Daniel K Tarullo: Regulating systemically important financial firms
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Peter G Peterson Institute for International Economics, Washington DC,
3 June 2011.
* * *
As the one-year anniversary of the Dodd-Frank Act approaches, there will be much
discussion about the progress that has been made in reforming financial regulation. Today I
would like to get a head start on this exercise, concentrating on Dodd-Frank's requirement
that the Federal Reserve Board establish special prudential standards for systemically
important financial institutions or, as they are now generally known, "SIFIs." My focus will be
on the requirement for more stringent capital standards, which has generated particular
interest.
Let me begin by placing this regulatory task in context. The financial crisis spawned or
strengthened many reform agendas - among them consumer protection, securities and
commodities market regulation, and traditional bank regulation. But a focus on systemic risk
has been central to reform efforts, and fittingly so. It was, after all, a systemic financial crisis
that we experienced and that led to the Great Recession that affects us still today.
Regulatory reform in the wake of the crisis cannot be judged a success if it does not reduce
the incidence and severity of future crises.
The pre-crisis regulatory regime had focused mostly on firm-specific or, in contemporary
jargon, "microprudential" risks. Even on its own terms, that regime was not up to the task of
assuring safe and sound financial firms. But it did not even attempt to address the broader
systemic risks associated with the integration of capital markets and traditional bank lending,
including the emergence of very large, complex financial firms that straddled these two
domains, while operating against the backdrop of a rapidly growing shadow banking system.
A post-crisis regulatory regime must include a significant "macroprudential" component, one
that addresses two distinct, but associated, tendencies in modern financial markets: First, the
high degree of risk correlation among large numbers of actors in quick-moving markets,
particularly where substantial amounts of leverage or maturity transformation are involved.
Second, the emergence of financial institutions of sufficient combined size,
interconnectedness, and leverage that their failures could threaten the entire system.
In prior speeches I have discussed the correlated risks present in such areas as money
market funds and repo markets.1 This afternoon I turn to some of the issues surrounding
regulation of SIFIs. Before doing so, it is important to underscore what is at stake here. For
all the disagreements among legislators, policy officials, and the public over the right set of
financial reform measures, I have noted one point on which there is near unanimity: No one
wants another TARP program. Not those who thought TARP was the best of a bad set of
options in the fall of 2008. Certainly not those who opposed it. Not the American people,
many of whom saw the injection of billions of dollars of government capital into financial firms
as more a bail-out of large banks than an imperative to stabilize the financial system. And not
even, I suspect, most of the large financial firms that received the government capital.
In a period of financial stress, the disorderly failure of one or more SIFIs carries the potential
for a devastating impact on the financial system. The fear elicited by that prospect led the
Bush Administration to ask for TARP authority. That same fear led many members of
Congress with no great love for large financial firms to vote for TARP. Those actions are
further evidence for the proposition that, no matter what their general economic policy
principles, government officials faced with a cascading financial crisis that threatens to bring
down the national economy will usually support measures to rescue large banks. In order to
avoid the need for a new TARP at some future moment of financial stress, the regulatory
system must address now the risk of disorderly failure of SIFIs.
Rationale for enhanced capital requirements
Last fall central bank governors and heads of supervision from countries represented on the
Basel Committee on Banking Supervision agreed to the important package of reforms in
capital regulation known as Basel III. The Basel III requirements for better quality of capital,
improved risk weightings, higher minimum capital ratios, and a capital conservation buffer
comprise a key component of the post-crisis reform agenda. But they are just that - a
component. Although a few features of Basel III reflect macroprudential concerns, in the
main it was a microprudential exercise. The new minimum equity capital ratio and
conservation buffer were calibrated on the basis of an historical examination of the individual
loss experiences of banks in the United States and six other countries.
A macroprudential perspective on capital requirements complements the microprudential
orientation of Basel III. There would be very large negative externalities associated with the
disorderly failure of any SIFI, distinct from the costs incurred by the firm and its stakeholders.
The failure of a SIFI, especially in a period of stress, significantly increases the chances that
other financial firms will fail, for two reasons. First, direct counterparty impacts can lead to a
classic domino effect. Second, because losses in a tail event are much more likely to be
correlated for firms deeply engaged in trading, structured products, and other capital market
instruments, all such firms are vulnerable to accelerating losses as troubled firms sell their
assets into a declining market.
A SIFI has no incentive to carry enough capital to reduce the chances of such systemic
losses. The microprudential approach of Basel III does not force them to do so. The rationale
for enhanced capital requirements for SIFIs is to take these costs into account, make SIFIs
less prone to failure, and thereby to make the financial system safer. An ancillary rationale is
that additional capital requirements could help offset any funding advantage derived from the
perceived status of such institutions as too-big-to-fail.
Of course, if a SIFI could be resolved in an orderly fashion, negative externalities could be
greatly reduced. The special resolution regime in Dodd-Frank aims at just such an outcome.
The FDIC is investing considerable time and talent into making that outcome more likely, and
thus bringing a greater measure of market discipline to large financial firms more generally.
Together with the FDIC, the Federal Reserve will be reviewing the resolution plans required
of larger institutions by Dodd-Frank and, where necessary, seeking changes to facilitate the
orderly resolution of those firms.
Still, we must acknowledge that we are some distance from achieving this goal. The legal
and practical complexities implicated by the insolvency of a SIFI with substantial assets in
many countries will make its orderly resolution a daunting task, at least for the foreseeable
future.2 Similarly, were several SIFIs to come under severe stress, as in the fall of 2008, even
the best-prepared team of officials would be hard-pressed to manage multiple resolutions
simultaneously.
For these reasons, the special resolution mechanism of Dodd-Frank and the enhanced
capital requirements called for by that same law should be regarded as complementary
rather than as substitutes. Indeed, additional capital requirements would relieve some
pressure on the insolvency regime. That regime, in turn, could over time induce additional
market discipline so as to make more likely the chances that failure of a very large institution
would be a manageable event.
Features of the enhanced capital requirement
While Dodd-Frank mandates an enhanced capital requirement for SIFIs, it does not specify
the form of that requirement. I would suggest five desirable characteristics.
First, in keeping with the macroprudential aims of SIFI regulation, an additional capital
requirement should be calculated using a metric based upon the impact of a firm's failure on
the financial system as a whole. Size is only one factor to be considered. Of greater
importance are measures more directly related to the interconnectedness of the firm with the
rest of the financial system. Several academic papers try to develop this concept based on
inferences about interconnectedness from market price data, using quite elaborate statistical
models.3 Others have proposed using more readily observed factors such as intra-financial
firm assets and liabilities, cross-border activity, and the use of various complex financial
instruments.
Second, the metric should be transparent and replicable. In establishing the metric, there will
be a trade-off between simplicity and nuance. For example, using a greater number of
factors could capture more elements of systemic linkages, but any formula combining many
factors using a fixed weighting scheme might create unintended incentive effects. On the
other hand, using a small number of factors that measure financial linkages more broadly
might reduce opportunities for unintended incentive effects, but at the cost of some sensitivity
to systemic attributes of firms. Whatever the set of factors ultimately chosen, the metric must
be clear to financial firms, markets, and the public.
Third, the enhanced capital standards should be progressive in nature. Dodd-Frank itself
mandates that they "increase in stringency" with the systemic footprint of the firm, though the
statute gives the Federal Reserve Board discretion in deciding how to realize this goal. There
are good reasons for this requirement. Systemic importance is not a binary determination,
but one of degree. A related point is that it is generally better to avoid cliff effects, whereby
significant regulatory consequences ensue based on relatively modest differences among
firms. On this point, I would note that, while Dodd-Frank requires us to apply enhanced
capital standards to all bank holding companies with more than $50 billion in assets, we
would not want a big difference between the capital requirements for firms with assets just
over that level and those just under that level. Thus the supplemental capital requirement for
a $50 billion firm is likely to be very modest.
At the same time, it is important to build in constructive incentive effects. That is, the
regulatory structure for SIFIs should discourage systemically consequential growth or
mergers unless the benefits to society are clearly significant. There is little evidence that the
size, complexity, and reach of some of today's SIFIs are necessary in order to realize
achievable economies of scale and scope.4 Some firms may nonetheless believe there are
such economies. For them, perhaps, the highest level of an additional SIFI capital charge
may be worth absorbing. Others, though, may conclude in light of the progressive form of the
capital requirement that changes in the size and structure of their activities would align better
with their returns.
The implication of this point is that the enhanced capital requirements should increase based
on the metric I discussed a few moments ago. As a theoretical matter, the ideal approach
would be a continuous function, by which the percentage rate of the additional requirement
would vary precisely with the measure of a firm's systemic importance. An alternative would
be a tiered structure, by which firms are divided into several groups on the basis of the
systemic metric, with the rate of the additional requirement varying by group but the same for
every firm in each group.
Fourth, it is important that an enhanced requirement be met with high-quality capital. Our
presumption is that this means common equity, which is clearly the best buffer against loss
and is what markets focused on during the crisis when evaluating the viability of financial
firms. Some have suggested that a form of contingent capital instruments ("CoCos") could be
a partial or complete substitute for common equity. There is surely conceptual appeal in
so-called "going concern" CoCos that convert from debt to equity early enough to forestall a
run on a firm and keep it a viable financial intermediary even under stressed conditions.
However, for all the attention paid to CoCos in the last few years, it is even now not clear as
a practical matter that an instrument can be developed which would be cheaper than
common equity but still structured so as to convert in a timely, reliable fashion.5 Furthermore,
as the history of Tier 1 capital under the original Basel Accord teaches, there is considerable
risk that once some form of hybrid is permitted, a slippery slope effect ensues, whereby
national regulators approve increasingly diluted forms of capital under political pressures.6
Fifth, U.S. requirements for enhanced capital standards should, to the extent possible, be
congruent with international standards. The severe distress or failure of a foreign banking
institution of broad scope and global reach could have effects on the U.S. financial system
comparable to those caused by failure of a similar domestic firm. The complexities of
crossborder resolution of such firms, to which I alluded earlier, apply equally to foreign-based
institutions. For these reasons, we have advocated in the Basel Committee for enhanced
capital standards for globally important SIFIs.
Achieving and implementing such standards would promote international financial stability
while avoiding significant competitive disadvantage for any country's firms. I would note in
this regard that it will be essential that any global SIFI capital standards, as well as Basel III,
be rigorously enforced in all Basel Committee countries.
Work on this subject in the Basel Committee started a bit slowly, but it has picked up
considerably in recent months. Although there is not yet consensus on some of the key
elements, discussions have decidedly moved in that direction. I am hopeful that in the next
several months we will be able to agree upon a proposal on which the Basel Committee can
seek public comment. This international process would roughly coincide with a domestic
notice and comment process on a proposed Federal Reserve rulemaking covering enhanced
prudential standards for SIFIs. The parallelism of the international and domestic processes
should facilitate the goal of congruence. Of course, we will in any case apply our enhanced
standards, as required by Dodd-Frank, to foreign banking organizations operating in the
United States.
Calibrating the enhanced capital standards
As I mentioned earlier, the minimum and conservation buffer capital requirements of Basel III
were calibrated by looking to the loss experience of larger banks. The intuition behind this
approach was that historical loss experience provided the best basis for determining the
amount of capital a bank would need in order to be regarded by counterparties as a viable
financial intermediary. The minimum requirement was calculated by reference to the loss
experiences of larger banks over several decades. The conservation buffer, intended to be
the amount of capital necessary for a bank to withstand losses during a period of stress and
still be above minimum required levels, was calculated by reference to the recent financial
crisis.
A number of significant assumptions must be made in conducting analyses of this sort. For
this reason, we found it more sensible to think in terms of ranges of capital requirements
implied by this approach, rather than a specific number. Setting the final requirements still
required some judgment, not least on the question of how much we should try to minimize
the chances of failure. The requirements ultimately agreed upon by the Basel Committee
were within the range we had estimated, though at the lower end of that range. But the key
point is that there was a single, reasonably persuasive approach to calibration around which
regulators here and abroad converged.
When we move from the microprudential to macroprudential rationale for capital regulation,
there is no such single accepted method for calibration. We do want to reduce further the
probability that a SIFI might fail under stress. In that sense the exercise has some continuity
with the microprudential approach - the percentage of required capital needs to be increased
to achieve a smaller probability of failure based on the kind of loss history examined for
Basel III purposes. But the macroprudential rationale for enhanced capital standards is the
amount of harm a SIFI failure will inflict on the rest of the financial system, not the amount of
loss its shareholders and creditors will incur. The calibration of the additional requirement
needs to reflect this concern.
Several different methodologies have been considered by the Basel Committee. The
"expected impact" approach tries to determine how much additional capital would be needed
to reduce the probability of failure of a SIFI sufficiently to equalize the expected impact on the
financial system of the failure of a SIFI and the failure of a banking firm just outside systemic
status. For example, if the loss to the financial system from the failure of a SIFI would be five
times that resulting from failure of the non-systemic firm, then the SIFI would have to hold
additional capital sufficient to make the expected probability of failure one-fifth that of the
non-SIFI. The enhanced capital requirement implied by this methodology can range between
about 20% to more than 100% over the Basel III requirements, depending on choices made
among plausible assumptions.
Another methodology uses macroeconomic models to estimate both the costs and benefits
of higher capital requirements to the economy as a whole. The motivation for this "long-run
economic impact" approach is still macroprudential, even though it differs from that informing
the expected impact approach. However, isolating the effects of capital levels within a
general macroeconomic model is a very challenging task and, perhaps for that reason, it
produced lower implied increases in capital requirements than did the expected impact
approach.
A third methodology tries to determine how much additional capital would be needed to offset
any reduction in funding costs associated with the perceived too-big-to-fail status of SIFIs.
The capital requirement increases implied by this approach were considerably higher than for
the other two approaches. However, the results seemed even more sensitive to changes in
reasonable initial assumptions than did the other two models. Moreover, while the possible
moral hazard and competitive funding advantage associated with SIFIs are certainly of
concern, they do not relate directly to the conceptual foundation for enhanced capital
requirements, which lies in the negative externalities associated with a SIFI failure.
In reaching our final view on calibration, the Federal Reserve Board will consider all these
approaches, though I note that the expected impact methodology has had the most influence
on our staff's analysis. We will also take account of observations from academics and
financial institutions. We are certainly mindful of the uncertainties associated with these
methodologies. But, at the same time, we cannot ignore the costs to society that the failures
of SIFIs would cause the financial system and the economy more generally.
Objections to enhanced capital standards
As we draw closer to the January 2012 statutory date for a rule on enhanced prudential
standards for SIFIs, and as the Basel Committee makes progress on a SIFI surcharge,
various objections have been raised to additional capital charges for SIFIs. Some have
suggested that the statutory requirement for stricter capital requirements could be formally
met by lowering capital requirements for banks with less than $50 billion in assets, or by
modestly increasing the consequences of falling below the Basel capital buffer for banks with
more than $50 billion in assets.
An examination of these objections does not, I believe, undermine the case for the type of
SIFI capital standard I have described. On the contrary, some of these objections actually
strengthen the case by revealing certain misplaced assumptions about the financial system
that are embedded in the arguments of those who oppose a meaningful additional capital
requirement.
A first objection is that equity is expensive - that the enhanced standard will force SIFIs to
reduce their balance sheets because, with higher capital ratios, they cannot earn the rate of
return that will be demanded by their investors. The purported result would be reduced
intermediation, with consequent costs to the economy. This argument is conceptually
incomplete, if not flawed, even when applied to generally applicable capital requirements. To
the extent that equity investors demand higher rates of return from financial firms than from
non-financial firms, it is largely because financial firms are so much more highly leveraged.
Thus the risk of loss is greater, even as the prospect for outsized returns on the limited equity
is improved. The lower leverage that would result from higher capital requirements should
lead to at least some reduction in the required return on equity.
The argument is even weaker in the context of an additional charge limited to SIFIs. To the
degree that systemically important institutions find the additional capital requirement makes
some lending unprofitable, that lending could be assumed by smaller banks that do not pose
similar systemic risk and thus have lower capital requirements. To be sure, there may not be
perfect substitution, particularly not in the short term. In part for that reason, we contemplate
a fairly generous transition period to the SIFI capital regime. In addition, though, it is worth
recalling that not every additional dollar of lending or capital market activity is necessarily
socially optimal. Just as monetary policy must at times induce higher credit costs in order to
forestall the wider problems that high inflation would bring, so some checks on the scale of
SIFIs are warranted to avoid a repeat of the financial crisis.
A second objection lodged by opponents is that what they characterize as the "punishment"
of size and interconnectedness is shortsighted, because SIFIs are needed in a global
financial system. But as earlier noted, while there are good reasons for firms to be big, there
is little if any research showing that firms need to have balance sheets with the size and
composition some do in order to achieve genuine economies of scope and scale. Moreover,
a SIFI capital requirement would not prohibit the size and interconnectedness of today's
firms. Rather, it would incentivize firms to maintain those dimensions only if there are
riskadjusted returns for activities that require this scale. If research does establish some true
economies for the largest, most interconnected firms, those benefits would need to be
balanced with the societal risks associated with their potential distress or failure.
A third objection is that establishing SIFI metrics and capital requirements will actually
increase, rather than mitigate, moral hazard by identifying which firms are considered
too-big-to-fail. For those of us in the United States, Congress has already rejected this
argument by its creation of the requirement for enhanced prudential standards.7 More
fundamentally, the likelihood of systemic impact does not change regardless of whether firms
have to meet enhanced capital standards. And moral hazard is already undermining market
discipline on firms that are perceived to be too-big-to-fail. Higher capital standards will help
offset the existing funding advantage for SIFIs.
A fourth objection is that a SIFI surcharge is unnecessary because Basel III and the
Dodd-Frank Act have already put in place an adequate set of safety and soundness
protections. I have already explained that Basel III is largely a microprudential tool, which
does not fill the important macroprudential function of containing systemic risk. Provisions of
Dodd-Frank such as the Volcker rule and the requirement for standardized derivatives to be
centrally cleared are directed at specific activities believed by Congress to give rise to
particular risks. It is important to recognize, first, that the diminution of such risks will carry
some reduction in capital requirements and, second, that a crucial role of capital regulation is
to provide a buffer against loss from all activities of a banking organization. As to the first, the
cessation of proprietary trading and the limiting of private equity activities will directly reduce
risk-weighted assets and thus capital requirements. Similarly, centrally cleared derivatives
will carry lower capital charges.
As to the second point, the history of financial regulation over the last thirty years suggests
that, when certain activities are restricted, firms will look for new areas in which to take more
risk in the search for return. Capital regulation is the supplest and most dynamic tool we have
to keep pace with the shifting sources of risk taken by financial firms. It is far from a panacea,
subject as it is to arbitrage and dependent as it is on supervisory rigor. That is perhaps why
Congress has also required enhanced prudential standards in other areas such as liquidity,
concentration of counterparty exposures, and risk management. But, I would say in
conclusion, capital requirements are integral to both microprudential and macroprudential
regulation. They are the foundation upon which much other regulation is built.