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NEW YORK - Good afternoon. It is a privilege to address the distinguished audience at the Hyman Minsky Conference.
Today, I would like to present an overview of how recent financial reforms are designed to maintain financial stability, and thereby promote confidence in our financial system.
One of America’s great institutions has been its financial system. Over the years, this system has enjoyed a degree of openness, transparency, safety, dynamism, and creativity unmatched by any other. People from all over the world have trusted this system with their money. They have come to America to open businesses, to seek investment, and to see their investments grow.
This system, which has served as a foundation for America’s global leadership and prosperity, nearly collapsed during the financial crisis. Financial institutions lost trust in each other, and consumers, investors, and businesses lost trust in financial institutions and the markets. And thus the financial system was unable to perform its most basic credit intermediation function, which is of vital importance to the real economy.
New Products, Changed Firms, and Expanding Linkages
Often, the starting point for speaking of restoring trust in the financial system begins with the years immediately preceding the financial crisis. To appreciate fully what the Dodd-Frank Act seeks to accomplish, it helps to take a step back and to trace some important developments in the financial industry over the past three decades.
Those decades witnessed significant innovation in the world of finance. Many aspects of this innovation were positive and contributed to our growth and prosperity. But some of this change was also accompanied by peril.
Today, I touch on four developments that I believe were significant:
- First, we saw an increase in the size and complexity of some financial institutions;
- Second, there was a significant degree of financial product innovation;
- Third, new financial actors outside of the bank regulatory framework became increasingly involved in credit intermediation;
- Fourth, this changed landscape contributed to an unprecedented level of interconnectedness between financial firms.
The story of the increase in the size and complexity of many financial firms is undoubtedly familiar to this audience. In 1980, for example, the top four banking organizations accounted for about 15 percent of industry assets. By 2007, the top four banks held 46 percent of industry assets. As this statistic suggests, with increasing size came increasing concentration.
Financials firms also became increasingly complex. The concept of the “business of banking” was expanded from its earlier, more circumscribed definition. The banking legislation enacted in the 1990s both enabled and reflected the underlying changes in the business. These years witnessed the expansion of interstate banking and the ability of bank holding companies to engage in businesses such as investment banking, which allowed them to own broker-dealers.
Thus, firms grew along multiple dimensions. They began to manage a more diversified portfolio of assets and a greater number of lines of business. They also became more reliant on the capital markets for both shorter-term and longer-term financing. Many firms relied on leverage to expand their balance sheets. In 1979, broker dealers had on average total liabilities to equity capital ratios of 18-to-1. By 2007, this ratio had increased to about 37 to 1.
Second, this time period witnessed a tremendous outburst of creativity resulting in the introduction of many new financial products, many of which were designed to manage and disperse risk. The first interest rate swap was arranged in 1981 for risk management purposes between the World Bank and IBM. The credit default swap was conceived in 1997 as a hedging tool to mitigate risk for bank loan portfolios. Notwithstanding their recent creation, over-the-counter derivatives transactions today represent $600 trillion in notional amount and involve increasingly complex products used for a broad variety of purposes.
This time period also saw the development of asset-based securitization, which improved the availability of credit and lending capacity by distributing the underlying credit exposure to third parties. Securitized products were tailored to meet investor risk and duration appetites. By the mid-1990s, securitization had spread from mortgages to other asset classes and structured products became increasingly complex. As it turned out, however, the risks of these new products were poorly understood in many cases. Many overlooked the risks posed by the illiquid, long-term assets upon which the securitized products were collateralized and the nature of the support offered from private credit and liquidity enhancement.
Third, as firms and products evolved, new financial actors – outside of the existing bank regulatory structure – became increasingly prominent in credit intermediation. For example, money market funds grew from $76 billion in financial assets in 1980 to $3 trillion in 2007. The number of hedge funds, and the amount of assets under management by those firms also expanded. Between 1990 and 2007, hedge funds grew from 530 firms with $39 billion under management to 7,600 firms with $1.9 trillion under management.
During this period, practices of established actors also changed. Further innovations in securitization lead to the growth of structured investment vehicles and attracted a broad new set of investors, ranging from traditional banks to insurance companies. Structuring to achieve advantageous credit ratings fueled the growth of these investment vehicles and the access of otherwise conservative investors.
Fourth, these developments and others, such as vast improvements in technology, contributed to an unprecedented degree of interconnectedness. The new products linked regulated, unregulated, and differently regulated firms in unfamiliar ways. For example, by selling a credit default swap, a firm became potentially liable to another firm, but in a way unlike traditional liability relationships. Credit default swaps created not only a ‘jump-to-default’ liability, but the possibility of a ‘double default’, whereby the protection buyer was now exposed to the counterparty credit risk of the protection seller.
These risks were not only poorly appreciated, but largely hidden due to the absence of adequate reporting rules and recordkeeping requirements. Even so, credit default swaps and other derivative contracts tied the fates of our largest financial firms to each other. In a moment of stress, even strong firms could be vulnerable to the failure of a weaker firm.
The Failure of the Regulatory Framework
The regulatory framework did not keep pace with these innovations. Both the institutional structures, and the substance of our rules, proved insufficient.
One fundamental shortcoming of the regulatory structure was that there was no requirement that regulators collectively and collaboratively monitor the financial system as a whole. At different points in American financial history, circumstances had demanded the creation of specific regulatory agencies to perform specific tasks and to solve specific pressing problems. When these agencies were created, financial firms and markets were not as complex or interconnected. Thus, the foundations of the old regulatory system were based on assumptions about the nature of financial firms, their activities, and their relationships that would be outgrown during these three decades.
To be sure, during this period, regulatory practice and legislation recognized the increasing need for interaction and coordination between the agencies. What we did not sufficiently appreciate was how quickly the world was changing, and how much more robust that interaction and coordination would need to be. As a most basic example, the largest financial institutions were not subject to consolidated supervision.
Second, financial regulation did not keep up substantively with the many issues presented by the firms and markets. Firms did not hold sufficient capital or liquidity. Risk management was outdated. Securitization incentives were misaligned. Credit ratings proved to be unreliable. The list is lengthy. The lack of proper regulation and oversight resulted in deteriorating market discipline and it skewed incentives so as to reward excessive risk taking.
Establishing Macro-Prudential Supervision
The financial crisis revealed that the risks facing our system can be correlated and crosscutting, and that they could affect multiple firms and markets simultaneously. The crises laid bare the weaknesses of the financial regulatory infrastructure: insufficient coordination among regulators; limited tools to understand complex financial firms; inadequate authority to regulate for safety and soundness outside the core banking system; and, no provisions for orderly resolution.
To preserve financial stability, it thus became essential to establish a regulatory structure that could properly assess the financial system as a whole, not simply its component parts – a regulatory structure in which the failure of one firm, or problems in one corner of the system, would not risk bringing down the entire financial system.
The Dodd-Frank Act responds to this need by creating a dynamic, forward-looking regulatory apparatus that seeks to restore market discipline. While we cannot predict precisely the threats that may face the financial system in the future, we can put in place a modern regulatory framework to help keep pace with financial sector innovations and safeguard financial stability.
The Financial Stability Oversight Council
The Financial Stability Oversight Council was created to require financial regulators to regularly convene to monitor financial stability. While each agency plays an important role in maintaining a stable and well-functioning system, the crisis revealed that no single agency had sufficient authority to manage a financial crisis on its own. Acting in the collective, the Council’s function is to identify risks to the financial stability of the United States and respond to emerging threats to the stability of the U.S. financial system.
The Council was created to be the central point of coordination across the regulatory system. By statute, it must meet officially no less frequently than once a quarter. Thus far, it has met much more frequently. The Council must also release an annual report that assesses the impact of significant financial market and regulatory developments on financial stability.
The Council possesses both general duties and specific authorities. Among the Council’s general duties are to monitor the financial services marketplace to identify potential threats to financial stability. The monitoring duty is fulfilled partly by relying on the Council’s constituent agencies, but also by drawing on the work of the Office of Financial Research, which supports the Council and its member agencies.
The OFR is charged with developing tools for risk measurement and monitoring; collecting data and providing these data to the Council; and standardizing the types and formats of data reported and collected. The OFR’s work will enable regulators to aggregate and analyze the data, to see more clearly the interaction between developments in our financial system and the global economy, and to understand the risks faced by financial firms, including their interconnectedness.
An example of the OFR’s recent work is advancing the establishment of a Legal Entity Identifier. The LEI aims to create a global standard for the identification of parties to financial transactions. This standard will improve data quality, allowing regulators and firms better to manage counterparty risk, improve the integrity of their business practices, and lower processing and transaction costs.
Two other general duties of the Council are, first, to facilitate information sharing and coordination among the member agencies and other regulators and, second, to monitor financial regulatory proposals, identify gaps in regulations, and recommend supervisory priorities to agencies. Both sets of duties are core to the Council’s intended role as the central point of coordination across the financial regulatory infrastructure.
Modernization of Oversight through Designation
Financial stability requires conditions wherein system-wide financial intermediation is preserved and payment services are not disrupted. Some of the Council’s specific authorities go to addressing these two components of financial stability. The financial crisis taught us that the failure of one significant firm can destroy confidence in the financial system and disrupt financial intermediation.
Accordingly, Dodd-Frank has given the Council specific authority to designate nonbank financial companies for supervision by the Federal Reserve under enhanced prudential standards. In addition, financial market utilities provide market participants with the fundamental confidence that our system is safe and sound, and that the terms of their transaction obligations will be honored. Although this fact is often overlooked, the statute gives the Council the authority to designate these utilities systemically important for enhanced supervision.
Last week, the Council approved the final rule that lays out the criteria and process for designating certain nonbank financial companies. The Council has now begun the three-stage designations process. In addition, the Council also issued a final rule in July 2011establishing criteria by which financial market utilities may be designated for enhanced prudential standards. The designation process outlined by that rule is also under way.
Other Essential Tools to Preserve Financial Stability
Other major tools of Dodd-Frank to strengthen system-wide oversight and mitigate threats to financial stability include: stronger regulation of large bank holding companies; a comprehensive approach to oversight of the derivatives market; and, a new orderly liquidation authority for financial companies.
The crisis showed that large bank holding companies are potentially vulnerable to major counterparty credit, liquidity, and other risks in the midst of market stress. Accordingly, the statute requires all bank holding companies with at least $50 billion in assets to be automatically subject to enhanced prudential standards by the Federal Reserve Board.
The Federal Reserve issued its Notice of Proposed Rulemaking for enhanced prudential standards in January, and is currently collecting comments. The proposed standards will include more stringent regulations for liquidity and capital, single-counterparty credit limits, and overall risk management protocols, including risk committees and stress tests.
The crisis also showed that links between firms created by derivative contracts could exacerbate a crisis. The statute adopts a comprehensive approach to reform of the derivatives markets, which had previously lacked oversight. The flaws attendant to this area of financial transactions were many: poor documentation such that, at critical times, neither supervisors nor counterparties knew who owed what to whom; poor risk management such that firms were not able to satisfy their contractual obligations with respect to collateral; and a generally fragmented and opaque market.
To reduce these risks, financial firms will now be subject to important recordkeeping and transaction documentation requirements. They will also be required to submit standardized contracts to central counterparties for clearing. The reforms also include trading and transaction reporting requirements designed to make the derivatives markets more transparent. Finally, transaction information will be recorded in data repositories, which will allow regulators to monitor this market better.
Third, the experiences with Lehman Brothers showed the potentially devastating consequences to financial stability of the disorderly bankruptcy of a significant financial firm. Thus, the statute provides for orderly resolution.
The FDIC and Federal Reserve have already adopted a number of rules related to the resolution authority, including a “living wills rule,” that requires large bank holding companies and designated nonbank financial companies to prepare resolution plans. The largest bank holding companies will submit the first living wills in July. Recognizing the interconnected nature of the financial system, resolution authority will serve to prevent the failure of one institution from taking down the entire system. And it should play an important role in restoring market discipline, by reducing reliance on government backstops.
Finally, administering reforms to maintain financial stability is important not just for the U.S. financial system, but for the global financial community. There should be a level playing field for all firms and regulatory coordination. We continue to work with our partners in the G-20 and the Financial Stability Board to ensure that the financial reform agenda is global in scope.
Conclusion
Over the past three years, we have made substantial progress in restoring trust to our financial system and to improving financial stability. Bank balance sheets are stronger. Tier 1 common equity at large bank holding companies increased by more than 70 percent or by $560 billion since the first quarter of 2009.
Additionally, at the four largest bank holding companies, for example, reliance on short-term wholesale financial debt has decreased from a peak of 36 percent of total assets in 2007 to 20 percent at the end of 2011. The firms’ liquidity positions are more robust and their funding sources are more reliable. Firms have significantly reduced leverage. Recent stress tests showed that the largest financial firms are better able to withstand significant shocks.
While our financial system is growing stronger and more resilient, we should not rest on current successes. Rather, we must remember two important caveats.
First, financial stability is not static. Firms change, products change, and so does the locus and nature of risk. Constant vigilance is needed, which is why the Dodd-Frank Act conceives of a forward-looking, dynamic approach to monitoring risk and maintaining financial stability. When fully implemented, these new rules of the road will provide regulators with better tools, promote market discipline, and better protect all market participants, from retail consumers to institutions.
Second, we should not simply assume that better regulation will prevent all future crises. Confidence in the financial system also depends on the integrity of both the private institutions that operate within it and the individuals who run those institutions.
The task of maintaining financial stability thus is ultimately a collective responsibility.
Thank you.
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