Ben S Bernanke: Implementing a macroprudential approach to
supervision and regulation
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the 47th Annual Conference on Bank Structure and Competition, Chicago, Illinois,
5 May 2011.
* * *
The recent financial crisis revealed critical gaps and weaknesses in the U.S. financial system
and the financial regulatory framework. The Congress and the Administration last year
provided a roadmap for addressing many of these problems, in the form of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) - the topic of this year's
conference.
Legislative reforms in any complex area always face the risk of fighting the last war,
responding to the causes of the last crisis without sufficient attention to where new problems
may arise. To their credit, the authors of the Dodd-Frank Act attempted to reduce this risk by
building in a number of features aimed at helping our system of financial oversight adapt over
time to changes in the financial environment. Notably, a central element of the legislation is
the requirement that the Federal Reserve and other financial regulatory agencies adopt a
socalled macroprudential approach - that is, an approach that supplements traditional
supervision and regulation of individual firms or markets with explicit consideration of threats
to the stability of the financial system as a whole. The act also created a new Financial
Stability Oversight Council, whose membership comprises a diverse group of federal and
state financial regulators, to coordinate the government's efforts to identify and respond to
systemic risks.
The explicit incorporation of macroprudential considerations in the nation's framework for
financial oversight represents a major innovation in our thinking about financial regulation,
one that is taking hold abroad as well as in the United States. This new direction is
constructive and necessary, I believe, but it also poses considerable conceptual and
operational challenges in its implementation. In my remarks today I will briefly discuss the
rationale for macroprudential supervision and regulation, describe the new structure of
macroprudential supervision and regulation in the United States, and explain how we at the
Fed are doing our part to implement the macroprudential approach to financial oversight.
Macroprudential supervision and regulation
Ultimately, the goal of macroprudential supervision and regulation is to minimize the risk of
financial disruptions that are sufficiently severe to inflict significant damage on the broader
economy. The systemic orientation of the macroprudential approach may be contrasted with
that of the traditional, or "microprudential," approach to regulation and supervision, which is
concerned primarily with the safety and soundness of individual institutions, markets, or
infrastructures.
Relative to traditional regulation and supervision, executing a macroprudential approach to
oversight can involve heavier informational requirements and more-complex analytic
frameworks. In particular, because of the highly interconnected nature of our financial
system, macroprudential oversight must be concerned with all major segments of the
financial sector, including financial institutions, markets, and infrastructures; it must also
place particular emphasis on understanding the complex linkages and interdependencies
among institutions and markets, as these linkages determine how instability may be
propagated throughout the system. Moreover, broadly speaking, macroprudential regulators
must be concerned with at least two types of risks. The first type encompasses aspects of
the structure of the financial system - such as gaps in regulatory coverage or the evolution of
shadow banking - that pose ongoing risks to financial stability. The second class of risks are
those that vary over time with financial or economic circumstances, such as widespread
buildups of leverage in good times that could ultimately unwind in destabilizing ways.
To be sure, a macroprudential approach to oversight does not avoid the need for careful
microprudential regulation and supervision. The oversight of individual institutions serves
many purposes beyond the enhancement of systemic stability, including the protection of the
deposit insurance fund, the detection of money laundering and other forms of financial crime,
and the prevention of unlawful discrimination or abusive lending practices. Equally important,
however, is that microprudential oversight also provides the knowledge base on which a
more systemic approach must be built; we cannot understand what is going on in the system
as a whole without a clear view of developments within key firms and markets. Without a
strong microprudential framework to underpin them, macroprudential policies would be
ineffective.
That said, a key lesson of the crisis is that a purely microprudential approach, focused on the
conditions of individual firms or markets, may fail to detect important systemic or
crosscutting risks. For example, a traditional microprudential examination might find that an
individual financial institution is relying heavily on short-term wholesale funding, which may or
may not induce a supervisory response. The implications of that finding for the stability of the
broader system, however, cannot be determined without knowing what is happening outside
that particular firm. Are other, similar financial firms also highly reliant on short-term funding?
If so, are the sources of short-term funding heavily concentrated? Is the market for short-term
funding likely to be stable in a period of high uncertainty, or is it vulnerable to runs? If
shortterm funding were suddenly to become unavailable, how would the borrowing firms react -
for example, would they be forced into a fire sale of assets, which itself could be
destabilizing, or would they cease to provide funding or critical services for other financial
actors? Finally, what implications would these developments have for the broader economy?
The analysis of risks from a systemic perspective, not just from the perspective of an
individual firm, is the hallmark of macroprudential regulation and supervision. And the
remedies that might emerge from such an analysis could well be more far-reaching and more
structural in nature than simply requiring a few firms to modify their funding patterns.
Implementing the macroprudential approach in the United States
Let me be more concrete and talk about the implementation of the macroprudential approach
in the context of the evolving U.S. regulatory system.
The first required element of macroprudential oversight is a system for monitoring evolving
risks to financial stability. Beyond assigning individual regulatory agencies this responsibility,
the Dodd-Frank Act took the additional step of setting up a new body, the Financial Stability
Oversight Council, as I mentioned earlier. The council is charged with monitoring the U.S.
financial system, identifying risks that threaten the stability of that system, and promoting
market discipline and other conditions that mitigate excessive risk-taking in financial markets.
The council is made up of 10 voting members - including the Federal Reserve - and
5 nonvoting members, who serve in an advisory capacity.1
The regulatory agencies represented on the council oversee a wide range of participants in
the U.S. financial system. The broad membership of the council is intended to limit the
tendency of regulators to focus narrowly on the institutions and markets within their
jurisdictions while overlooking risks from interdependencies that cut across jurisdictions. The
council also facilitates coordination and information sharing among member agencies. By
breaking down the silos that in the past sometimes discouraged agencies from looking
beyond their specific responsibilities, the council should help identify and eliminate gaps and
weaknesses within the regulatory structure.
The Dodd-Frank Act also established - within the Treasury Department - the Office of
Financial Research, which is responsible for improving the quality of financial data available
to policymakers. The oversight council may direct the research office to collect information
from certain individual financial companies to assess risks to the financial system. This
collection and analysis of financial-sector data should allow regulators to see more of the
financial landscape and better equip them to identify systemic risks and other emerging
threats.
To digress for a moment, it's interesting that the United States isn't the only jurisdiction that
has recently created a new institutional structure to implement macroprudential policies.
Notably, the European Union (EU) established the European Systemic Risk Board, which is
responsible for the macroprudential oversight of the EU's financial system. The board will
collect and analyze information on the EU's financial system, identify and prioritize systemic
risks, and issue warnings and recommendations to national and European authorities. It will
also work closely with the three newly created European Supervisory Authorities, which in
turn are charged with coordinating prudential regulations for banking, insurance, and
securities among EU member states.2 In the United Kingdom, the government plans to move
its microprudential regulatory authority back into the Bank of England and create a new
Financial Policy Committee to implement macroprudential policies. (Former Federal Reserve
Board Vice Chairman Donald Kohn has been tapped to serve on the Financial Policy
Committee, which must make him one of the few people to have served as a top financial
regulator in two different countries.) The U.K. committee is expected to identify and monitor
systemic risks and take actions to remove or reduce them. And it will operate a new
resolution regime for failing financial firms.
The monitoring efforts of the Financial Stability Oversight Council in the United States are
already well under way. Staff members from the member agencies have established working
groups with responsibility for specific sectors or aspects of the financial system and are
making regular presentations to the council. This work will also be reflected in the council's
required annual report to the Congress on financial stability, which is expected to be released
in the summer.
Of course, the identification of threats to financial stability must be followed by appropriate
remedies. The powers of the council itself are relatively limited in this regard, at least under
most circumstances. Perhaps its most important responsibility is the designation of certain
nonbank financial firms and financial market utilities as systemically important and thereby
subject to additional regulation and oversight by the Federal Reserve and other member
agencies, including the Commodity Futures Trading Commission and the Securities and
Exchange Commission (SEC). To make those designations, the council will need to
determine criteria for identifying firms whose financial distress would impose the greatest
risks to financial stability. Of course, this task requires continued development of an
analytical framework for understanding systemic risk and its sources.
Although the council's own powers are circumscribed to some degree, the potential benefits
of its ability to foster cooperative work among U.S. regulatory agencies should not be
underestimated. To cite just one example, the stability of money market mutual funds
- which suffered dramatic runs that worsened funding conditions at the height of the crisis -
is clearly a systemic issue, not just an industry issue. The SEC, which has already issued
rules to increase the stability of money market mutual funds, is appropriately taking the lead
in investigating whether further steps are necessary. Under the aegis of the council,
however, the SEC has consulted with other agencies, including the Federal Reserve, which
have provided their own analyses and perspectives. In particular, interagency consultation
has helped clarify the potential systemic implications of instability in the money market
mutual fund industry. The Federal Reserve will be among the agencies participating in a
roundtable on money fund regulation sponsored by the SEC later this month.
Understandably, given the damage wrought by the crisis, the council and its members
remain focused on addressing possible sources of financial instability, including both
structural problems and risks arising from ongoing economic or financial developments.
However, no one's interests are served by the imposition of ineffective or burdensome rules
that lead to excessive increases in costs or unnecessary restrictions in the supply of credit.
Increased coordination and cooperation among regulators, under the auspices of the council
where appropriate, should serve not only to improve our management of systemic risk, but
also reduce the extent of duplicative, inconsistent, or ineffective rulemakings. More generally,
in evaluating alternative approaches to mitigating systemic risks, regulators must aim to
avoid stifling reasonable risk-taking and innovation in financial markets, as these factors play
an important role in fostering broader productivity gains, economic growth, and job creation.
Macroprudential policy at the Federal Reserve
As I have mentioned, besides creating new institutions like the Financial Stability Oversight
Council, the Dodd-Frank Act has also imposed a macroprudential mandate on individual
agencies, including the Federal Reserve. This mandate comes, in some cases, with changes
in the powers and responsibilities of key agencies. In the case of the Federal Reserve, in
addition to membership on the Financial Services Oversight Council, our new responsibilities
include the supervision of thrift holding companies as well as oversight of nonbank financial
firms and certain payment, clearing, and settlement utilities that the council designates as
systemically important. In consultation with other agencies, we also are responsible for
developing more-stringent prudential standards for all large banking organizations and for
nonbank firms designated by the council as systemically important. These enhanced
standards include tougher capital and liquidity requirements, the development of resolution
plans (so-called living wills), mandatory stress tests conducted by the Federal Reserve and
by the firms themselves, new counterparty credit limits, and more-demanding
riskmanagement requirements.
The Federal Reserve has made and will continue to make significant organizational changes
as needed to best fulfill our responsibilities. Even before the enactment of the Dodd-Frank
Act, we had begun to overhaul our supervision of the largest, most-complex financial firms.
An important milestone in this regard was the Federal Reserve's leadership in the spring of
2009 of the Supervisory Capital Assessment Program, popularly known as the bank stress
test, which comprehensively evaluated the health of the largest banking organizations in the
country. We learned valuable lessons from that exercise, including an appreciation of the
additional insights that can be gained by examining a number of major institutions
simultaneously, with a focus on comparative performance. Another lesson of the stress test
was the value of a multidisciplinary approach to supervision, one that combines the skills of
economists, financial experts, payments systems analysts, and other specialists with those of
supervisors and examiners.
Drawing on this experience, we created a high-level, multidisciplinary working group within
the Federal Reserve to oversee the supervision of large financial institutions. Under the
auspices of this committee - called the Large Institution Supervision Coordinating
Committee, or LISCC - Federal Reserve supervisors, supported by economists and other
experts, now routinely use horizontal, or cross-firm, reviews to monitor industry practices,
common investment or funding strategies, changes in the degree or form of financial
interconnectedness, or other developments with implications for systemic risk.
Supplementing its individual and horizontal reviews, the LISCC has also made increasing
use of improved quantitative methods for evaluating the health and performance of
supervised firms as well as the risks they may pose to the broader financial system. A similar
committee structure within the Federal Reserve is being developed to help us meet our
obligations to supervise systemically important financial market utilities.
To improve our monitoring of the financial system and to coordinate work bearing on financial
stability, we have also created a new office within the Board, called the Office of Financial
Stability Policy and Research. This office brings together staff with a range of backgrounds
and skills and works closely with other groups at the Federal Reserve. The office helps
monitor global financial risks and analyze the implications of those risks for financial stability;
works with our bank supervisory committees, for example, on the development of
quantitative loss models and alternative scenarios to serve as the basis for stress tests;
serves as a liaison to the Financial Stability Oversight Council and its various working
groups; and helps develop and evaluate alternative approaches to implementing
macroprudential regulations.
The recent Comprehensive Capital Analysis and Review, in which the Federal Reserve
evaluated the internal capital planning processes and shareholder distribution requests of the
19 largest bank holding companies, is an example of a horizontal assessment with a
macroprudential approach. In the wake of the crisis, banks' capital payouts had been kept to
a minimum. As banks' earnings and capital positions continued to improve in 2010, however,
some firms sought approval to increase dividends or restart share repurchase programs. The
simultaneous assessment of the payout requests in the capital review allowed the Federal
Reserve, working through the LISCC, to evaluate not only the conditions of individual banks
but also the potential implications of capital payouts for aggregate credit extension and the
sustainability of the economic recovery. Thus, the program had both microprudential and
macroprudential goals. From a traditional safety-and-soundness perspective, we wanted
each firm to demonstrate that it had robust risk-management systems as well as a capital
plan that would allow it to manage potential losses in stress scenarios while comfortably
meeting Basel III capital requirements as they are phased in. But, with the help of
macroeconomic and capital market analysts, we also considered the implications of the
requests for the capital available to the banking system as a whole, with the objective of
ensuring that bank credit would still be available to households and businesses even if the
economy were to perform more poorly than expected.
We now also routinely apply macroprudential methods to the analysis of significant economic
developments, whether domestic or foreign. The sovereign debt concerns in Europe provide
one example. As yields on European sovereign debt and bank debt rose in the spring of
2010, Federal Reserve supervisors began to evaluate U.S. banking firms' exposures to
European banking firms and sovereigns. In addition to evaluating direct exposures, we
analyzed scenarios under which sovereign debt concerns might lead to broader financial
volatility. Our focus was on the possibility that financial disruptions might impede credit flows
and economic activity in both Europe and the United States. In our work we conferred
extensively with European bank supervisors; for example, we discussed potential risks to
European banks' abilities to obtain dollar funding and the implications of European banks'
need for dollars on U.S. money markets. This work suggested that providing a backstop for
the dollar-funding needs of European financial institutions could mitigate the potential for
spillovers to the United States from European sovereign debt concerns. In accord with this
analysis, in May 2010 the Federal Open Market Committee announced that it had authorized
dollar liquidity swap lines with other central banks in a preemptive move to avert a further
deterioration in liquidity conditions.
Macroprudential considerations have also been important for the Federal Reserve's
rulemaking, particularly those rules implementing the Dodd-Frank Act. For example, with
other regulators, we recently proposed rules to set margin requirements for over-the-counter
derivatives that are not cleared through a central counterparty. The proposed rules reflect not
only safety-and-soundness concerns but also macroprudential goals; specifically, the rules
seek to increase the resiliency of the financial system as a whole by reducing the potential
for contagion between swap market participants. Under the proposed rules, the
moststringent margin requirements would apply to derivatives contracts between swap dealers or
other major swaps market participants, as such arrangements could otherwise involve a risk
of "default chains" in which distress at one major firm could cascade through the swap
markets.
As I mentioned earlier, the macroprudential approach to financial regulation is gaining
increasing adherence internationally. Along with our efforts to implement reforms
domestically, the Federal Reserve has for some time been working closely with foreign
counterparts to help coordinate the reform process at the international level. The objectives
of international coordination are of the highest importance. These goals include maintaining a
level competitive playing field across countries, minimizing opportunities for multinational
firms to take advantage of weaker or inconsistent regulations in some jurisdictions,
establishing consistent and complementary standards, and ensuring effective oversight of
internationally active firms and markets. The Group of Twenty has devoted considerable
attention to financial-sector policies in its meetings during the past couple of years. The
Financial Stability Board, the Basel Committee on Banking Supervision, and other
international groups also have undertaken substantial work to coordinate macroprudential
policies across borders.
Much of the Federal Reserve's international effort has involved working with other regulatory
agencies and central banks to design and implement new prudential requirements for
internationally active banks. This work resulted in the adoption of more-stringent regulatory
capital standards for trading activities and securitization exposures in the summer of 2009,
as well as the agreement last fall on the major elements of the new Basel III framework for
globally active banks. Consistent with the macroprudential approach, the Basel III framework
requires the largest, most globally active banks to hold more, higher-quality capital, reflecting
the greater systemic risk associated with financial distress at the largest institutions.
Conclusion
The financial crisis demonstrated clearly that supervisory and regulatory practices must
consider overall financial stability as well as the safety and soundness of individual firms. The
Dodd-Frank Act requires regulators to mitigate the buildup of financial excesses and reduce
vulnerabilities, and it created an interagency council to monitor financial markets, to identify
emerging threats, and to help formulate policies to contain those risks. For our part, the
Federal Reserve has restructured its internal operations to facilitate a macroprudential
approach to supervision and regulation and to monitor systemic risks. We are committed to
working closely with the oversight council and other agencies to promote financial stability.
While a great deal has been accomplished since the act was passed less than a year ago,
much work remains to better understand sources of systemic risk, to develop improved
monitoring tools, and to evaluate and implement policy instruments to reduce
macroprudential risks. These are difficult challenges, but if we are to avoid a repeat of the
crisis and its economic consequences, these challenges must be met.