Federal Reserve Gov. Daniel K. Tarullo highlighted why he believes the regulatory regime enacted by the Dodd-Frank Act, in response to the 2008 financial crisis, is essential to the continued stability of the economy.
Tarullo, speaking at the recent Financial Stability Conference in Washington, D.C., led off his speech by talking about the role the current regulatory regime played as the economy climbed out of recession, as well as the correlation he believes exists between the implementation of the regime and the U.S. now boasting what he described as “the strongest and most diverse financial system of any major economy in the world.”
The Fed governor also offered a refresher on some of the more impactful events of the most drastic financial downturn since the Great Depression. Later in his speech, he stressed his belief that “it is critical that we not forget our still-quite-recent history.”
He recapped the demise of Bear Stearns and other financial giants, reflected on how some converted themselves into bank holdings companies in an effort to gain market confidence, and brought up how Fannie Mae and Freddie Mac “teetered on the brink of failure” and were placed into government conservatorship, with accompanying full government guarantees of their liabilities. He also pointed out how even insured depository institutions that had access to special resolution procedures, such as Wachovia and Washington Mutual, were merged into existing banks with government benefits to make absorbing such failing banks worthwhile for the institutions doing the acquiring.
Several sizable bank holding companies experienced “grave stress” while several financial markets either ceased functioning or came incredibly close, Tarullo recollected.
“[T]he nation’s financial system faced not just severe liquidity problems, but a solvency crisis,” Tarullo said. “In response, following enactment of the Troubled Asset Relief Program by Congress, Secretary Henry Paulson oversaw the injection of government capital into the nation's largest financial firms, as well as into many smaller banking firms. This first step toward stability was reinforced in early 2009, when Secretary Timothy Geithner initiated the stress test exercise to determine how much capital these firms needed to remain viable financial intermediaries and, perhaps as importantly, to share this information with markets. In the succeeding months, the Federal Reserve obliged the firms to raise enough private capital to replace the government capital and to meet the minimum capital levels established by the stress tests.”
The stabilization of the financial system by the latter part of 2009 required a significant amount of tax dollars and support from lending facilities and guarantees, which the Federal Reserve, Treasury and Federal Deposit Insurance Corp. (FDIC) provided for banks and non-bank financial institutions, Tarullo said.
“What accounts for this dramatic change in the position of the U.S. financial system?” he asked, rhetorically. “First, the crisis response by U.S. authorities was fairly quick and complete. The resolute actions of the Bush administration in late 2008 and the Obama administration early in 2009 helped stabilize banks and begin their recovery in fairly short order. Recapitalization proceeded quickly, even as the stress test compelled an early reckoning with actual and potential losses. The forceful monetary policy response, the liquidity programs of the Federal Reserve and the FDIC’s guarantee of bank debt prevented the bottom from dropping out of the badly shaken financial system. The emergency fiscal stimulus of 2009 helped prevent a downward spiral in the real economy from a Great Recession to another depression.
“Second,” he continued, “was the regulatory reform program put in motion even before the crisis had ended. This program has steadily strengthened the capital, liquidity and risk management positions of large banks, with progressively more stringent measures applied to the most systemically important institutions.”
He said the new regulatory regime for large banks serves “two important, complementary goals” which are:
To ensure that the nation’s large financial institutions are strong enough to continue to function effectively, lending to creditworthy businesses and households, even in a period of substantial financial and economic stress.
To address the too-big-to-fail problem. “When some combination of the size, functions, portfolios and interconnectedness of a financial institution are such as to make authorities fear that its failure could endanger the entire financial system, they will be tempted to rescue the firm through direct capital injections or indirect measures to strengthen its solvency. Knowing this, other market actors will be willing to lend to that institution at a premium lower than its actual risks would suggest is warranted, an effect that is particularly apparent during periods of stress,” he said.
With those goals in mind, Tarullo went on to say that the regulatory regime must strive to significantly increase the resiliency of large banks more so than smaller ones, making them capable of functioning even under serious stress without solvency assistance from the government and, by doing so, the economy could avoid some harm. The regime also must be able to “contemplate failure” among exceptionally large banks to enable planning for the possibility that it may one day become insolvent “notwithstanding much greater ex ante resiliency.” The regime must promote market discipline as well and offset the “moral hazard” that comes when a financial institution and its creditors think the government is in a position where it must bail out certain large banks.
After breaking down the important of four key elements taken into account during the building of the current regulatory regime – capital, liquidity, risk management and resolution planning – Tarullo said he thinks ongoing discussions about the right types and levels of capital requirement for financial institutions and the right mix of policies will be beneficial in the long run.
He then offered some near-term steps the Federal Reserve can take to advance financial stability goals.
“First is to continue focused work on making the largest, most systemically important firms resolvable in order to minimize both moral hazard and any harm that may befall the economy if such a firm were to fail,” he said. “This means continued work by the Federal Reserve and the FDIC to require these firms to develop their resolution plans and, more importantly, modify their organizational structures and day-to-day practices such as liquidity management so as to enable an orderly resolution, should it become necessary. Along these lines, I would hope that Congress will move forward with a set of changes to the bankruptcy code to facilitate the resolution of large financial firms and, thereby, limit the number of instances in which the government would need to use the Title II procedures of Dodd-Frank. In the very short term, we will also finalize our rule requiring the most systemically important firms to hold a sizeable amount of long-term debt, which would be available to the FDIC or a bankruptcy judge for conversion into equity should the firm fail.
“A second step is to determine if we can develop metrics that would reflect a firm’s particular vulnerabilities to funding shocks, liquidity shocks, and fire sale dynamics in their needed capital as part of the annual stress test. These measures would directly take into account macroprudential concerns of financial system stability. They might well counsel increased capital requirements for some of the largest banks.
“A third step is to take another look at the capital and liquidity positions of large U.S. branches of some foreign banks. As has become apparent, the actual consolidated capital positions of some such banks can be difficult for us to discern when the bank uses internal models to compute its required regulatory capital. It is critical to ensure that large U.S. branches of foreign banks do not create financial instability in the United States if their parents’ global positions come under stress.”
In addition to his suggestion that the country’s recent economic past not be forgotten, Tarullo said he believes there is a need for “a more explicit and thorough tiering of requirements within the prudential regulatory regime,” adding that “the largest banks need stricter and more wide-ranging regulation because of the special risks they pose is that the smaller and less interconnected a bank is, the less risk it presents and thus the less strict its regulatory requirements need be. The Dodd-Frank Act reflects this principle, not only in its mandate of progressively more stringent requirements as the systemic importance of a financial firm increases, but also in the asset-size thresholds it establishes for various new regulations. However, as I have noted in the past, I think these thresholds were set too low in places.”
Tarullo acknowledged that he is aware that many smaller banks often may not recognize the benefits of regulation off-setting the compliance costs.
“[W]hile I think it is worthwhile to continue, for example, efforts to simplify capital rules for small banks, the greater value for those banks may lie in efforts to streamline the number of rules that apply to them and to reduce the number of separate compliance exams and exercises to which they are subject,” he said. “While especially applicable to small banks, this point has broader application, as in our earlier-mentioned proposal to exempt most banks with less than $250 billion in assets from the qualitative component of our annual CCAR exercise.”
Tarullo cautioned that although compliance regulations often are complicated, it is best to resist the urge to put forth simple solutions as answers to complex issues. He concluded by acknowledging that although the regulatory regime likely could benefit from further refinement, especially in regard to smaller banks, he feels the regime itself is crucial to maintaining future stability within the financial system.