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Good morning, it is a pleasure to be speaking to the Institute of International Bankers (IIB) again. Thank you for giving me the opportunity to continue the long standing tradition of Treasury officials discussing key financial and economic policy issues before this distinguished group.
As we meet here today I am heartened that we do so against the backdrop of one of the strongest economies in many years. Macroeconomic conditions in the United States have been quite favorable GDP growth at 3.5 percent last year and projected to run at roughly that level for the current year; strong and increasing job creation, which should inevitably have attendant income effects; strong and durable productivity growth; robust tax receipts; and household wealth at an all-time high.
Moreover, it is clear that financial markets have a great deal of confidence about the future. The Dow is above 11,000, Treasury yields remain low and stable and credit spreads are at historically narrow levels.
This benign environment allows scope for reflection on policy development, and four items we will be working on in 2006 that are of particular interest to the IIB and that I would like to discuss with you today are: the Basel Accords, regulatory relief, GSE reform and the Treasury's examination of changes in the financial markets.
Basel II and IA
Basel II made headlines recently when the issue came up during Chairman Bernanke's testimony to the Senate Banking Committee. Both Senators Sarbanes and Shelby threatened to stop the implementation of the Basel II accords if it resulted in capital levels dropping dramatically.
As we all know reforming the risk-based capital standards for domestic and international banks through the Basel II process has been a long and painstaking exercise, and the implementation of the most recent version of the Basel II framework announced in June 2004 has posed many challenges for U.S. and international regulators. In an Advance Notice of Proposed Rulemaking issued in September of last year, the banking regulators announced a delay in the implementation of the phase-in period for Basel II, which will not begin until 2008, a year after European banks will begin implementing Basel II. That delay was predicated on the returns from a Quantitative Impact Analysis (QIS-4) involving 26 surveyed institutions that resulted in a 17 percent reduction in aggregate minimum required risk-based capital for the group and a wide dispersion of required capital across individual institutions and types of asset portfolios. The proposed rulemaking is expected this quarter.
Beginning in 2008, the 20 U.S. banks that will adopt the new accord will be required to comply with both the existing capital standard and Basel II. In 2009, if regulators are satisfied with the results, the banks would be allowed to use the new standard, but with specified limits on how much capital levels could drop.
Over the past months, the U.S. banking agencies have been undertaking a more complete assessment of the QIS-4 results to determine the essential steps that must be undertaken to effectively implement the Basel II framework for U.S. banks. Our regulatory agencies remain committed to the Basel process and are proceeding as quickly as they can to implement the Basel II Accord, but, most importantly, to make sure it is implemented correctly and in a way that reduces competitive inequities between financial institutions as much as possible. We will continue to urge the regulatory agencies to work cooperatively in this effort and move the process forward in a timely fashion.
Regulatory Relief
There a number of efforts currently underway in Congress to address unnecessary regulatory burdens imposed on financial institutions. To promote the efficient operations of our Nation's financial institutions, it is important that we continue to evaluate the structure of our regulatory oversight system with an eye toward eliminating outdated regulations and unnecessary requirements.
At the same time, we must remain aware of the fundamental purpose of existing regulations, both in terms of chartering differences among financial institutions and basic safety and soundness requirements. It seems to me that if we are going to move regulatory relief legislation forward, it is important that we stick to the basic task as opposed to using regulatory burden relief bills to address other more fundamental structural changes.
We also understand the banking industry's concerns with the regulatory burden associated with Bank Secrecy Act regulations. A number of important steps have been taken in this regard, and I continue to work with my enforcement counterparts to develop a regulatory structure that is tough where it needs to be, but is also fair and flexible in its overall approach to addressing this issue.
GSE Reform
The release of the Rudman Report a couple weeks ago may be the catalyst that gets the Government Sponsored Entity (GSE) reform effort moving again. As many of you know, the topic of reforming the regulatory structure of the housing GSE's Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System has been hotly debated for the last couple of years in Washington. I believe this deliberation will come to a head in 2006.
The Administration's key focus on GSE reform is to maintain a strong national housing finance system that meets the mortgage credit needs of our nation and provides financing opportunities for new homeowners. In light of the recent events at the GSE's--such as significant financial restatements--the need for meaningful reform is even clearer.
As we originally outlined in detail in 2003, the regulator for the GSE's should have powers comparable in scope and force to those of other financial regulators. As bankers, you will understand that we would like to see a regulator with all the powers of the regulators you deal with daily. It must have clear general regulatory, supervisory, and enforcement powers with respect to the GSE's. These powers must include enhanced authority to set capital standards; the ability to assess the entities for independent funding outside of the appropriations process; approval authority over new activities; and the ability to place a failed GSE in receivership.
The issue that has received the most attention recently is the recommendation by the Administration to place limits on the GSE's retained mortgage portfolios. The need for portfolio limits stems from a combination of factors that pose potential systemic risk to our financial system: the large size of the GSE's retained portfolios; the link between the GSE's financing and hedging activities and the rest of our financial system, and a general lack of market discipline.
We'd like to see these holdings significantly reduced. With an appropriate phase-in period, we believe that our capital markets could adjust to a significant reduction in the presence of the GSE's as mortgage investors. Now, in the 21 st century--so very different from the markets in which Fannie Mae was born--we have a vast and prolific liquid market for mortgage credit that could readily absorb such a divestment program. Our country has seen great advances in securitization and there is a wide and sophisticated pool of mortgage investors.
The housing mission of the GSE's is still a vital one--helping to provide a liquid secondary market for housing credit. Even with a significant reduction in their portfolios, the GSE's would still be able to stay true to their mission. Their securitization and guarantee activities are now an integral and large part of the fabric of our housing credit markets and, as such, these businesses serve well the original GSE mandate.
I am hopeful that there will be a progress on the GSE reform debate in 2006.
Examination of Changes to the Financial Markets
In addition to these issues, we at Treasury are focusing on our ability to understand and stay well ahead of the risks in our fast-changing financial markets. Specifically, the Treasury is examining whether the growth of certain sophisticated and complicated financial instruments and vehicles, such as derivatives and hedge funds, hold the potential to change the overall level or nature of risk in our markets and financial institutions.
For instance derivatives now serve a key role in our capital markets primarily by increasing efficiency, liquidity and the ability to segregate and distribute risk. In testament to their utility, derivative contracts are growing rapidly in size--their aggregate notional value now reaches into trillions of dollars. They are concentrated in our largest financial institutions that tend to have the capital and sophistication to act as high volume counterparties. We at Treasury, given the explosion in the type and use of derivatives, and institutions that use them, want to ensure that the magnitude of risk and exposure are properly measured and that investors and market participants have full and adequate disclosure upon which they can make informed decisions.
We are also reviewing several structural changes we see in our markets:
- The greater systemic importance of a smaller number of large bank-centered financial institutions;
- The greater role played by non-bank financial institutions;
- The rapid growth of GSEs and appetite for their securities;
- The growth of capital accumulation through less-regulated entities such as private equity funds and hedge funds;
- Greater operational demands on the core of the clearing and settlement structure;
- An increase in the complexity of risk management and compliance challenges; and
- The extent of global financial integration.
Looking forward, the Treasury will be focused on seeking to understand in the most comprehensive way possible whether and how changes in the structure of the financial services industry have affected the way markets operate put another way, whether the growth of certain types of institutions or instruments have materially affected the efficiency with which markets intermediate risk, whether risk is placed or pooled in different ways or different places than it has been in the past and if so, what appropriate policy responses might be.
We will seek to be forward looking and to think about these changes not in a fragmented fashion as has too often been the case up to now but in a comprehensive way. At the moment it is too soon to say what initiatives will result from this focus we do have a fairly significant agenda to execute on in the next few months but this is the lens through which we will filter the various ideas and efforts with which we will all be grappling over the next few years.
Thank you, and I'll now be happy to take any questions you might have.