For release on delivery
4:30 p.m. EDT
April 4, 2017
Departing Thoughts
Remarks by
Daniel K. Tarullo
Member
Board of Governors of the Federal Reserve System
at
The Woodrow Wilson School
Princeton University
Princeton, New Jersey
April 4, 2017
Tomorrow is my last day at the Federal Reserve. So in this, my final official speech, it
seems appropriate to offer a broad perspective on how financial regulation changed after the
crisis. In a moment, I shall offer a few thoughts along these lines. Then I am going to address in
some detail the capital requirements we have put in place, including our stress testing program.
Eight years at the Federal Reserve has only reinforced my belief that strong capital requirements
are central to a safe and stable financial system. It is important for the public to understand why
this is so, especially at a moment when there is so much talk of changes to financial regulation.
The Post-Crisis Regulatory Response
To understand the regulatory changes made in response to the 2007 to 2009 financial
crisis, it is useful to recall the circumstances with which regulators and legislators were
confronted. First, of course, was the sheer magnitude of the impact on the economy, which
suffered its worst recession since the Great Depression. Second was the dramatic freezing up of
many parts of the financial market, risking successive waves of fire sales that would send asset
values plummeting anew. Third was the rapid deterioration of financial firms. Hundreds of
smaller banks eventually failed. Bear Stearns, Merrill Lynch, Wachovia, and Countrywide were
all close to failure when they were acquired by other financial firms with one or more forms of
government support or assistance. American International Group was rescued directly by the
government. Lehman Brothers did fail, which set off the most acute phase of the crisis.
The impact of Lehman's bankruptcy seemed to confirm fears that failure of the largest
financial firms risked the complete implosion of the financial system. This, of course, is the too-
big-to-fail problem: government officials may feel compelled to save private financial firms
with public (that is, taxpayer) capital. Meanwhile, financing markets had nearly frozen up.
Hence the extraordinary government actions that followed. Public capital was injected into all of
the nation's largest remaining banking firms following congressional enactment of the Troubled
Assets Relief Program (TARP). The Federal Reserve and the Department of the Treasury
provided financing and backstops, respectively, for money market funds and various forms of
securitized assets. The Federal Deposit Insurance Corporation extended its guarantees to bank
deposits and the senior debt of banks.
These and other measures ultimately proved successful in placing a floor under the
downward spiral of the financial system. But it was against the backdrop of the need for massive
taxpayer-backed assistance--to firms and to markets more generally--that Congress and financial
regulators developed responses to the woefully inadequate capital levels of prudentially
regulated firms; the systemic consequences of stress at previously non-prudentially regulated
firms such as the free-standing investment banks; the widespread failures of risk management
within these firms; the parallel failures in supervision of these firms; and the fragility of a
financial system that had become characterized by large amounts of runnable short-term funding.
The first and, to my mind, still the most important element of regulatory strengthening
was to increase the amount of capital held by banks to ensure they remained viable financial
intermediaries that could finance economic activity. In fact, this effort began as part of the
emergency stabilization efforts in early 2009, when we conducted a stress test of the 30 largest
banking firms. Where we determined a firm did not have enough capital, we required that it
either raise equity in the public markets or take some of the remaining government TARP
capital.
The quick action in assessing the firms, recapitalizing them where needed, and sharing
the results of the stress tests with the public stands as one of the turning points in the crisis.
From there, we pursued a strategy of gradually strengthening ongoing capital requirements.
With a few exceptions, the approach we took from the fall of 2009 onward allowed the banks to
use retained earnings to build their capital. We also began development of the first quantitative
liquidity regulations to be used in prudential regulation by the U.S. banking agencies. This
initiative was, of course, a direct response to the liquidity squeezes encountered during the crisis
itself.
The capital and liquidity efforts were well underway by the time Congress passed the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in mid-2010.
And Congress was, of course, aware of these efforts. So it is perhaps not surprising that the
provisions of the Dodd-Frank Act relating to capital set some important qualitative standards for
capital regulation rather than addressing capital levels as such.
A law as long and wide-ranging as the Dodd-Frank Act cannot be reduced to a single key
premise or concern, excepting its general focus on financial stability and systemic risk.1
However, with respect to the too-big-to-fail problem, I do think it fair to say--on the basis of both
the text itself and its legislative history--that a pivotal choice was to make tighter the prudential
regulation of the practices and activities of large banking organizations the presumptive approach
to taming too-big-to-fail problems.
The alternative, much discussed at the time and since, would have been a structural
approach. One such approach could have been something like the old Glass-Steagall Act
separation of commercial banking from investment banking, which prohibited rather than simply
regulated certain activities in different types of firms. Another structural approach would have
been outright size limitation resulting in the breakup of some of the largest financial firms. The
Dodd-Frank Act does give regulators authority to require divestitures by firms posing risks to
financial stability. But these authorities, which contain only the most general of standards, seem
intended to be used only if the panoply of other measures in the legislation have failed to contain
the too-big-to-fail problem.
Thus, at least in the first instance, the Dodd-Frank Act forgoes structural solutions, which
might have been cleaner conceptually, but perhaps much more complicated as a practical matter.
Instead, it imposes a host of restrictions and requirements. So we have counterparty credit limits,
risk retention requirements, incentive compensation constraints, resolution planning
requirements, and others. These new statutory measures were meant to, and do, coexist with the
capital and liquidity requirements put in place by the banking agencies under their pre-existing
authority, as enhanced by the Dodd-Frank Act. An important corollary of this basic approach
was that the Dodd-Frank Act requires that many of these regulations be progressively more
stringent as applied to firms of greater systemic importance.
From this perspective, then, it is not surprising that the Dodd-Frank Act implementation
has been a major undertaking, that banks (and sometimes supervisors) feel overwhelmed by the
breadth of the resulting compliance effort, and that there is some overlap among some of the
regulations. This outcome was, in effect, the price of the largest banks not being subject to a
direct structural solution such as breakup.
None of this is to say that the Dodd-Frank Act got the mix of restrictions just right. To
the contrary, it would have been surprising for such a major piece of legislation passed in the
immediate aftermath of the crisis to have done so. Usually, a law like the Dodd-Frank Act
would have been followed some months later by another law denominated as containing
technical corrections, but also usually containing some substantive changes deemed warranted by
analysis and experience. But partisan divisions prevented this from happening. And the novelty
of many of the forms of regulations adopted by financial regulators, either in implementing the
Dodd-Frank Act or under existing authorities, almost assures that some recalibration and
reconsiderations will be warranted on the basis of experience.
So there are clearly some changes that can be made without endangering financial
stability. Foremost among these are the various bank size thresholds established in the Dodd-
Frank Act or in agency regulations for the application of stricter prudential requirements. For
example, as I have said for several years now, we have found that the $50 billion in assets
threshold established in the Dodd-Frank Act for banks to be "systemically important," and thus
subject to a range of stricter regulations, was set too low. Similarly, the $10 billion asset
threshold for banks to conduct their own required stress tests seems too low. And the fact that
community banks are subject at all to some of the Dodd-Frank Act rules seems unnecessary to
protect safety and soundness, and quite burdensome on the very limited compliance capabilities
of these small banks.
Beyond the thresholds issue, though, are there statutory provisions or regulations whose
substance could be adjusted to better match economic or compliance costs with financial stability
benefits? Again, it would be very surprising if this did not prove to be the case over time. It
would also be surprising if we did not find areas in which rules needed to be strengthened in
order to achieve financial stability goals, particularly as financial markets change. Generally, I
think it is a bit early to judge the balance of costs and benefits of many of the new rules. Some
are not yet fully implemented. Firms are still in the process of adjusting to the new rules. And it
is still somewhat difficult to determine, for example, what should be considered "normal" levels
of liquidity or lending, insofar as the pre-crisis period was one in which high levels of both
lending and liquidity proved unsustainable. Moreover, given the healthy increases in lending
over the last several years and the record levels of commercial bank profits recorded in 2016, it
would seem a substantial overreach to claim that the new regulatory system is broadly
hamstringing either the banking industry or the economy.
But there are areas where I think the case for change has become fairly strong. The
Volcker rule is one. During the debates on what became the Dodd-Frank Act, former Chairman
Paul Volcker offered a fairly straightforward proposal: no insured depository institution or
affiliate thereof should be permitted to engage in proprietary trading. It seemed then, and seems
now, like an idea that could contribute to the safety and soundness of large financial firms.
However, several years of experience have convinced me that there is merit in the contention of
many firms that, as it has been drafted and implemented, the Volcker rule is too complicated.
Achieving compliance under the current approach would consume too many supervisory, as well
as bank, resources relative to the implementation and oversight of other prudential standards.
And although the evidence is still more anecdotal than systematic, it may be having a deleterious
effect on market making, particularly for some less liquid issues.
There are three problems--two in the statute and one in the regulatory approach--that I
think are related. The first statutory problem is that five different agencies are involved. While
the statute does not require a single regulation agreed upon by all five, it understandably calls for
coordination and consistency in rulemaking and implementation. The joint or parallel
rulemaking among multiple agencies required in various parts of the Dodd-Frank Act has
advantages and disadvantages that differ across subject matter. Here, though, the disadvantages
seem to dominate. Because almost any effort to distinguish market making from proprietary
trading, for example, is impossible to sensibly reduce to a formula or precise rule across all
traded instruments, there is ongoing and substantial need for context-specific, data-heavy
judgment. Efforts to achieve consistency in treatment across agencies have been both time-
consuming and, at times, unsuccessful.
The second problem is that the approach taken in the regulation in pursuit of consistency
was one that essentially contemplated an inquiry into the intent of the bankers making trades to
determine, for example, whether the trades were legitimate market making. The agencies knew
this approach would be complicated when we adopted it, but it seemed the best way to achieve
consistency, at least over time. I think the hope was that, as the application of the rule and
understanding of the metrics resulting from it evolved, it would become easier to use objective
data to infer subjective intent. This hasn't happened, though. I think we just need to recognize
this fact and try something else.
Had there been an obviously better approach, we would have taken it five years ago. My
suspicion is that it lies in reviewing and monitoring the trading limits established on all trading
desks. As contemplated in the statute, capital requirements might also be used as a
complementary tool, such as by requiring progressively higher amounts of capital as trading
inventories age--a pretty good indicator that market making is morphing into proprietary trading.
Whether a consistent approach can be developed while five agencies continue to be involved is
not clear, but it is certainly worth trying.
The third problem, also in the statute, is that the Volcker rule applies to a much broader
group of banks than is necessary to achieve its purpose. As I have said before, the concerns
underlying the Volcker rule are simply not an issue at community banks.2 Many regional banks
have few or no trading assets of any sort, so proprietary trading is obviously not a concern there
either. While the regulatory agencies have tried to tailor the rules so as to avoid burdening these
banks, even the process of figuring out that the rules do not constrain them is a compliance cost
that should be eliminated. One approach would be to exempt all banks with less than $10 billion
in assets and other banks that report less than some nominal amount of trading assets.
Capital Regulation
Let me now turn to capital. The history of financial regulation over the last several
decades is in many respects defined by an increasing emphasis on capital requirements and,
specifically, higher minimum ratios based on a more rigorous definition of what constitutes loss-
absorbing capital. This tendency can be explained by the fact that capital is a particularly supple
prudential tool. As activity and affiliation restrictions on banks have been loosened, and as the
integration of traditional lending with capital markets has created new financial products at a
rapid pace, capital requirements can provide a buffer against losses from any activities.
No single measure of capital is sufficient to ensure an adequate buffer however. Simple
leverage ratios are a good check on banks becoming too debt dependent, but they encourage
more risk-taking, insofar as they impose the same capital charge for every asset, no matter how
risky. Standardized risk-based capital ratios implement the intuitively appealing notion that a
bank's capital should depend on the riskiness of its assets. But the grouping of individual loans
and securities into necessarily broad categories of risk weights (e.g., residential mortgages) can
be arbitraged. And a firm holding lots of assets that look very low-risk in normal times can be
vulnerable if its total leverage is high during stress periods. Models-based capital requirements
can better distinguish among risks to some degree, and they can be made more forward-looking
than static leverage or risk-based ratios. But, to the extent that banks' internal models are used, it
is difficult to monitor whether banks are intentionally or unintentionally running models that
understate their risks. And, of course, they are subject to the usual limitations of models that are
based only on past experience and correlations.
In the post-crisis period, we have continued the previous U.S. practice of using
complementary leverage ratio and standardized risk-weighted capital requirements, though at
higher levels and with more reliance on common equity as the preferred measure of true capital
strength on a going concern basis. We have added a stress test, now based on a supervisory
model. We, along with some other jurisdictions that are home to banks of global systemic
importance (G-SIBs), have also applied surcharges to the leverage and risk-weighted
requirements of such banks. The rationale for this feature of our capital regime is that the
potential negative externalities caused by the stress or failure of a G-SIB warrant a higher level
of capital.3 Graduated capital surcharges have the additional policy benefit of providing these
firms with an incentive to reduce the size and scope of their activities so as to present lesser risk
to the financial system.
The U.S. banking agencies based post-crisis capital requirements on historical loss
experiences so as to require banks to have a capital buffer that could absorb losses associated
with a significant economic downturn and remain viable financial intermediaries in the eyes of
customers, counterparties, and financial markets.4 But our researchers, like those at some other
3
As implemented in the United States, the surcharge for G-SIBs was calibrated to provide a sufficient amount of
additional capital to sufficiently reduce the chances of a G-SIB's failure so that the impact of its failure, discounted
by the probability of that failure occurring, would approximately equal the impact of the failure of a large bank
holding company that is not a G-SIB, discounted by the somewhat higher probability of its failure (because its
capital ratio is lower without a surcharge). For a fuller explanation of this "expected impact" approach, see Board of
Governors of the Federal Reserve System (2015), "Calibrating the G-SIB Surcharge," white paper (Washington:
Board of Governors of the Federal Reserve System, July 20),
www.federalreserve.gov/aboutthefed/boardmeetings/gsib-methodology-paper-20150720.pdf.
4
See, for example, Daniel K. Tarullo (2011), "The Evolution of Capital Regulation," speech delivered at The
Clearing House Business Meeting and Conference, New York, NY, November 9,
www.federalreserve.gov/newsevents/speech/tarullo20111109a.htm.
official-sector entities, have been using more formal economic analysis to estimate the level of
capital requirements that best balances the benefits associated with reduced risk of financial
crisis with the costs of banks funding with capital rather than debt. A recent study by three
Federal Reserve Board researchers concludes that the tier 1 capital requirement5 that best
achieves this balance is somewhere in the range of 13 percent to 26 percent, depending on
reasonable choices made on some key assumptions.6 By this assessment, current requirements
for the largest U.S. firms are toward the lower end of this range, even when one takes account of
the de facto capital buffers imposed on most firms in connection with the stress test.
This assessment, when added to our original historically-based approach and the
methodology used in developing the capital surcharges, suggests strongly that a reduction in risk-
based capital requirements for the U.S. G-SIBs would be ill-advised. In fact, one might conclude
that a modest increase in these requirements--putting us a bit further from the bottom of the
range--might be indicated. This conclusion is strengthened by the finding that, as bank capital
levels fall below the lower end of ranges of the optimal trade-off, the chance of a financial crisis
increases significantly, whereas no disproportionate increase in the cost of bank capital occurs as
capital levels rise within this range. In other words, in trying to avoid a future financial crisis, it
is wise to err somewhat toward the higher end of the range of possible required capital levels for
this group of firms.
On the other hand, it seems reasonably apparent that the increased granularity of the
standardized risk-weighted capital requirements put in place after the crisis, while necessary to
deal with the range of risks in larger banks, is unduly complicated for community banks. It's not
that these requirements have increased appreciably the amount of capital community banks hold,
but more that the complexity of compliance and reporting imposes costs that are
disproportionately much greater for these banks, given that they have much smaller balance
sheets over which to amortize the associated costs. For this reason, I believe we should be
moving toward a much simpler capital regime for community banks. The federal banking
agencies have already taken some steps in this direction, and they can take a few more. But it
may be helpful to amend the law so as to make clear that the agencies would have the flexibility
to create a simple capital regime applicable only to community banks.
There has been much discussion of late of the leverage ratio requirement, from multiple
perspectives. There are proposals to make a higher leverage ratio requirement either mandatory
or optional for banks, which would then be relieved of risk-weighted capital requirements and
many other prudential regulations. There are also those who have questioned the relative cost-
benefit tradeoff of the "enhanced supplementary leverage ratio," the 2 percent surcharge
applicable to all eight U.S. G-SIBs.
Increasing the current 4 percent or 5 percent leverage ratio requirement to, say, 10
percent would certainly yield a very well-capitalized set of banks based on the current balance
sheets of large banks. But one needs to look at the dynamic effects of such a requirement. Since
a higher leverage ratio would also make banks less profitable, and with the constraints of risk-
based capital and liquidity requirements lifted, they would be strongly incentivized to change the
composition of their balance sheets dramatically, shedding safer and more liquid assets like
Treasuries in exchange for riskier but higher-yielding assets.7 After all, with a leverage ratio as
the only significant constraint, the regulatory cost of holding a short-term Treasury bill is
identical to that of a junk bond. It is this very limitation of a leverage ratio that led to the
creation of a complementary risk-based capital requirement in the 1980s. To truly assure the
safety and soundness of the financial system, a leverage ratio serving as the sole or dominant
form of prudential regulation would probably have to be set considerably higher, at a level where
the impact on financial intermediation could be quite substantial.
As to the impact of the 2 percent enhanced supplementary leverage ratio, our experience
leads me to believe that it may be worth changing to account for the quite different business
operations of the G-SIBs, particularly those in the custody business. The complementarity of
risk-based capital requirements and leverage ratios suggests that there should be some
proportionality between the two. This is, of course, the current situation with respect to the
standards applicable to non-systemic banks, with the leverage ratio requirement being sensibly
set somewhat below the risk based requirement. However, with the additional standards
applicable only to the eight systemically important firms, we have a sliding scale of risk-based
surcharges but an across-the-board 2 percent leverage ratio surcharge.
In practical terms, the asymmetry is most significant for the two banks that are
dominantly custodial and transactional in nature, rather than lending and trading firms. These
banks have had the lowest risk-based surcharges of the eight G-SIBs--currently 1-1⁄2 percent--but
their leverage surcharge is 2 percent. This is especially problematic for their operations, since
they prudently reinvest custody customer deposits into safe and liquid assets.
I think it would be sensible for the banking agencies to consider altering the enhanced
supplementary leverage ratio requirement so that it would be set with an eye toward the risk-
based surcharge. One, but certainly not the only, way to do this would be for the enhanced
supplemental leverage ratio to be 1 percent for the firms with a 1 percent to 1-1⁄2 percent risk-
based surcharge, 1-1⁄2 percent for those with a 2 percent or 2-1⁄2 percent risk-based surcharge, and
2 percent for those at 3 percent or above.
An alternative approach to mitigating the distortionary effects of the leverage ratio
requirements is to exclude certain "riskless" assets from the denominator. Some central bankers
around the world have been arguing to exclude central bank reserves from the leverage ratio
denominator, on the ground that they are "safe" and that including them may make monetary
policy harder to execute in a period of unusually large central bank balance sheets. But this
would defeat the whole purpose of a leverage ratio, which is to place a cap on total leverage, no
matter what the assets on the other side of the balance sheet may be. Cash holdings, for
example, are not excluded. This proposal would also create a classic slippery slope risk, which
was illustrated during a discussion in which I participated last year. When a central banker
raised the idea of excluding reserves, a finance ministry official mused aloud that perhaps
sovereign debt should also be excluded.
Stress Testing
Raising the minimum ratios in leverage and risk-based capital standards, requiring that
qualifying regulatory capital be truly loss absorbing, and setting higher requirements for the most
systemically important banks have been important steps toward the goal of a well-capitalized,
and thus safer, financial system. But the stress testing system begun during the crisis, and
continually refined since, has been the key innovation in capital regulation and supervision and
makes those other measures more effective. The success of the 2009 stress test in restoring
confidence in the financial system during the crisis encouraged Congress to make stress testing a
required and regular feature of large-firm prudential regulation.
As the term suggests, stress tests evaluate the capacity of banks to absorb losses that may
be associated with major economic adversity and remain not only technically solvent, but also
viable financial intermediaries. They are explicitly forward-looking, in that they involve creating
unlikely but plausibly severe economic scenarios and then modeling the likely impact of those
scenarios on bank assets and earnings. The Federal Reserve has tied the results of stress tests
into capital regulation by requiring that bank capital distributions be consistent with maintaining
viability in the event the severe scenario were to materialize. That is, dividends and share
repurchases cannot bring the bank's capital level below the sum of minimum capital
requirements and the amount of losses that could be sustained in the stress event. By looking at
the impact of such scenarios on the considerable part of the financial industry accounted for by
the larger bank holding companies subject to the requirement, the Federal Reserve's approach
gives insight into how substantial economic or financial shocks would affect the financial system
and the real economy.
One virtue of stress testing is that it allows a forward-looking assessment of potential
losses that is customized to the portfolios and business models of each bank, while still being
consistent across the banks. The Federal Reserve uses independent supervisory models to
estimate losses and revenues under stress, both to achieve more comparability across the results
for different banks and to preclude any temptation for banks to game their own models. This
linkage of stress testing to bank capital requirements has been a good way for regulators to
regularize exercise of their broad statutory discretion to set individual capital requirements on a
bank-by-bank basis.8 Banks subject to the supervisory stress tests have generally found it to be
their binding capital constraint. This is as it should be, insofar as stress testing is meant to help
set capital requirements for when they will most be needed--that is, in a serious economic
downturn.
From the first stress test performed in the winter of 2009, the Federal Reserve has
publicly disclosed progressively more information about its supervisory model, the scenarios,
and the results. During the crisis, disclosure was intended to help restore confidence in the
banking system. Our continuation and expansion of disclosure helps market participants,
analysts, academics, and the public better evaluate both the condition of the banks and the rigor
of supervisory oversight. It thus serves the dual purpose of market discipline and government
agency accountability.
To serve its important financial stability purpose, stress testing must never become static.
As the financial system evolves, with the creation of new products and new correlations among
asset price movements, the supervisory model must account for these changes. And as salient
risks to the financial system arise, the scenarios must test for these new risks. Apart from the
inherent need for adaptation, though, there is one respect in which the Federal Reserve's stress
testing program is incomplete and other respects in which it is still in transition from a crisis and
post-crisis measure to a permanent and central feature of prudential oversight.
The significant way in which the stress testing program is incomplete is that it has only
limited features with which to assess the condition of participating banks from a macroprudential
perspective.9 For example, it generally does not directly take account of second-round effects of
stress on the financial system, such as the possible fire sale of assets by financial firms in need of
capital or funding, which can further depress asset values of other firms below levels resulting
from the initial economic or financial shock.10 These effects are harder to model but very
important for a stress test designed to achieve financial stability objectives. The Federal Reserve
has begun a research program to try to develop, over the next few years, sound macroprudential
elements to incorporate into the stress test alongside some of the countercyclical features that
have already been added.
The transition of stress testing from crisis program to a permanent feature of prudential
oversight is unfinished in both Federal Reserve regulations and supervisory practice. The de
facto capital requirements produced by the stress test have not been fully integrated into, and
reconciled with, other applicable capital rules. Thus, for example, our stress testing program
assumes that a firm will continue to make its planned capital distributions during a stress period
even though the regulatory capital rules now include a capital conservation buffer to limit such
distributions. As to supervision--because the failure of a firm to meet Federal Reserve
expectations with respect to its capital risk-management and planning processes can lead to a
"qualitative" objection to its capital distribution plans--firms (and, at times, perhaps supervisors)
have placed more emphasis on these matters than on other issues raised in the supervisory
process throughout the year.
It is probably worth noting at this juncture that one of the features of the stress testing
program that some banks have found most troubling is that it culminates in the annual
announcements of whether the Federal Reserve objects to each participating bank's capital plan--
an event that still garners considerable investor and public attention.11 The potential for
embarrassing, public objections to their plans has been disconcerting to some banks, which
pointed out that--by design--they were not given the supervisory model for calculating post-
stress minimum capital levels and that they might not be able to predict when supervisory
concerns with some aspects of their capital planning processes would ripen into a public
objection.
It is certainly the case that this feature of our stress testing program was intended to, and
has, focused the minds of banks' senior management on their capital positions and capi