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. * * * 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

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 see daniel k. tarullo ( 2010 ), “ lessons from the crisis stress tests ”, speech delivered at the federal reserve board international research forum on monetary policy, washington, march 26. 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