(Archived Content)
As prepared for delivery
WASHINGTON – I thank the National Association for Business Economics for hosting me today. I will first briefly share my views on recent developments in the global economy. I will then move on to the main focus of my speech, which is the meaningful progress that has been achieved in the area of international financial reform. This is one of the most successful areas of G-20 cooperation, but also one I believe that does not get the credit it is due.
While the U.S. economy continues to gain steam, with real GDP growing above trend, job creation picking up sharply, and unemployment declining, global growth remains slow and uneven. For a strong and sustained global recovery, all major economies should employ a comprehensive strategy that marshals all levers of economic policy – monetary, fiscal, and structural – to address shortfalls in domestic demand, create jobs, and raise incomes. Failure to take the necessary actions leaves the door open to further disinflationary risks for the global economy. The world fundamentally needs more demand.
These general themes are echoed in the recent performance of the major foreign economies. For example, in Europe the recovery remains tentative, demand is weak, and in some countries growth is still overly dependent on exports. Accordingly, a strong case can be made that those countries with large external surpluses and fiscal space should pursue bolder policies to boost domestic demand, including investment in infrastructure. We encourage European policymakers to work toward a comprehensive approach to promote economic growth, using the full range of policy tools.
We continue to monitor the situation in Greece closely, encouraging all sides to work pragmatically together to find a path forward. Greece has made enormous progress in addressing its fiscal imbalances, but further structural reforms are necessary to allow the supply-side of its economy to compete successfully in Europe and internationally. It is important that Greece work with its European partners and the international community to sustain its progress toward recovery and reform.
In Japan, the weakness of economic growth through the last three quarters of 2014 underscores the need for a reinvigorated application of all three arrows of Prime Minister Abe’s economic program, particularly structural reforms with an eye toward catalyzing domestic demand over the medium-term. Resolute action by the authorities will improve Japan’s economic prospects and help foster the escape from deflation, which in turn should contribute positively to an improved global outlook.
China faces difficult challenges, amid moderating growth, as it shifts its economy away from an unusually high investment share of GDP toward greater reliance on consumption. Chinese policymakers have recognized the need to transition to a more market-oriented economy, and they have tools to manage this transition. Also critical to China’s success is accelerating its move to a market-determined exchange rate; progress has been made in recent years, but such efforts must be broadened and become more entrenched.
Now let me pivot to international financial regulatory reform. The case for U.S. leadership in this area is clear and compelling. We live in a world where regulation is carried out at the national level but financial markets are globally integrated. Developments in one economy can quickly spill over to the rest of the world. We have a vital interest in protecting our citizens and taxpayers from the incalculable economic, financial, and social costs of another global financial crisis.
In this light, U.S. policymakers have worked to ensure that, just as we have raised our own financial standards, other countries do the same. Such action will discourage regulatory arbitrage and prevent gaps in regulation that could create vulnerabilities and stress in the global financial system, while also ensuring a level playing field that allows U.S. financial institutions and markets to thrive. For all these reasons, cooperation on international financial regulation is crucial to maintaining our financial stability and prosperity here at home.
I will first describe the basic coordination challenges that countries face when trying to set international financial standards. I will then highlight our key priorities, the progress we have made at the domestic and international levels, and briefly outline some important remaining challenges. Throughout these remarks, I will emphasize that the role played by the G-20 and the Financial Stability Board (FSB) is crucial for protecting American citizens from the risk of another global financial crisis.
As background, the G-20 leaders established the Financial Stability Board in 2009 and gave it responsibility for coordinating and monitoring implementation of the G-20’s financial regulatory reform agenda. The FSB brings together national authorities (including finance ministries, central banks, and supervisors) responsible for financial stability in major economies, along with the standard-setting bodies and international financial institutions. The United States has three representatives to the Plenary: myself, a Federal Reserve Governor, and the Chair of the Securities and Exchange Commission. The FSB’s work is carried out largely through the activities of three standing committees, which focus respectively on the assessment of vulnerabilities, standards implementation, and supervisory and regulatory cooperation.
The Necessity of International Cooperation
International coordination can be difficult even under the best circumstances. To highlight this point, consider the following scenario. Suppose that financial authorities in two countries must decide whether to set relatively strong or weak financial regulations.
In the immediate aftermath of a financial crisis, policymakers in both countries likely agree that cooperating to achieve a more robust regulatory framework is desirable. That said, neither country wants to be alone in raising standards, fearing the short-term competitive costs of regulatory arbitrage.
But financial reforms take time to be passed into law and fully implemented. For this reason, there is a risk that support for strong reforms may dwindle as memory of the crisis fades and pressures to ease standards mount. Thus, over time, both countries may come to doubt that the other will actually implement strong reforms.
A key insight is that if neither country trusts the other to adopt and maintain high standards, both may weaken their reforms in order to avoid the risk that they adopt and the other does not. In this case, both countries end up worse off than if they had cooperated. The result will be a patchwork system of inconsistent regulations and a temptation to engage in a “race to the bottom.”
What’s missing from this scenario is a coordination mechanism to establish communication and trust between the players. Such a mechanism would give each country confidence that the probability of the other adopting strong regulation is sufficiently high that the best strategy is to adopt strong reforms.
Let’s now consider the real life mechanisms that can get us to favorable outcomes. Communication between financial authorities is enhanced through standard-setting bodies such as the Basel Committee, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). Since the crisis, the G-20 and the FSB have supported the standard-setting bodies by actively coordinating the implementation of recommended reforms.
But communication is not enough. Countries must also establish trust that international partners will hold up their end of the bargain. This is why the FSB conducts regular peer reviews to encourage jurisdictions to follow through on their reform commitments.
To be clear, the U.S. government holds a different view than the two countries in this example. We strongly believe that, regardless of what other countries do, strong domestic financial standards are necessary to maintain a well-functioning financial system. I believe that all of our G-20 partners hold this same view. However, we cannot deny the risk that, over time, fading memories of the crisis might leave policymakers more willing to weaken their regulatory standards. The G-20 and FSB help guard against this risk.
Causes of the Financial Crisis
As you would expect given the complexity and interconnectedness of the global financial system, the crisis that began in 2007 had multiple causes. The contributing factors included persistent macroeconomic imbalances, the accumulation of complex and opaque exposures in the financial system, and woefully inadequate risk management in financial institutions. But the hard truth is that, in addition, policymakers, regulators, and supervisors did not get the job done.
That is why, after quickly moving to put out the financial fires and restore growth, the U.S. government turned to making our financial system safer. As Secretary Lew has said, “[t]his effort produced the most comprehensive overhaul of our financial regulatory system since the Great Depression, bringing our financial system into the 21st century and creating tools to address complex and ever-changing markets and institutions.”
But the United States could not confront this problem alone. The global financial system had become dramatically more integrated in the years leading up to the crisis. Between 2000 and 2008, exposures of banks to borrowers outside their home country more than tripled to over $35 trillion. U.S. banks were a key driver and beneficiary of this integration: one-third of the revenue earned by the largest globally active U.S. banks comes from overseas.
In short, the United States is not a financial island. We cannot be safe if we confront risks only at home. This is why we have sought to pair our domestic regulatory reform agenda with efforts internationally to promote high-quality standards abroad, move toward a level playing field, and prevent risk from migrating to areas where regulation is less rigorous. Working through the G-20, the FSB, and the standard-setting bodies, we have sought to incorporate the lessons of the crisis into global financial standards and worked to implement these standards around the world.
We have been explicit about what these standards are geared to achieve. As was stated at the G-20 London Summit in April 2009, strengthened regulation should “guard against risk across the financial system; dampen rather than amplify the financial and economic cycle; reduce reliance on inappropriately risky sources of financing; and discourage excessive risk-taking,” all with the aim of supporting strong and stable growth.
Let me now turn to the four key objectives for global financial regulatory reform that the G-20 has focused on since the crisis.
Capital and Liquidity
One of the salient lessons from the crisis was that major banks did not have enough capital to absorb their losses without government support. Banks had not built sufficient capital cushions. Accordingly, in the years after the crisis, U.S. regulators required banks to recapitalize swiftly and robustly, implementing credible stress tests in 2009 that pushed these institutions toward recovery. To complement our progress at home, we urged major economies to move with us. At the G-20 Pittsburgh Summit in September 2009, for example, the United States led the international call to establish more rigorous capital standards for globally-active banks. In response to this call, the Basel Committee developed the Basel III framework, which was finalized in 2011.
In my mind, Basel III’s most important innovations are (1) calling on banks to hold significantly larger and higher quality capital buffers, including surcharges for the globally systemic banks; (2) strengthening global liquidity standards so that banks are less vulnerable to run dynamics; and (3) introducing an internationally consistent leverage ratio.
These reforms are already making the financial system safer and prompting banks to rethink their business models. The aggregate Tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, for large U.S. banks has more than doubled from 4.9 percent in 2008 to over 12 percent in the third quarter of 2014, reflecting an increase in Tier 1 common equity from $325 billion to $870 billion during the same period. We are also making progress internationally, with the average capital adequacy ratio for all large global banks rising significantly to over 10 percent in mid-2014.
The work done by the Basel Committee is an excellent example of how working together can get us to better outcomes. Through communication and cooperation, international bank supervisors have pursued more rigorous standards that make the entire global financial system safer.
OTC Derivatives
The second big agenda item has been reforming OTC derivatives markets, which grew at an incredible pace in the years before the financial crisis. Notional outstanding amounts rose from $95 trillion in 2000 to nearly $700 trillion in 2008.
In the run-up to the crisis, derivatives were often traded over-the-counter on a bilateral basis, without any centralized reporting or data collection. This created a complex web of non-transparent exposures across financial institutions. Neither firms nor their regulators had the capacity to adequately assess the risks embedded in their derivatives exposures, and many of these exposures were uncollateralized. As the crisis erupted, a toxic combination of underlying opacity with increased uncertainty led to a massive sell-off of assets in many markets, presenting a systemic threat to the global financial system.
In response, the G-20 Leaders at the Pittsburgh Summit concluded that standardized OTC derivatives transactions should be centrally cleared and traded, and that all derivatives contracts should be reported to trade repositories.
The United States has led implementation in this area. The CFTC has already adopted rules for central clearing, trading, and reporting. In Europe, while reporting has begun, clearing obligations will likely not start until later this year, and trading rules will not go into effect until 2017. In Asia, Japan has been the pacesetter, while other major Asian financial centers where these products are traded must catch up to meet G20 standards.
Although we are working to ensure that rules are well aligned across major economies, these differing implementation timelines have made cross-border cooperation between regulators more difficult. Even so, we are committed to continue working closely with our G-20 partners to ensure that all jurisdictions implement the Pittsburgh Summit commitments. Over time, this should provide a robust basis for heightened regulatory cooperation, including efforts to move toward “substituted compliance” in the area of OTC derivatives.
Resolution
The third key issue on the G-20’s agenda addresses the problem of resolving systemically important financial institutions (or SIFIs). A successful resolution regime should address lingering perceptions in the market that any firm is “too big to fail.”
The failure of Lehman Brothers revealed that we did not have an adequate framework in place for resolving and winding down large, interconnected financial companies in an orderly manner. Approximately eighty Lehman subsidiaries entered insolvency in eighteen different jurisdictions. Around the world, counterparties tried to run and creditors rushed to seize assets. In financial markets, uncertainty and volatility spiked as Lehman’s clients scrambled to adjust. Financial contracts were unwound haphazardly, and money market funds came under pressure from spiraling redemptions.
At that time, our resolution framework did not extend to non-banks like Lehman. One of the key reforms in the Dodd-Frank Act is the Orderly Liquidation Authority, which under certain conditions allows regulators to take over a failing financial company and wind it down in an orderly manner. But reforming the U.S. resolution framework is not enough. A failing global bank needs to be effectively wound down in each jurisdiction in which it operates, and in a coordinated manner. To achieve this objective, home and host authorities must cooperate.
Against this backdrop, the G-20 Leaders have called for the development of robust resolution tools for financial institutions. The United States has played a key role in this effort. For example, the FDIC and the Bank of England developed a “Single Point of Entry” strategy, which is a top-down approach to resolution that reduces the incentives of host countries to ring-fence assets and promotes financial stability by allowing subsidiaries to continue operating. Last year, U.S. authorities helped lead an effort at the FSB to develop a new standard on total loss absorbing capacity, or TLAC, for global systemically important banks. TLAC facilitates orderly resolution by providing a mechanism for shareholders and creditors of a failed company to absorb the associated losses.
Creating frameworks under which it is credible for investors – rather than taxpayers – to bear the cost of failure has been a key objective of our international financial reform efforts.
Shadow Banking
The final G-20 policy priority I will discuss is the oversight and regulation of the potential risks posed by shadow banking, which the FSB broadly defines as credit intermediation outside of the regular banking system.
To be clear, shadow banking might instead be called “market-based financing” and viewed as a valuable alternative to funding from banks. The United States is a much more resilient and dynamic economy due to the diverse ecosystem of our capital markets. With regulation and oversight appropriate to the systemic risks posed, we should aim to promote greater market-based financing for firms and consumers around the world. Indeed, European regulators have emphasized this point in their recent efforts to create a Capital Markets Union.
Nonetheless, we learned from the crisis that market-based financing can also be a source of systemic risk and that, as we strengthen regulations in the banking sector, activities tend to migrate to the non-bank financial sector. In the United States, the Dodd-Frank Act has widened the perimeter of regulation to cover more market-based financing activities, and the Financial Stability Oversight Council has a thorough process for reviewing such risks and proposing remedies by the appropriate regulator or supervisor, if needed.
Internationally, the FSB similarly continues to develop policy recommendations aimed at further transforming shadow banking into resilient market-based financing. The FSB has produced recommendations to mitigate risks in banks’ interactions with shadow banking entities, reduce the susceptibility of money market funds to runs, and improve transparency and align incentives in securitization. This year’s FSB-led peer review of shadow banking frameworks in member countries represents another notable milestone in our shared efforts.
Looking Ahead
In sum, I believe that the G-20’s financial regulatory reform efforts have made meaningful progress. There is global commitment to the international financial regulatory reform agenda, and this commitment is marching forward due to the collective work of the FSB, standard-setting bodies, and national and regional authorities.
This reform agenda has largely moved past the design phase and is now into implementation. Accordingly, this is not the time to scale back our efforts. Hard work to ensure strong and consistent implementation across countries is urgently needed. Additionally, some essential issues must still be dealt with.
On capital. More work needs to be done on the consistency of risk weighting practices across jurisdictions, and we welcome the Basel Committee’s 2015 work plan to address this issue.
On derivatives. We are encouraged by the progress that the U.S. and European authorities have made in addressing cross-border concerns on central counterparty equivalence determinations. We also look forward to domestic implementation of the Global Margin standards for non-centrally cleared trades.
On resolution. Several important work streams are ongoing, but finalizing the FSB’s TLAC proposal by the G-20 Leaders Summit in November is a particular priority.
On shadow banking. We will continue to work on the G-20’s shadow banking roadmap and further examine the systemic risks arising beyond banking and insurance.
As we progress in these four priority areas internationally, we must also address new vulnerabilities. For example, we are mindful that central counterparties now play a more critical role in the financial system. This is why the G-20 has asked the FSB and standard-setting bodies to develop a work plan to identify and address any remaining financial stability risks arising from CCPs that are systemic across multiple jurisdictions.
Some Concluding Thoughts
Finally, let me say a word about U.S. leadership in this area. As I have argued, countries are likely to obtain worse outcomes when they choose to go it alone or when communication is limited. The financial crisis made clear that the world needs a coordinated and inclusive strategy to ensure strong standards and the resilience of financial markets.
International standards, such as the Basel III accord, are developed by the leading standard-setting bodies. In such bodies, the work is done by technical experts, and the United States is well-represented by its financial regulatory agencies. This was true before the crisis, and it remains true today.
What has changed is the effectiveness of global coordination. Since the crisis, G-20 Leaders have tasked the FSB with bringing together the national authorities and standard-setting bodies responsible for financial stability, to help ensure that timelines and work plans are met and that potential gaps in the regulatory structure are identified and addressed. The G-20 and FSB in turn endorse the work of the standard-setting bodies.
The value of this process is evident if we consider the counterfactual. What would happen if we did nothing internationally while overhauling our domestic regulatory framework? The answer is that our globally active institutions would likely face starkly conflicting and inconsistent regulations across jurisdictions. Of even greater concern, to the extent that other jurisdictions pursued less vigorous approaches, risks would tend to migrate outside the United States, setting up potentially harmful international competition and a destructive race to the bottom.
Let me conclude. For all of the reasons that I have outlined, the United States is a strong supporter of international regulatory coordination. We will continue working with other G-20 members to leverage the FSB to our collective advantage, steering it in the direction of supporting greater financial stability and more robust growth both in the United States and globally.
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