Ben S Bernanke: Lessons of the financial crisis for banking supervision
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Chicago Conference on Bank Structure
and Competition, Chicago, Illinois (via satellite), 7 May 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
After more than a year and a half of financial crisis, both bankers and policymakers must
contend with two questions: What have we learned from this extraordinary episode? And
how can we apply those lessons to strengthen our banking system and to avoid or mitigate
future crises? Getting the answers to these questions right is critical for our future financial
and economic health.1
The Federal Reserve has been intensively evaluating the lessons of the crisis, both with
respect to the companies we supervise and to our own policies and procedures, and we are
actively incorporating what we have learned into daily supervisory practice. Increasing the
effectiveness of supervision must be a top priority for our institution. In my remarks today I
will outline some steps that the Federal Reserve has already taken in the wake of the crisis
to strengthen capital, liquidity, and risk management in the banking sector, as well as to
improve the supervisory process itself. I will also touch on what we have learned about the
importance of effective consolidated supervision and the potential benefits of a more
macroprudential orientation to financial oversight.
The Federal Reserve's role in banking supervision
It may be useful first to briefly review the Federal Reserve's bank supervisory responsibilities
and how they interact with the other parts of our mission. The Fed has supervisory and
regulatory authority over bank holding companies (including financial holding companies),
state-chartered banks that choose to join the Federal Reserve System (state member
banks), the U.S. operations of foreign banking organizations, and certain types of U.S.
entities that engage in international banking.2 In fulfilling these responsibilities, we work with
other federal and state supervisory authorities to promote the safety and soundness of the
banking industry, foster the stability of the broader financial system, and help ensure fair and
equitable treatment of consumers in their financial transactions. The Federal Reserve Banks
manage the process of onsite bank examinations, while providing a strong regional presence
that allows us greater insight into local economic conditions.
Besides working with other U.S. agencies responsible for the oversight of banking and other
areas of the financial system, we also coordinate closely with foreign supervisors. These
relationships are fostered through regular interactions within bodies such as the Basel
Committee on Banking Supervision and the Financial Stability Board. Through these
organizations we contribute to the development of international banking standards. For
example, we helped lead the Basel Committee's development of the revised Principles of
Liquidity Risk Management, which was issued last year and is currently being incorporated
into supervisory guidance in the United States.3 Our close relationships with key foreign
supervisors, central banks, and other authorities have proved very helpful as we have dealt
with the challenges of the crisis.
The Federal Reserve's role in banking supervision complements its other responsibilities,
especially its role in managing financial crises - a point I have made on other occasions.4
The complementary nature of its functions was evident, for example, after the September 11
terrorist attacks, when the Federal Reserve's supervisory staff provided critical assistance to
policymakers in evaluating conditions in the financial sector in a quickly evolving, chaotic
situation. During the current crisis, supervisory expertise and information have repeatedly
proved invaluable in helping us to address potential systemic risks involving specific financial
institutions and markets and to effectively fulfill our role as lender of last resort. Our
supervisors' knowledge of interbank lending markets and other sources of bank funding also
contributed to the development of new tools to address financial stress, such as our Term
Auction Facility. The Fed's prudential supervision benefits, in turn, from the expertise we
develop in carrying out other parts of our mission - for example, the knowledge of financial
and economic conditions we gather in the formulation of monetary policy and the insight into
retail financial markets that flows from our consumer protection responsibilities.
Lessons from the financial crisis
Since the onset of the crisis, the Federal Reserve and other U.S. supervisors - in many
cases along with supervisors from other countries - have been working to identify both its
causes and its lessons. Our contributions have been reflected in reports issued by, among
others, the Financial Stability Board, the President's Working Group on Financial Markets,
and the Senior Supervisors Group, which includes representatives of seven industrial
countries.5 Ongoing international collaboration, which began before the crisis, has enabled
U.S. supervisors to learn from the international experience and allowed us to compare the
performances of individual U.S. institutions with those of a broad cross section of global
financial firms.
The Federal Reserve is also in the midst of its own comprehensive review of all aspects of its
supervisory practices. Since last year, Vice Chairman Kohn has led an effort, with
participation from Board members, Reserve Bank presidents, and staff from around the
System, to develop recommendations for improvements in our conduct of both prudential
supervision and consumer protection. We are including feedback from the Government
Accountability Office, the Congress, the Treasury, and others as we look to improve our own
supervisory practices. Among other things, our analysis reaffirms that capital adequacy,
effective liquidity planning, and strong risk management are essential for safe and sound
banking; the crisis revealed serious deficiencies on the part of some financial institutions in
one or more of the areas. The crisis has likewise underscored the need for heightened
vigilance and forcefulness on the part of supervisors to make sure that standards are met.
Strengthening capital, liquidity, and risk management
Because capital serves as such an important bulwark against potential unexpected loss, U.S.
supervisors have been giving it very close attention since the beginning of the crisis. We
have been closely monitoring firms' capital levels relative to their risk exposures and
discussing our evaluations with senior management. We have also been revisiting our
policies regarding capital; for example, earlier this year we issued supervisory guidance for
bank holding companies on dividends, capital repurchases, and capital redemptions,
reemphasizing in the process that holding companies must serve as a source of strength for
their subsidiary banks.
As you may know, the Federal Reserve is leading the interagency Supervisory Capital
Assessment Program, which is aimed at ensuring that the largest and most systemically
important U.S. banking organizations have a capital buffer sufficient to remain
wellcapitalized and actively lending, even should macroeconomic conditions prove worse than
currently anticipated. More than 150 examiners, supervisors, and economists from the
Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit
Insurance Corporation cooperated in a simultaneous review and evaluation of the
prospective losses and earnings of 19 major institutions, which collectively hold about
twothirds of the assets of the U.S. banking system. The exercise has been comprehensive,
rigorous, forward-looking, and highly collaborative among the supervisory agencies.
Undoubtedly, we can use many aspects of the exercise to improve our supervisory
processes in the future.
Although capital remains a critical bulwark of a strong banking system, the crisis has also
demonstrated the importance of effective liquidity management. Along with our colleagues at
the other U.S. banking agencies, we are monitoring the major firms' liquidity positions on a
daily basis and are discussing liquidity strategies, key market developments, and liquidity
risks with the firms' senior managements. As we have learned over the past year and a half,
adequate liquidity management entails more than holding assets that are liquid in normal
times; firms must take into account how their liquidity positions might fare under stressed
market conditions. We are also requiring firms to consider risks arising from the need to fund
off-balance-sheet positions.
The third key element of safe and sound banking, after capital and liquidity, is effective risk
management. The crisis exposed the inadequacy of the risk-management systems of many
financial institutions. We have stepped up our efforts to work with banks to improve their
riskidentification practices. For instance, we have emphasized to banks the importance of stress
testing to help detect risks not identified by more-typical statistical models, such as
abnormally large market moves, evaporation of liquidity, prolonged periods of market
distress, or structural changes in markets.
As I noted in a speech last month, financial innovation can benefit consumers, the financial
system, and the broader economy, but it also has risks that must be properly understood.6
Indeed, as you know, financial innovations in areas such as structured credit products and
mortgage lending in some degree helped precipitate the current crisis. Accordingly, we are
requiring banks to evaluate more comprehensively the possible unintended consequences of
proposed new financial instruments as well as how those instruments are likely to perform
under stressed market conditions.
Counterparty credit risk is another area in which the Federal Reserve has been working for
some time, and, as the crisis has unfolded, we have intensified our monitoring of how firms
manage this type of risk. Institutions are being pushed to further improve their understanding
of key linkages and exposures across the financial system. They are also being asked to
analyze how their own defensive actions during periods of stress might put pressure on key
counterparties, especially when other market participants are likely to be taking similar
measures.
A critical component of risk management is understanding the links between incentives and
risk-taking, such as in the design and implementation of compensation practices. Bonuses
and other compensation should provide incentives for employees at all levels to behave in
ways that promote the long-run health of the institution. The Federal Reserve has been
working in international forums on compensation and incentives issues; one product of those
efforts was the publication last month by the Financial Stability Board of new principles for
sound compensation practices.7 Certainly, an important lesson of the crisis is that the
structure of compensation and its effect on incentives for risk-taking is a
safety-andsoundness issue.
In this and other areas, one of the key lessons for bankers has been the need for timely and
effective internal communication about risks. We are putting a high priority on ensuring that
management and board of directors are well informed about the various risks that confront
the organization and that they are actively engaged in the management of those risks.
As we have worked with financial institutions to strengthen their governance and risk
management, we are also mindful that the crisis has revealed the need for improvement in
our own supervisory procedures and internal communication. We have updated and
strengthened our processes for disseminating supervisory information within the Federal
Reserve System, for establishing supervisory priorities, for tracking emerging issues, and for
issuing timely supervisory guidance. In the area of consumer protection, the Fed has recently
revised its compliance examination program to ensure that it stays current with market
developments and practices. We have introduced the concept of continuous supervision to
consumer compliance to ensure ongoing and comprehensive monitoring of our largest state
member banks.
Drawing on a particularly important lesson of the crisis, our supervisors are emphasizing to
institutions that maintaining strong risk-management practices is at least as important in
good times as in bad. It is precisely during those good times, when risks appear low and the
financial horizon seems clear, that financial market participants can become overly optimistic
and make costly mistakes. Part of the job of supervisors is to counter such trends. In such
cases, we must ensure that our supervisory communications are forceful, clear, and directed
at senior management and boards of directors, so that emerging issues are given proper
attention and satisfactorily resolved.
Consolidated supervision
As we review the lessons of the crisis, another issue deserving attention is the role of
consolidated supervision. The crisis has demonstrated that effective and timely risk
management that is truly firmwide is vitally important for large financial institutions. To make
sure that that happens, all systemically important financial firms - and not just those affiliated
with a bank - should be subject to a robust framework for consolidated supervision.
Although the Federal Reserve is not the primary supervisor of the majority of U.S.
commercial bank assets, under the Gramm-Leach-Bliley Act of 1999 it serves as
consolidated supervisor of all bank holding companies, including financial holding
companies. We take this role very seriously. Before the onset of the crisis, we had already
begun enhancing our consolidated supervision of bank holding companies, working within
the framework established by the act. Those efforts resulted in comprehensive supervisory
guidance on consolidated supervision last year. The guidance directs our examination staff
to focus on key areas as it supervises large, complex firms with multiple legal entities. For
instance, it directs the staff to pay special attention to activities - such as clearing and
settlement in critical financial markets - that have the potential to affect not only the
institution, but the financial system more broadly.
The Fed's guidance on consolidated supervision also provides more-explicit directions for
supervisory staff for evaluating the capacity of a banking organization to measure and
manage risks across the entire firm. For example, our process for assessing firmwide credit
risk management begins with a review of the overarching design of this function at the
consolidated level; we then drill down to individual business lines, such as retail credit or
mortgage lending, to ensure that they are being managed in ways consistent with the
company's overall framework. The guidance also reaffirms that examiners must assess the
financial condition and risk profile of a holding company's nonbank subsidiaries to
understand their potential for adversely affecting the affiliated banks or the organization as a
whole.
Consolidated supervision also improves our evaluation of firms' ability to comply with
applicable laws, rules, and regulations. The Federal Reserve last year issued supervisory
guidance on compliance risk, which stresses the need for both supervisors and bankers to
understand those risks both within and across business lines, legal entities, and jurisdictions.
Compliance with consumer protection regulations receives close scrutiny, and consumer
compliance specialists participate in the evaluation of the risk assessments, supervisory
plans, and annual letters that our supervisors prepare for large, complex banking
organizations. Last year, Federal Reserve staff also led an interagency pilot program to
examine the practices of subprime mortgage lenders, including two nonbank subsidiaries of
bank holding companies. The pilot provided important insight into lenders' practices,
particularly their oversight of broker relationships.
Provisions of the Gramm-Leach-Bliley Act limit the ability of the Federal Reserve, as
consolidated supervisor, to examine, obtain reports from, or take actions with respect to
subsidiaries that are supervised by other agencies. Consistent with these provisions, we
have worked with other regulators and, wherever possible, sought to make good use of the
information and analysis they provide. In the process, we have built good cooperative
relationships with other regulators - relationships that we expect to continue and strengthen
further. Moreover, our consolidated supervision guidance has helped to clarify the protocols
for relying on other supervisors, as well as to identify cases in which we need to take a more
active role as the consolidated supervisor.
However, the restrictions in current law still can present challenges to timely and effective
consolidated supervision in light of, among other things, differences in supervisory models -
for example, between those favored bybank supervisors and those used by regulators of
insurance and securities subsidiaries - and differences in supervisory timetables, resources,
and priorities. In its review of the U.S. financial architecture, we hope that the Congress will
consider revising the provisions of Gramm-Leach-Bliley to help ensure that consolidated
supervisors have the necessary tools and authorities to monitor and address safety and
soundness concerns in all parts of an organization.
Financial stability
I have been discussing supervisory policy aimed at ensuring the stability of individual
financial institutions. However, the Federal Reserve also has the broader objective of
enhancing the stability of the financial system as a whole. Supervision of individual
institutions and fostering broader stability are, once again, complementary activities, with
information and expertise gained in one arena often proving highly useful in the other.
Drawing on the lessons of the crisis, we have gone beyond efforts to improve our supervision
of individual institutions to try to bolster the capacity of the financial system overall to
withstand shocks.
Our efforts to strengthen the financial infrastructure are a good illustration of these initiatives.
We have been working since before the crisis with the institutions that support trading,
payments, clearing, and settlement systems. For instance, the Federal Reserve Bank of New
York, in cooperation with other supervisors and market participants, has helped improve
arrangements for clearing and settling credit default swaps and other over-the-counter
derivatives. As a result, the accuracy and timeliness of trade information has improved
significantly. But the infrastructure for managing these derivatives is still not as efficient or
transparent as the infrastructure for more-mature instruments. So, along with others, we are
creating increasingly stringent targets and performance standards for market participants.
Protecting consumers also contributes to financial stability. The increased complexity of
many consumer products, as well as their sale by a range of financial institutions to a larger
segment of the public, is arguably one of the causes of the current crisis. In the past year or
so, the Board has developed extensive new disclosures for a variety of financial products,
most notably credit cards, and we are currently in the midst of a major overhaul of mortgage
disclosures. Because even the best disclosures are not always adequate, we also
comprehensively overhauled our mortgage and credit card regulations to prohibit certain
practices.
Our ability to foster financial stability depends on having a staff with a diverse range of
knowledge, expertise, and skills. The Fed is accustomed to using interdisciplinary
approaches to solving problems, and that perspective often gives us a more accurate picture
of financial activities and the potential risks they produce. During the current crisis, we have
seen very close collaboration among our supervisors, economists, accountants, attorneys,
and consumer affairs experts. We must ensure that we continue to increase our expertise so
it is properly matched with the problems and challenges we will face in both our bank
supervisory role and in meeting our traditional financial stability mandate.
Looking forward, I believe a more macroprudential approach to supervision - one that
supplements the supervision of individual institutions to address risks to the financial system
as a whole - could help to enhance overall financial stability. Our regulatory system must
include the capacity to monitor, assess, and, if necessary, address potential systemic risks
within the financial system. Elements of a macroprudential agenda include
•
monitoring large or rapidly increasing exposures - such as to subprime mortgages -
across firms and markets, rather than only at the level of individual firms or sectors;
•
assessing the potential systemic risks implied by evolving risk-management practices,
broad-based increases in financial leverage, or changes in financial markets or
products;
•
analyzing possible spillovers between financial firms or between firms and markets,
such as the mutual exposures of highly interconnected firms;
•
ensuring that each systemically important firm receives oversight commensurate with
the risks that its failure would pose to the financial system;
•
providing a resolution mechanism to safely wind down failing, systemically important
institutions;
•
ensuring that the critical financial infrastructure, including the institutions that support
trading, payments, clearing, and settlement, is robust;
•
working to mitigate procyclical features of capital regulation and other rules and
standards; and
•
identifying possible regulatory gaps, including gaps in the protection of consumers
and investors, that pose risks for the system as a whole.
Precisely how best to implement a macroprudential agenda remains open to debate. Some
of these critical functions could be incorporated into the practices of existing regulators, or a
subset of them might be assigned to a macroprudential supervisory authority. However we
proceed, a principal lesson of the crisis is that an approach to supervision that focuses
narrowly on individual institutions can miss broader problems that are building up in the
system.
Conclusion
The events of the past two years have revealed weaknesses in both private-sector risk
management and in the public sector's oversight of the financial system. It is imperative that
we apply the lessons of this experience to strengthen our regulatory system, both at the level
of its overall architecture and in its daily execution. Indeed, although reform of the current
system is necessary, much can be done within the current framework. The Federal Reserve
has engaged in extensive introspection and review of the lessons of the crisis and is working
diligently to implement what has been learned. As the past two years have brought home to
everyone, the development of a more stable and sound financial system should be of the
highest priority.