U.S. Department of the Treasury

 

WASHINGTON -  Good morning.  I would like to thank the ABA’s Banking Law Committee for inviting me to be here today.   I am honored to join this group of distinguished panelists from financial institutions, law firms, and regulatory and government agencies who are part of this event.  The panel discussions over the next two days will address a wide range of legal, regulatory and policy issues impacting the financial sector.  My remarks this morning will focus on the Dodd-Frank reforms, specifically our progress in implementation, and my view of the opportunities presented by these reforms – opportunities for the largest, most complex financial firms to analyze and improve their own internal risk management and business practices.

 

In the wake of the financial crisis, the Dodd-Frank Act fundamentally changed the landscape of financial regulation.  As part of the team that brought Dodd-Frank into being, I will be the first to recognize that some of today’s panelists may have different views on the specific merits of the various reforms. However, it remains as true today as during the crisis that financial reform was necessary and overdue.  The reforms introduced by Dodd-Frank will help guard against future crises while making sure taxpayers are never put at risk for the failure of a financial institution again. 

 

In the four years since Dodd-Frank’s enactment, we are already starting to see a safer financial system beginning to emerge.  Banks have added over $500 billion of capital over the last five years to cushion against unexpected losses, support lending to consumers and businesses, and reduce overall leverage in the banking system.  Concurrently, asset quality continues to improve and the banking sector has generally shifted to more stable funding (as aggregate deposits continue to grow) and stronger liquidity buffers.  This progress is real and it is consequential.

 

Just over a year ago, Secretary Lew promised to “step on the accelerator” to implement Dodd-Frank, and he articulated several financial reform milestones that he hoped to achieve.  We have hit every one of these milestones.  Building on what has already been put in place, our independent regulatory agencies have made substantial progress over the last year.  I will highlight several major milestones quickly, but this list speaks to the diligence with which the regulators have continued the push to complete implementation.

 

·         Late last year we finalized the Volcker Rule – notable in part because five regulators completed at the same time a single joint rule, even though as many as three would have been possible under the law.

 

·         The “ability to repay” rule and qualified mortgage standards became effective in January of this year. And late last year, regulators finalized a rule consolidating two separate mortgage disclosures into one simple form.

 

·         In early 2014, the Federal Reserve Board finalized rules establishing enhanced prudential standards for our largest banks and foreign banking organizations operating in the U.S.

 

·         In April, the banking regulators finalized rules establishing an Enhanced Supplementary Leverage Ratio standard, which strengthens the backstop capital requirement.

 

·         This summer, the SEC adopted new reforms of money market mutual funds (MMFs), including a requirement for institutional prime funds to operate with a floating net asset value (NAV).

 

·         The SEC also finalized rules addressing transparency and accountability for credit ratings agencies, and significantly revised its Regulation AB to improve disclosure, reporting and registration of asset-backed securities.

 

·         In September, the banking regulators finalized the Liquidity Coverage Ratio and have re-proposed rules for margin on uncleared swaps.

 

·         In the past few weeks, six federal agencies finalized the long-anticipated joint regulations establishing risk retention requirements for asset-backed securitizations.

 

·         Finally, just this week, the Federal Reserve Board issued a final rule implementing Financial Sector Concentration Limits (from section 622 of the Dodd-Frank Act) setting a cap on growth by acquisition for the largest financial companies.

 

As with any large-scale, comprehensive regulatory reform, growing pains will inevitably exist in the first few years, but our financial system is safer and stronger because of the actions taken in response to the crisis and the reforms that have since been implemented.. 

 

While you may look at Dodd-Frank and see a laundry list of new compliance requirements; I encourage you to look deeper, and review the internal structure of these reforms and view them as a springboard towards not only effective internal risk management but also a stronger, more resilient business.  This morning I will illustrate this notion by walking through a few specific reforms.

 

 

Let’s start with an example from this afternoon’s agenda – the Volcker Rule.  Prior to Dodd-Frank, our financial regulatory system did not address many aspects of proprietary trading.  Instead it was largely left to shareholders, boards, and management to police such trading as a matter of risk appetite or risk management, and clients could take their business to desks that they felt were more client oriented.  But with the Volcker Rule, Dodd-Frank prohibited banks’ proprietary trading while continuing to allow banks to perform essential functions such as market-making and hedging.  In the course of the legislative debate, advocates argued that it could only strengthen banks if they were required to focus on their customers, while many in the industry argued that trying to separate proprietary trading from market making or hedging was not worth the effort -- or that it simply was not possible.  For many in this room, that debate is no longer relevant; instead the key question may now be “how do we build compliance systems to implement the rule?”

 

For many of your clients and your firms, much of the last year was spent working through the challenges of building systems to calculate and report on metrics for your trading desks.  But, the metrics banking entities are now required to report to regulators will also give firms more detailed and more consistent ways to monitor their own trading activities.  For example, one of the more complex requirements is the calculation of risk factor sensitivities – of decomposing the positions on a desk into specific market risks and modeling how those positions will move under various conditions.  But being able to calculate these sensitivities should be an achievable standard for risk management systems.  Moreover, defining a desk’s trading mandate and risk management plan with respect to these risk factors; or assessing performance based on a concrete ability to attribute the desk’s profits and losses, as Volcker requires firms with large, complex trading operations to do, is a best practice for business-line managers one that many firms already employ.  And because regulators have noted explicitly that the required metrics could be refined, firms should be willing to make the analytical case for why certain metrics are most effective – or, alternatively, why new or different metrics should instead be the focus.

 

Regulators continue to use the stress test process to dynamically assess capital adequacy at our largest banks.  Stress testing has several important system-wide benefits, which this audience is probably well attuned to already.  For example, these include:  helping to ensure that firms remain sufficiently capitalized to support the economy – households and businesses – in a severe economic downturn; equipping regulators with a data-driven tool to assess different key risks facing the broader financial system; and providing the public with greater information to understand the health of our banks.  However, beyond these important macro advantages, stress testing is also intended to  be a valuable process at the firm level by helping to improve internal capital planning and risk management processes. 

Regulators have intentionally made the stress test a dynamic process. Two ways they have done this is by subjecting the design of the stress scenarios to continuous change from year to year; and also by not disclosing the specific models supervisors use to run the quantitative stress test results.  While firms have expressed concern about their ability to plan around the Comprehensive Capital Analysis and Review process, known as CCAR, we think this structure provides important benefits.

 

·         Regulators have not disclosed the supervisory models to avoid efforts by firms to “game the models” through copying and relying upon the Federal Reserve’s models in lieu of their own.  This would be counterproductive to the goal of improving firm’s own risk management practices; and would likely encourage the type of complacency that the stress test exercise is seeking to avoid. 

·         The continuous change of the stress scenarios is a realistic acknowledgement that a future severe stress scenario will be difficult, if not impossible, to anticipate.   Regulators and firms need to share the burden of getting ahead of and preparing for future crisis scenarios: firms, through their own risk management practices, models, and capital planning; and regulators, through their independent assessments and innovations in scenario design.  For example, since the first stress test exercise in 2009, which tested a severe recession and trading market shock, the Federal Reserve has tested a number of other key risks, including: a sudden and sharp increase in interest rates; the default of a firm’s largest counterparty; and severe stress in Europe and Asia.[1] 

 

At a minimum, such dynamism in the CCAR process helps the largest firms pay closer attention to key risks and improve the data available to supervisors should such risks materialize.  Not knowing exactly how a firm will be stressed leans against the natural inclination to be finely calibrated to one test or one set of assumptions. And at its best, the uncertainty from year to year in the CCAR test provides a much more realistic test of risk management and business model choices.[2] 

 

 

Due to the nature of the information provided, and of the living will process itself, these plans consume a lot of time and resources for every firm that is required to submit a resolution plan.  I’m sure most of you agree that this kind of intense planning lies on the critical path towards making the system safe from the failure of any firm.  But, I understand that planning for your firm’s or your client’s failure may not feel like a natural way to improve your businesses. 

 

The structure of the living will process, however, requires you not only to review the effectiveness of your contingency plans, but also the efficiency of your business structures.  Everyone here understands the rigor these plans require, and I have no doubt that each firm has seen a way where their structures or practices could be improved or refined.  While the headline numbers on the hundreds and thousands of subsidiaries are striking, the harder and more important work is the  analysis needed to determine the true nature of material entities, to align business lines with legal entities, and to review and assure the continuity of operational systems and shared services.  It’s important not just to close down the many subsidiaries that, as we have heard from firms, are easy to eliminate but also to seize this as an affirmative opportunity to improve the efficiency and internal transparency of  business operations. 

 

For example, Is this an opportunity to consolidate shared services into one entity, perhaps to improve contract management and to take full advantage of your firm’s purchasing power?  Or is it an opportunity to analyze liquidity management functions to optimize and reduce rollover risk during periods of stress?  Living wills necessarily require an investment in understanding your entire firm, and we have heard from some firms that they are using that investment to monitor and manage the average duration of financing contracts and take a closer look at close out provisions and effects.  The finalization of the ISDA protocol is a tremendous collective step forward in this area, and one that we understand many firms view as enhancing a critical piece of their resolvability under their living wills. 

 

Along similar lines, as part of the living will process, individual firms are reviewing internal structures and the interlinkages they face across the financial system, such as their clearing bank relationships and cross-margining procedures, which have become more important for many firms because of the derivatives reforms that are being implemented.  Going forward, firms will need to fix their gaze more firmly on external relationships that represent concentrated risks, both within the firms as well as the wider financial system in which they operate. 

 

 

As Secretary Lew has noted “financial reform is not about writing a set of rules and then walking off the field.”  Effective financial reform requires “an enduring commitment to make our financial system a model of stability and to keep it that way.”  As we finish the job that Dodd-Frank set out for us, we continue to deepen our understanding of the next challenges in financial reform.  We look forward to engaging with you and others as we pursue policies that support effective financial reform and promote U.S. financial stability.

 

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