Fed Governor Tarullo reflects on regulation post-crisis and key components of new regulatory regime.
On December 2, 2016, Governor Daniel K. Tarullo provided his thoughts on regulation since the financial crisis at the Federal Reserve Bank of Cleveland and Office of Financial Research 2016 Financial Stability Conference in Washington D.C. He reflected on the post-crisis efforts to promote financial stability, their success and what effort is still required.
Reflecting on Regulation Post-Crisis
During his presentation, Tarullo emphasized the importance of recalling why these regulatory efforts were required, citing the destruction from the financial crisis and the Great Recession that followed. He pointed to the unsustainable and fragile pre-crisis financial system with direct connections among financial firms, and the contagion effects from these firms holding similar assets as direct causes.1 Tarullo believes the first step toward stability following the crisis was Secretary Timothy Geithner’s initiation of the stress test exercise in 2009, with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act.2 Key elements of the regulation of note include Living Wills and higher capital requirements, with the Consumer Protection Act following closely after.
Impact of Regulation Post-Crisis
Today, Tarullo considers the US to be “..the strongest and most diverse financial system of any major economy in the world.”3 He notes that increases in credit default swap spreads and other market indicators suggest investor confidence, allowing banks to expand their lending and realize growth post-crisis. Tarullo credits this change to two key factors:4
1) The swift response by US authorities to the crisis, noting the efforts of both the Bush and Obama administrations to help stabilize the banks. He cites monetary policy response, Federal Reserve Board liquidity programs, Federal Deposit Insurance Corporation’s (FDIC) guarantee of bank debt and the emergency fiscal stimulus as support for this argument.
2) The regulatory reform program that was enacted following the crisis, which strengthened the capital, liquidity and risk management positions of large banks. He supported the regulation of systematically important financial institutions (SIFIs), noting that this would make them strong enough to function as well as address too-big-to-fail.
Considering the progress made since the crisis, Tarullo advocates for greater resiliency of the large banks under the new regulatory regime to make large financial institutions strong enough to function even under financial and economic stress. He believes that the regime promotes market discipline and balances moral hazard offsets, as it is crucial that these large banks continue to function without assistance from the government in the event of another financial crisis.5
Key Components of New Regulatory Regime
Examining the benefits of the new regulatory regime, Tarullo raises two key hypothesis for consideration: 1) are institutions reasonably confident they could weather a period of stress without endangering the entire financial system; and 2) should statutory or regulatory provisions be adjusted if they are not the most efficient means of achieving financial systemic stability.6
Nevertheless, he largely attributes the improved performance and security of the financial system to the new regulatory regime, which he summarizes in four key components:7
1) Capital: Tarullo cites the implementation of minimum capital requirements, global systemically important bank (G-SIB) buffer requirements and surcharge on SIFIs as evidence of improvement in capital monitoring under the new regulatory regime. Sizing of the buffer and surcharge was calibrated to help provide enough accessible capital to meet the minimum requirements in times of stress. These measures have served to increase the resiliency of large banks, with many banks more than doubling their high-quality capital and eliminating riskier assets and activities from their portfolios.
- Emerging regulation: In regards to capital, there is emerging regulation in which the amount of a new “stress capital buffer” will be linked to Comprehensive Capital Analysis and Review (CCAR) results. The goal of this regulation is to make capital more risk-sensitive by using firm-specific information on risks drawn from a stress test.
2) Liquidity risk: Tarullo supports the implementation of quantitative liquidity regulations, such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), which helped strengthen the foundation of larger banks.
3) Risk Management: Since the financial crisis, banks have instituted new risk management systems to allow them to aggregate exposures to particular counterparties and business lines. Tarullo attributes the improvement of these information and risk management systems to regulatory changes like CCAR.
4) Credible Resolution Options: Effective resolution planning has also promoted confidence in the financial system, promoting market disciple and eliminating moral hazard. Tarullo cites the importance of maintaining these, as it took time and careful planning to develop effective resolution options, like Living Will plans and internal stress tests. Tarullo also notes that the implementation of resolution planning has provided the government with more confidence.
Tarullo offers several recommendations for the future as well as key considerations in light of evolving regulation. He highlights the importance of having a methodology that can balance competing priorities and that is well-founded on research, citing capital requirements as an example. Recent research on the formulation of Basel II capital standards suggests that the costs of higher capital requirements may be somewhat lower with broader benefits, while there may be diminishing benefits to tighter capital standards. Ultimately, Tarullo believes this is an ongoing discussion in which the adequate level of capital requirements and mix of policy will need to be determined.8
In the short term, Tarullo cites several activities in which the Federal Reserve can engage to advance financial stability goals, highlighting recent efforts to assess regulation that has generally had beneficial effects in containing excessive and unsustainable liquidity. Tarullo thinks it is important to continue their work on making SIFIs resolvable, minimizing moral hazard and preventing potential widespread harm to the economy. He encourages the examination of capital and liquidity positions of large US branches of foreign banks to make sure that they do not create financial instability. Tarullo also highlights that other forms of liabilities exist outside traditional large financial firms, cautioning against the potential rise of new forms of shadow banking.9
Specifically, Tarullo offers his support for the following regulatory changes:10
1) Changes to the bankruptcy code that would facilitate the resolution of large firms and limit the number of instances in which the government would need to use the Dodd-Frank Title II procedures.
2) Finalization of the rule requiring SIFIs to hold a sizable amount of long-term debt, which would be available to the FDIC or bankruptcy judge for conversion into equity as a last resort in the event of a financial crisis.
3) Development of metrics that would take into account macroprudential concerns of financial stability reflecting vulnerabilities to capital, liquidity and funding shocks as part of their annual stress test.
4) Elimination of the qualitative assessment exercise in CCAR for firms with less than $250 billion in assets.
5) Raising the Enhanced Prudential Standards threshold from $50 billion to $100 billion as a means to better align prudential regulatory requirements to the larger and more complex institutions.
6) Exemption of community banks (with less than $10 billion in assets) from some regulation, including the Volcker Rule and the incentive compensation rule.
In his closing remarks, Tarullo urged conference attendees to remember the origins and effects of the financial crisis in order to understand the importance of recently implemented statutory and regulatory measures. He cautioned against being attracted to simple answers and potentially undoing the regulatory progress made in the financial system. He cited the success of increasing bank’s resiliency through increased capital and regulatory requirements. While Tarullo believes that there is always room for change and improvement, he does not see a sound economic case for weakening these regulatory requirements.
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Newsletter Author: Venetia Woo, Jennifer Zink
- “Financial Regulation Since the Crisis,” Governor Daniel K. Tarullo speech at the Federal Reserve Bank of Cleveland and Office of Financial Research 2016 Financial Stability Conference, Board of Governors of the Federal Reserve System, December 2, 2016. Access at:https://www.federalreserve.gov/newsevents/speech/tarullo20161202a.htm
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