the committee,1 implementation of Basel 2.5 and
Basel III into national legislation or regulations is at various stages of progress around the
world.
Two points are worth making with respect to U.S. implementation. First, while U.S. bank
regulatory agencies have published a proposed regulation for the new market risk capital
requirements, we did not include the trading book securitization and resecuritization portions
of Basel 2.5. The complication here, and with part of Basel III implementation, lies in the use
of agency credit ratings. The Dodd-Frank Wall Street Reform and Consumer Protection Act
requires the removal of agency credit ratings from all regulations throughout the government.
The banking agencies thus need to develop substitutes for agency ratings in each of the
quite different contexts within the capital standards where they are used. This has not been
the easiest of tasks, but I believe we are now close to convergence on the approaches we
will take in fashioning these substitutes. Thus we should soon be able to draft a proposed
regulation for the rest of Basel 2.5. Work on the Basel III rule has had to compete for staff
time with all the other rulemakings currently underway at the banking agencies, but I would
expect a proposed regulation in the first quarter of 2012.
My second point pertains to the six-year transition period for Basel III, which by its terms
phases in the requirements for both the improved quality and increased quantity of capital in
somewhat backloaded stages beginning in January 2013. Questions have arisen - particularly
here in the United States, though elsewhere as well - as to supervisory expectations for capital
levels during this rather lengthy period. Specifically, there has been some uncertainty as to
whether supervisors intend to "pull forward" the various transition points outlined in Basel III.
While the Federal Reserve intends to ensure that firms are on a steady path to full Basel III
compliance, we do not intend to require firms to raise external capital or reduce their
riskweighted assets in order to meet any target earlier than at the time specified in the Basel III
transition schedule. However, because this issue is complicated somewhat both by certain
expectations stated in Basel III and by the relationship of Basel III implementation to the
Federal Reserve's requirement for annual capital planning by certain large bank holding
companies, I think it may be useful to provide some further details on our expectations.
In the first place, the Federal Reserve will require bank holding companies that are subject to
our proposed capital plan rule (generally companies with $50 billion or more in total assets)
to take affirmative steps to improve capital ratios, such as external capital raises, when those
steps would be needed to meet each Basel III transition target on time.
Next, I would remind everyone of a statement made by the Governors and Heads of
Supervision (GHOS) - the oversight body of the Basel Committee - in announcing
agreement on Basel III in September 2010. The GHOS said that banks should "maintain
prudent earnings retention policies" so as to meet both the new minimum equity standard
and the conservation buffer "as soon as reasonably possible."2 In the spirit of that statement,
we will expect large bank holding companies that have not yet met the fully phased-in
Basel III requirements (including any expected G-SIB capital surcharge) to improve their
capital ratios steadily during the transition period through prudent earnings retention policies,
even if they already meet any applicable intermediate targets. In practical terms, we will
monitor their progress through our review of the capital plans that we require large bank
holding companies to submit annually. That is, we will be comfortable with proposed capital
distributions only when we are convinced they are consistent with a bank holding company
readily and without difficulty meeting the new capital requirements as they come into effect.
We will provide more detail on this point in a few weeks when we issue guidance and
instructions for the 2012 capital review.
Last, it is important to note that supervisors may require banking organizations to increase
capital ratios above the minimum levels specified in Basel I and II for a variety of safety and
soundness reasons. Institution-specific measures of this sort are explicitly contemplated in
both Basel II and U.S. banking regulations. During the financial crisis, we used our safety
and soundness authority to require banks to hold sufficient capital to weather the impact of
the crisis and the serious recession that followed. Similarly, our annual capital plan review is
a forward-looking exercise that, in estimating losses and reduced revenues that would follow
an adverse economic scenario, may result in requiring banks to maintain more capital than
would a static snapshot of minimum capital levels.
Unlike the Basel 2.5 and Basel III capital standards, the quantitative liquidity framework
requires further work in the Basel Committee. The committee has developed two
complementary liquidity requirements: The Liquidity Coverage Ratio (LCR) was designed to
promote short-term liquidity resiliency of firms, while the Net Stable Funding Ratio (NSFR)
was directed at medium-term structural liquidity mismatches. The framework presented to
the GHOS in 2010 was genuinely pathbreaking, in that it was the first effort ever to establish
quantitative liquidity requirements. Precisely because of the novelty of this exercise,
questions were raised in the GHOS as to how the definition and calibration of the new ratios
aligned with actual experience in the crisis, and whether the ratios might result in some
adverse unintended consequences on financial markets. Consequently, the GHOS agreed to
delay implementation of both standards and provide for what were termed "observation
periods," during which further analysis will be done and changes very likely made.
Here, though, it is important to draw a distinction between the two standards. In recognition
of the fact that the NSFR needs considerable work, which is not yet under way, it is not
scheduled to become effective until 2018. The LCR, on the other hand, will go into effect in
2015. The Basel Committee has recently agreed to accelerate its review of the LCR so as to
be able to make changes well before that date and, thereby, give firms and markets ample
time to prepare and, as necessary, adjust.
In the coming months, the Federal Reserve, after consulting with the other U.S. banking
agencies, will be making recommendations for changes in the LCR. We have not yet finished
developing those recommendations, but I expect that we will, among other things, suggest
recalibration of certain deposit run-off and commitment draw-down rates, as well as
modification of the buffer definition to place a greater focus on the liquidity characteristics of
assets, as opposed to such things as the credit ratings associated with the assets. We are
also examining how the regulations might be best applied during liquidity stress events to
maximize the benefits for financial stability. Several other possible changes are also under
consideration, including altering the LCR so as to limit certain arbitrage opportunities that
appear possible from its current structure.
Finally, let me turn to the Basel Committee's framework for calibrating capital surcharges for
banks of global systemic importance. It is informed by the fact that failure of a systemically
important firm would have substantially greater negative consequences on the financial
system than the failure of other firms, even quite sizeable ones. Thus, the surcharge
attempts to reduce the chances of a G-SIB's failure so as to bring the expected impact of
failure of such a firm - that is, its expected damage to the system upon failure discounted by
the possibility that it will, in fact, fail - more in line with that of other sizeable firms. Moreover,
the metrics for determining G-SIB status are heavily weighted toward the kind of
interconnectedness features that pose macroprudential risks.
This framework includes a range of surcharges in the 1.0-2.5 percent range for what will
likely be a global group of about 30 banks, to be phased in as an expansion of the Basel III
capital conservation buffer from 2016 to 2019. The framework is consistent with the
obligation of the Federal Reserve under section 165 of the Dodd-Frank Act to impose more
stringent capital standards on systemically important institutions, including the requirement
that these additional standards be graduated based on the systemic importance of the bank.
For illustrative purposes, the Basel Committee used 2009 data to generate a list of banks
that were of global systemic importance and, based on the criteria developed from that data,
a hypothetical set of "buckets" associated with the different surcharge rates. It is important to
note, however, that this list will not be used to determine any bank's surcharge. The list of
banks to be covered and the buckets within which they will be placed when the surcharge
begins to take effect in 2016 will be based upon data collected in 2014. This is as it should
be, since the inclusion and ordering of the firms should be based upon the characteristics of
the banks as they have evolved closer to the effective date. Some banks have changed their
profiles materially in the past couple of years, and the prospect of capital surcharges may be
an incentive for others to do so as well. In this regard, I should also note that the bucket
allocation of each G-SIB will be recomputed in each year after 2016.
The use of more up-to-date data means that banks will not know for some time exactly which
buckets they will occupy when the surcharge first phases in. The Basel Committee does plan
to release by the latter part of 2014 the thresholds for each surcharge "bucket," as well as the
denominator reflecting the universe of global banking institutions against which each G-SIB
will be measured. To further advance the goals of transparency and predictability, we will
continue to work within the Basel Committee to ensure that the indicators used to determine
the systemic risk ranking of a firm are clear and based upon publicly available information
sources. If additional information is needed by firms to allow for effective capital planning, the
Basel Committee should be prepared to develop and release additional guidance.
Next steps for the reform agenda
As I stated earlier, strong capital and liquidity standards are central to an effective financial
regulatory system. Well-crafted capital standards provide a buffer against loss from any
activities of a bank, while good liquidity standards help provide assurance that a firm will
have breathing space during a period of financial stress, whether idiosyncratic or systemic.
But we cannot rely solely on these standards, important as they are, to provide a stable
financial system.
Basel 2.5, Basel III, and the G-SIB surcharges can only reduce the chances of highly
disruptive failure, not eliminate them. A necessary supplement is a strong resolution
mechanism for systemically important firms, both to counter too-big-to-fail perceptions and to
contain the harm to the financial system that would be caused by the failure of one of these
firms. Thus, my first candidate for a priority area of work in 2012 is to take concrete steps to
advance the useful analytic work that has been done in the Basel Committee and the
Financial Stability Board (FSB) on the resolution of financial firms with substantial
international presence.
Here in the United States, the Dodd-Frank Act provides for an orderly liquidation process.
Some other jurisdictions have, or are planning to, put in place comparable special-resolution
mechanisms. But the co-existence of internationally active firms with nationally based
insolvency regimes means that there can be potentially important transborder legal
complications when a home jurisdiction places into receivership a firm with significant assets,
subsidiaries, and contractual arrangements in other countries. A comprehensive, treaty-like
instrument for a global bank resolution regime is almost surely not achievable in the
foreseeable future, and perhaps well beyond that. But there should be room for more limited
cooperation agreements, coordinated supervisory work on resolution plans, and other
devices to make the orderly resolution of a large internationally active firm more feasible.
Similarly, the limits of even well-conceived liquidity requirements suggest a second item that
warrants attention in international fora - namely, the problems connected with wholesale
funding channels over the last several years. Broadly speaking, threats to financial stability
can arise in two ways: first, through the rapid deterioration or failure of a large institution with
leverage sufficient to produce widespread knock-on effects and, second, through the
breakdown of a significant market in which large numbers of leveraged actors depend upon
similar sources of liquidity and backup liquidity. While these two sources of systemic risk can
be, and usually are, related, the latter has not been the subject of the broad reform agenda
directed at the former.
You will note that the Basel III liquidity standards do not require global banks to reduce their
usage of wholesale funding; instead, they require a bank that uses more volatile funding
sources to hold more liquid assets. This requirement is critical to a sounder financial system,
to be sure, but it does not address completely the potential instability associated with
wholesale funding - even in the regulated institutions subject to these requirements, much
less in the rest of the financial system. We will need further measures if we are to mitigate
the risks of runs seen in 2007-2008 and, somewhat less dramatically, more recently.
Because the risk of runs in wholesale funding manifests itself in different ways in different
countries' financial systems, the appropriate response will likely be a mix of national and
international actions, not an international agreement like Basel III. But for this very reason, it
is important that there be ongoing attention to the issue, in order to share ideas for action
and monitor the steps various jurisdictions are taking to mitigate the risks.
For example, we in the United States need to move forward with changes to money market
funds and triparty repo markets to ensure that they do not serve as a trigger for wholesale
funding runs. We also need to address further the issues raised by the dependence of some
foreign banking institutions on large amounts of wholesale dollar funding. The responses to
these issues may themselves involve a mix of national and international measures.
A third priority is the area of OTC derivatives, where strong capital standards alone are not
enough to contain systemic risks. We know that OTC derivatives dealers, as a by-product of
that business model, become part of a global network of interconnected exposures. When
one dealer in the network fails, as we saw in the case of Lehman Brothers, fear of losses at
other dealers in the network can cause systemic stress. Capital, which covers only a fraction
of exposure, cannot alone prevent this contagion.
To reduce the systemic risk of OTC derivatives, the Group of Twenty (G-20) leaders have
agreed to mandate that standardized OTC derivatives must be cleared through a central
counterparty. Work in the United States is well under way to implement mandatory clearing.
Other countries have begun this work as well, but progress abroad has been slow to date. To
help ensure that a global move toward central clearing of derivatives actually reduces
systemic risk, it is critical that central counterparties in the derivatives market be very sound
and stable. Therefore, it is essential that the Committee on Payment and Settlement
Systems (CPSS) and the International Organization of Securities Commissions (IOSCO)
complete their important work on strengthening the oversight of central counterparties as
soon as possible.
To further build shock absorbers in the derivatives network, non-standardized derivatives that
are not suitable for clearing should have margin requirements that are sufficient to prevent
contagion when the next Lehman fails. An international working group has been formed for
this purpose. We hope to see considerable progress on this element of OTC derivatives
reform next year.
Institutional changes
An audience of banking lawyers will appreciate the impact of the institutional features of
international arrangements on the substantive output of those arrangements. In the time
remaining this afternoon, I cannot do justice to this subject. But I do want to leave you with
two observations about the international regulatory reform agenda of the last few years,
along with some implications of those observations for desirable institutional changes.
The first observation is that, although there are exceptions, the output of this agenda has
largely consisted of what are essentially regulatory rules, intended to be applied to firms
through national law. Second, most of these rules are being generated, or at least reviewed,
within an overlapping set of organizations and arrangements - the Basel Committee, IOSCO,
the FSB, the G-20, and a veritable potpourri of committees functioning under the umbrella of
the Bank for International Settlements (BIS).
These rather mundane observations lead, I think, to some rather important institutional
implications. It goes without saying that the benefits of international regulatory rules will be
realized only if they are implemented rigorously and consistently across jurisdictions. Not
only must they be incorporated into national legislation or regulations effectively, they must
also be rigorously enforced by national supervisors. We do not need formal dispute
mechanisms similar to those in the World Trade Organization, which could undermine
supervisory cooperation, but we do need effective, collaborative monitoring mechanisms
administered by the supervisors themselves and reported to the public. So, for example, the
Federal Reserve has suggested that the Basel Committee go beyond the important function
of reviewing legal implementation and also monitor how capital standards are applied within
banks. While a variety of methods could be used, we are particularly interested in
establishing international validation teams to verify methodologies used at individual banks
on such matters as the risk-weighting of trading assets.
Even as the Basel Committee should monitor compliance with the standards it establishes, it
must not lose sight of the importance of supervisory cooperation in pursuit of the shared goal
of a stable international financial system. The focus on rules and standards over the last few
years has been both understandable and necessary, but the Basel Committee should not be
purely a negotiating forum. The activities of the Basel Committee in the 1970s and early
1980s were largely informal, involving the sharing of supervisory perspectives and, perhaps
more importantly, the establishment of relationships that could be drawn upon when
crossborder supervisory problems arose. I regret that these functions have been substantially
attenuated over the years. With the increased membership and expanded scope of activities,
a return to early practice is not feasible. But other ways must be found to foster the common
goals of committee members in promoting safe and sound financial systems.
The overlapping, sometimes competing, activities of all the international committees and
arrangements is, like the recent emphasis on rules, completely understandable in light of the
number of new and urgent issues to be tackled. Similarly, the involvement of political officials
through the G-20 was imperative to galvanize the legislative and regulatory processes of
participating countries to undertake the breadth of needed reforms. But as we move toward
administering these new standards and arrangements, we must rationalize the often
confusing and duplicative process whereby the Basel Committee, the FSB, and some other
BIS committees are all involved in the same subjects.
Fortunately, the agenda breaks down rather naturally into the new substantive topics, such
as resolution and OTC derivatives, and the further refinement and implementation of
established regulatory areas such as capital standards. The new topics play to the
coordinating and gap-filling strengths of the FSB, which includes both regulators and finance
ministry representatives, and which can parcel out appropriate components of larger projects
to standard-setting committees. Work in established regulatory areas obviously falls more
appropriately within the province of the Basel Committee (or with respect to some securities
regulatory issues, IOSCO), which consists of the regulators with responsibility for
administering these standards domestically. In this regard, it is important that the
independence of regulators established domestically also be respected internationally.
Conclusion
The international dimension of financial regulation has grown even more important since the
financial crisis. Yet there are, as I have suggested, more subjects to be tackled. At the same
time, the pursuit of efficient and effective regulation requires priority-setting by, and
rationalization of, the web of international arrangements dealing with these issues.