Daniel K Tarullo: Involving markets and the public in financial regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Council of Institutional Investors meeting, Washington DC, 13 April 2010.
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As Congress returns from recess this week, attention will turn once again to financial
regulatory reform. The Federal Reserve and other financial regulators have, under existing
statutory authority, already implemented some changes to prudential rules and to
supervisory oversight processes. Other changes are under active consideration. Against this
backdrop, and mindful that my audience is composed of institutional investors, I would like
this morning to discuss the importance of more thoroughly involving markets and the public
in the financial regulatory system.1
The emerging structure of financial regulatory reform
The crisis arose against the backdrop of a regulatory system that had not adjusted to the
extensive integration of traditional lending with capital market activities, which had created
new sources of systemic risk. The internal information and risk-management systems of
many financial firms were revealed as inadequate to the task of identifying the scope of
market and credit risks, much less ensuring the soundness of those firms, in a period of
severe stress. The already significant problem of institutions perceived as too-big-to-fail was
further amplified by the government's actions in 2008 to prevent a complete collapse of the
financial system. To succeed, proposed reforms to counteract systemic risk must address
these quite fundamental deficiencies.
It may be helpful to organize the reform agenda by reference to the "three pillars" of financial
regulation enunciated by the Basel Committee on Banking Supervision - minimum prudential
requirements, supervisory oversight, and market discipline. Although the Basel Committee
formulated the three-pillar approach in the context of the Basel II framework for capital
requirements, this structure can also be applied to the broader set of reform measures.
There seems to be a fair consensus that the first two pillars of minimum prudential
requirements and supervisory oversight need to be substantially improved in the wake of the
crisis, including additional requirements based on the systemic role of firms. The widespread
acceptance of the need for a robust mechanism for resolving large financial institutions
reflects a consensus that market discipline needs to be substantially increased in order to
provide a genuine third pillar of the regulatory system. Finally, support for structural
measures such as the Volcker rule, mandatory central counterparties for certain derivatives
trading, and limits on the growth of large financial institutions reveals a belief that even a
strengthened three-pillar approach may not be enough to ensure financial stability. These
measures are, in effect, a proposed fourth regulatory pillar.
The evolution of this multi-pillar approach is an understandable response to the severity of
the financial crisis and ensuing recession. There are differing, though not necessarily
mutually exclusive, views as to what methods will be most effective in limiting the incidence
and severity of future financial crises. Thus, we should not be surprised to see a variety of
regulatory measures in both agency actions and legislative reform packages. Indeed,
building a regulatory system with multiple instruments has advantages, since established
regulatory mechanisms each have well-documented shortcomings, and the effectiveness of
new ones will necessarily be uncertain.
Yet some fear that the result will be an unwieldy system that will contain too many half
measures, rather than a few strong regulatory mechanisms. Others worry that the multiplicity
of regulatory instruments will suppress not just behavior that is excessively risky in light of
expected social returns, but also some socially desirable financial intermediation. The result
would be lower potential economic growth rates. There is also concern that imposing
additional forms of regulation on already supervised institutions could drive more financial
activity into unregulated firms and markets.
Certainly, with multiple instruments comes the need for meshing them into an effective
system of regulation, in which the shortcomings of each regulatory tool will be offset by other
tools in what must surely be a dynamic process of adjusting to new financial products and
practices. Channeling the information provided by market assessments of financial
institutions and organizing opportunities for public comment on the regulatory process can
play a key role in achieving a self-critical, dynamic regulatory system.
Incorporating market discipline into the regulatory system
Despite years of interesting academic work on incorporating market discipline into financial
regulation, it has to this point been consigned to a mostly cosmetic role. One obvious
consequence of this neglect was that moral hazard grew unchecked, as expectations of
government support for the financial system meant that potential losses from risky behavior
- even where understood by market participants - were not fully internalized by the
counterparties of, and investors in, large financial institutions. But the underpricing of risk
also meant that market judgments on such institutions were not as useful for regulatory
purposes as they could have been.
Any market signal about the absolute or relative health of a financial firm will always contain
considerable noise. And market signals will be of less use if, as may be the case, some
forms of risk are almost exclusively systemic, in the sense that the risk will turn into loss only
in a systemic crisis. But surely, even with these qualifications, the regulatory system has
much to gain from increasing market discipline in financial markets. Two possibilities have
been most widely discussed.
First, as already noted, there is wide support for a resolution mechanism for large financial
firms that would create a third alternative to the current, unsatisfactory options of bailout or
possibly destructive disorderly bankruptcy. Both the reform bill passed by the House last year
and the bill to be considered on the floor of the Senate contain variations on this basic
proposal.
Yet the debate around resolution proposals has highlighted the challenge of crafting a
workable resolution regime for large, interconnected firms. The basic design problem is that
such a regime must advance the goals of both financial stability and market discipline. While
these goals are usually complementary, they can at times be competing - especially in
periods of high financial stress, when time consistency problems can loom large. In the midst
of a crisis, governments fearful of financial upheaval can be tempted to provide assistance to
supposedly uninsured creditors, even at the cost of increasing moral hazard in the post-crisis
period.
Despite the design difficulties, I think certain features are essential in any special resolution
process. One is that any new regime should be used only in those rare circumstances where
a firm's failure would have serious adverse effects on financial stability. That is, the
presumption should be that generally-applicable bankruptcy law applies to nonbank financial
firms - even large, interconnected ones. Another is that once the new regime is invoked, the
government should have broad authority to wind down the financial firm in an orderly way.
Most importantly, there should be a clear expectation that the shareholders and creditors of
the failing firm will bear losses to the fullest extent consistent with preserving financial
stability. To personalize things for this audience, we must ensure that if you have invested
money in a large financial firm that runs aground, you will suffer losses. Shareholders of the
firm ultimately are responsible for the organization's management (or mismanagement) and
are supposed to be in a first-loss position upon failure of the firm. Shareholders, therefore,
should pay the price for the firm's failure and should not benefit from a government-managed
resolution process.
To promote market discipline on the part of the creditors of large, interconnected firms,
unsecured creditors of the firms must also bear losses. Here is where the potential conflict of
policy goals is obvious. While losses imposed on creditors will increase market discipline in
the longer term, the immediate effect could be to provoke a run on other firms with broadly
similar positions or business strategies. Thus, the allocation of such losses may need to
depend on the facts of the individual case. At the very least, however, subordinated debt, or
other financial interests that can qualify as regulatory capital, should be fully exposed to
losses.
As is implicit in the foregoing discussion, a novel resolution regime will probably not acquire
complete credibility until it is actually applied successfully. Other devices, such as the
so-called "living will" requirement, could help, but some uncertainty will inevitably remain. For
this reason, among others, it is important to ensure that other regulatory tools will help
compensate for the uncertainties associated with an essentially untested mechanism. It also
suggests the importance of exploring additional means to increase market discipline. A good
resolution mechanism is an essential component of an effective regulatory system, but
standing alone it is far from sufficient.
A second proposal that has received considerable attention is to require large financial
institutions to hold so-called contingent capital, which is basically debt that converts to
common equity as a result of some predefined triggering event. There are actually two
distinct concepts that may be characterized as "contingent" capital. The first is a requirement
for a specified kind of capital instrument to be issued by the firm - one that would have
debtlike characteristics in normal times but would convert to equity upon the triggering event. The
other is a requirement that all instruments qualifying as Tier 2 regulatory capital convert to
common equity under specified circumstances, such as a determination that the firm would
otherwise be on the brink of insolvency.
The market discipline effects of both variants could be considerable, since holders of certain
kinds of capital instruments would know that their debt-like interests in the firm would be lost
if the firm's financial situation deteriorated. However, there are also significant questions
about the feasibility of both. The specification of the trigger is critical. If supervisors can
trigger the conversion, investors cannot be certain as to when the government will exercise
the trigger. That uncertainty would make it difficult to price a convertible capital instrument
and diminish investors' willingness to hold it. Tying the trigger to the capital level of the firm
runs headlong into the serious problem that capital has traditionally been a lagging indicator
of the health of a firm. Using a market-based trigger could invite trading against the trigger,
which, in extreme cases, could lead to a so-called death spiral for the firm's stock.
Despite the work that has been done on contingent proposals, it is not yet clear if there is a
viable form of contingent capital that would increase market discipline and provide additional
equity capital in times of stress without raising the price of the convertible debt close to
common equity levels. The appeal of the concept is such as to make further work very
worthwhile but, for the moment at least, there is no proposal ready for implementation.
Before closing the discussion of mechanisms to increase market discipline, I want to add a
complementary thought to my earlier observation that these mechanisms are designed to
ensure that investors and counterparties suffer losses. If we are committed to achieving this
end - as I believe we should be - we also need to provide market participants with the
information needed to make accurate assessments of a financial firm's condition. I will have
more to say about disclosing supervisory information in a moment. As to disclosures by firms
themselves, the opaque nature of parts of a financial institution's balance sheet makes
special disclosure requirements especially important. There is, for example, a good case to
be made for enhancing the Basel II requirements for disclosures relevant to a firm's internal
ratings system, consistent with the protection of genuinely proprietary information. On the
other hand, there is little point - and the potential for considerable unnecessary cost - in
compelling disclosure of massive amounts of information that cannot be effectively
assimilated by investors and counterparties. We invite suggestions from investors such as
yourselves as to the kind and form of disclosures that will be most useful.
Incorporating the public into the regulatory system
As noted earlier, the financial regulatory system needs to be not only multifaceted, but also
adaptive in responding to changes in financial firms and markets. A dynamic regulatory
regime is most likely to be realized if it receives non-governmental perspectives on these
changes. In addition to disclosing more data to investors and counterparties, exposing
supervisory practices and policies to external assessment in a structured way can improve
supervision. Such exposure could, for example, reduce the chances of regulators converging
around a conventional wisdom that overlooks anomalous data.
One means for furthering this aim was suggested by our experience with the Supervisory
Capital Assessment Program (SCAP) last year. As you recall, the stress tests - as they have
been popularly called - were a stringent, forward-looking assessment of prospective losses
and revenues at the 19 largest U.S. regulated financial institutions. We took the unusual, if
not unprecedented, step of releasing publicly the methodology and findings of the SCAP,
including the capital needs and loss estimates for the 19 institutions.
The decision to make this information public was made in the context of a systemic crisis, in
which markets were hungry for information and in which the Treasury stood ready to inject
capital into any of the 19 institutions that were found to need it. Even so, it was much
debated within the Federal Reserve, in part because of concerns that weaker banks might be
significantly harmed by the disclosures. But I think that regularizing both stress tests and the
release of information relevant to them deserves serious consideration for at least two
reasons.
First, in line with my earlier discussion of market discipline, releasing such information could
assist investors in the difficult task of valuing loan portfolios that at present are not very
transparent. Second, releasing details about assumptions, methods, and conclusions would
expose our supervisory approach to greater outside scrutiny and discussion. Whether the
result is critique or validation of our approach, the reaction of informed investors and analysts
to our assumptions and methods would be beneficial.
I have previously identified several ways we might increase the transparency of our stress
tests.2 There are doubtless additional possibilities. There are, to be sure, countervailing
concerns. In economic times more normal than those prevailing when we conducted the
SCAP, market participants will not be fearing the worst and banks will not have access to
government capital injections as a backstop. At such a moment, the revelation that some
major banks may have capital needs under a stress scenario might be unnecessarily
destabilizing, though the possibility of this kind of market reaction may be lower if such
information is released frequently. Major unpleasant surprises would be less likely with
frequent, detailed disclosures. In any case, I hope that interested parties will consider the
merits of these possibilities and help advance the debate.
There are other ways to incorporate non-governmental views into the regulatory system. We
have already taken steps in this direction in conjunction with the Federal Reserve's overhaul
of its approach to supervising the largest financial holding companies. As part of this effort
- and with the aim of advancing both our microprudential and macroprudential goals - we
have created a quantitative surveillance mechanism (QSM) to regularize the collection and
analysis of relevant data. Among other things, the QSM will use market-based indicators
such as stock prices, option prices, credit default swap spreads, and short-term funding costs
to provide an external perspective on the condition of these institutions - one that will be
formally presented to regular meetings of senior supervisory and other Federal Reserve staff.
Market-based indicators of macroeconomic and financial market risks that could pose threats
to the largest institutions also will be used to assess their condition.
Indeed, the relatively undeveloped nature of macroprudential analytic and oversight functions
argues for extensive transparency by regulators and involvement of non-regulators. If, for
example, the Congress creates a council of regulators with, among other responsibilities, the
task of issuing periodic financial stability reports, the public at large will have ample
opportunity to comment on the council's analyses. Personally, I would go further and
establish an advisory committee that would assess not just the stability report, but other
macroprudential evaluations such as scenarios used in stress testing. By formalizing this
activity, senior regulatory officials would be required to confront and respond to the critiques
directly, an exercise that would help develop the embryonic function of macroprudential
oversight.
Conclusion
To conclude, I have covered a handful of specific ideas to involve markets and the public
more closely in the regulatory system. My more general point is that the reform of our
financial system to strengthen market discipline is both an essential change in itself and also
a starting point for increasing useful information flows between markets and regulators.
Market forces will operate more efficiently with information about banks that has usually
remained largely hidden from investors in anything but the most aggregated form. The
regulatory system will operate more effectively if the supervisory process integrates market
information which should, as a result of innovations such as a resolution mechanism, be
even more sensitive to the conditions of financial firms.
Experience before the financial crisis suggests that institutionalizing opportunities for external
voices, including dissident voices, will be an important element of macroprudential
supervisory efforts. Outside critics are not always right, of course. But the best way to
separate insightful and well-grounded criticisms from unfounded ones is through a rigorous
discussion in which the views of outside critics, as well as those of the regulators
themselves, will be subject to inquiry. Such a process may lead to uncomfortable moments
for regulators, but that is a small price to pay if it can help contain financial instability in the
future.