daniel k tarullo : large banks and small banks in an era of systemic risk regulation speech by mr daniel k tarullo, member of the board of governors of the us federal reserve system, at the north carolina bankers association annual convention, chapel hill, north carolina, 15 june 2009. the original speech, which contains various links to the documents mentioned, can be found on the us federal reserve system ’ s website. * * * the financial crisis and its aftermath have revealed fundamental problems in both risk management by financial institutions and supervision by government regulators. these shortcomings arose in no small part from a failure by both the private and public sectors to adjust to far - reaching changes in financial markets over recent decades. there is a growing, though certainly not unanimous, view that supervision and regulation must be substantially more oriented toward containing systemic risk and addressing the associated problems posed by institutions considered too - big - to - fail. the public policy agenda will thus rightly be dominated for some time by proposals for legislative and administrative measures directed at systemic risk. in a moment i will offer some of my own views on the subject. even as we move into this era of systemic risk regulation, however, it is important to recognize that changes in the financial services industry have affected every bank in america, large and small. while smaller banks will not likely see the extensive supervisory changes that have been proposed for the largest financial institutions, they too must adapt their risk - management practices to new competitive and economic conditions. only by doing so will they continue to play their distinctive role in providing credit to individuals and small businesses. the changes in the financial services industry that preceded the crisis, the crisis itself, and the regulatory changes that will follow together carry important consequences for all banks. it seemed to me particularly appropriate to address the implications of these changes here in north carolina, home to institutions that range from the very large to the very small. 1 large banks if we have learned anything from the present crisis, it is that systemic risk was very much built into our financial system. this situation was the outcome of a decades - long trend, during which traditional bank lending, trading, and other capital markets activities were increasingly integrated. the most visible manifestations of this trend were the explosive growth of securitization and the increasing involvement of banks and their affiliates in all parts of the securitization process. and, as we learned during the course of the crisis, the universe of institutions whose potential failure was regarded as having systemic

consequences extended well beyond banks, or even bank holding companies, to include financial firms not subject to mandatory prudential regulation. more generally, the emergence of the so - called shadow banking system changed important features of the traditional banking model, particularly at the largest institutions. these banks became increasingly dependent on the wholesale funding provided by securitization, commercial paper issuance, and other sources – funding that was often poorly matched to the maturity of the firm's assets. the views presented here are my own and not necessarily those of other members of the board of governors or the federal open market committee. the result was the rising vulnerability of these institutions to non - traditional sources of risk. the new market - based liquidity problems arose from sudden, sharp movements in asset prices that led to enormous market uncertainty concerning the values of those assets. as now liquidity - strained institutions made increasingly distressed asset sales, they placed further downward pressure on asset prices, leading to margin calls for leveraged actors and mark - to - market losses for all holders of the assets. since multiple firms were relying on similar marketable assets as a ready source of liquidity, extreme price declines could ensue, engendering a negative feedback loop that, if unchecked, would threaten the solvency of firms operating on the assumption of liquidity through asset sales or borrowings secured by such assets. these and other changes in the competitive environment both prompted and advanced the relaxation over the past few decades of many of the restrictions on bank activities and affiliations that had been established in the 1930s. as a result of these changes, which had taken place both through administrative action and by statute, banks could operate nationally, had few practical restrictions on their ability to pay competitive deposit rates, could conduct a much broader range of activities within their own operations, and could affiliate with virtually any kind of financial firm. in response to now - permissible bank involvement in more activities and affiliation with broker - dealers and other financial firms, regulatory agencies imposed more detailed capital requirements and insisted on better risk management. but there was no overhaul of financial regulation to take account of the impact of trading and capital market activities on both traditional banking and systemic risk. the financial crisis has focused the attention of policymakers on the need for just this kind of regulatory reorientation. i have recently set forth a fairly extensive explanation of the changes i believe should accompany this reorientation. 2 i will not repeat this whole agenda today. instead, let me simply highlight