U.S. Department of the Treasury

 

 

As Prepared for Delivery

 

 

CHICAGO - Good afternoon.  Thank you, David, for that kind introduction, and thanks for inviting me to be part of the Federal Reserve Bank of Chicago’s fifteenth annual International Banking Conference.  It is a pleasure to join this distinguished group of leaders in academia, government, and financial markets from around the world.  Events like these, which promote public and private sector collaboration, help officials like me rise above my daily work and focus on the broader issues that affect our economy and markets.  I look forward to engaging with you during the Q&A segment following my remarks.

 

As Under Secretary for Domestic Finance at the Treasury Department, I look for ways that we can work together on many of our country’s most pressing economic challenges.  I am very engaged in monitoring the economy and markets, managing our national debt, advancing housing finance reform, and overseeing the wind-down of our TARP investments.  I also have another day job — I call it financial regulatory reform.

 

Just consider one high-profile example: the Volcker Rule, which will restrict banking entities’ ability to engage in proprietary trading and limit their investments in certain funds.  Over the last two years, Treasury has been working closely with the five independent regulatory agencies responsible for writing the regulation.  We hold regular coordination meetings with the rule-writers. 

 

We received more than 18,000 comment letters, representing a wide range of views, on the proposed rule.  We’ve gained additional insights from dozens of meetings with investor advocates, industry officials, and other market participants.  Our goal is to achieve a strong and consistent rule, although the process is not as easy or simple as any of us would like.

 

Still, I’m pleased to report that we are making steady progress on the Volcker Rule, and perhaps just as importantly, on the dozens of other rules introduced by the Dodd-Frank Act.  Indeed, about 9 out of 10 rules scheduled to be in place have been either proposed or finalized – and we anticipate even more will take shape next year. 

 

That should leave consumers, businesses, and other market participants with greater clarity and certainty.  That is critical to strengthening our financial markets and instilling the confidence necessary for robust economic growth.

 

And that is why I want to take advantage of this opportunity to review some of the progress that we have made over the last four years and focus on some of the key areas that still need to be addressed.

 

A STRONGER FINANCIAL SYSTEM:  PUBLIC AND PRIVATE REFORMS

 

Today, it is all too easy for us to forget that only four years ago, we were in the middle of the worst financial crisis since the Great Depression.  Housing prices plunged nearly 30 percent – the first nationwide decline in over 70 years.  Our credit markets were frozen.  And many of our financial institutions were so weak that they threatened the stability of the entire financial system.

 

However, thanks to the combined actions of our regulators, lawmakers and officials from both parties, we were able to rebuild confidence, restore credit, and begin getting our economy back on track.  Through novel liquidity facilities, guarantees, capital support programs, and intervention in the housing market, our government prevented a far more severe outcome.  

 

Four years ago, almost no one anticipated recovering the crisis-related investments we made in our banking institutions or in AIG.  Earning a return was an even more distant prospect.  But thanks to the Treasury’s Office of Financial Stability (OFS), we have been carefully unwinding our outstanding investments in ways that are beneficial to both taxpayers and markets.

 

Although these measures were necessary to rescue our financial system and to begin repairing the damage, we recognized early on that they were not a substitute for meaningful, long-term reform.  We needed to make consumers safer, our financial institutions more resilient, and our markets more transparent.  We also needed to empower our regulators with new legal and risk management tools to make sure that taxpayers would not be in a position to bear the costs of these firms’ mistakes.

 

So, we enacted a package of critical reforms as part of the Dodd-Frank Act.  We set up several new institutions, such as the Consumer Financial Protection Bureau (CFPB), the Financial Stability Oversight Council (FSOC), and the Office of Financial Research (OFR).  New practices, such as annual stress tests and the use of living wills, were introduced to strengthen our financial institutions and make sure that our firms and regulatory agencies would be better prepared for the next financial storm.  Meanwhile, we have worked with our international counterparts to coordinate our efforts globally through the G-20, the Financial Stability Board, and other forums.

 

At the same time, the private sector has been changing many practices on its own.  We have seen financial markets and institutions adapt to a new environment, not just in anticipation of financial reform but in recognition that the old way of doing business would no longer work.

 

As a result of all these efforts, financial institutions have bolstered their level and quality of capital.  U.S. banks have raised their private capital levels to approximately $1 trillion, up 75 percent from $578 billion three years ago.  Our financial institutions are also less reliant on the so-called “shadow banking system” for funding.  Bank balance sheets are more liquid and transparent.  These developments have made our financial system safer and stronger—and better able to support lending and economic growth.

 

In fact, one of the most encouraging signs has been the vast improvement in the credit markets.  Four years ago, the credit markets were so deeply frozen that even the highest-quality issuers were unable to roll over their short-term debt.  Short-term funding market yields were over 400 basis points higher than the Fed’s policy rates.  Major industrial corporations were highly constrained in their ability to issue commercial paper.  In mid-September 2008, nearly three hundred billion dollars left prime money market funds in just one week.

 

Today, nearly all of the credit pipes of our financial system have reopened and, outside of the banking sector, credit spreads have largely returned to their pre-crisis levels.  Short-term funding rates are clustered near 30 basis points, with secured financial transactions playing a more important role.  And while we need to do more to restore credit availability, I am encouraged that consumers, businesses, and municipal governments are taking advantage of today’s historically low interest rates.  

 

Our financial markets are also becoming safer and stronger.  For example, most swaps trading activity will increasingly move onto clearinghouses and trading facilities over the next few years.  Much of this can be attributed to the Dodd-Frank Act, which created a comprehensive regulatory framework for over-the-counter (OTC) derivatives.  In fact, market participants have started to implement many of these changes in advance of full implementation of these new rules. 

 

Indeed, we have seen significant growth in centrally cleared interest rate swaps and credit default swaps.  This year, central counterparties (CCPs) have started to accept new types of derivatives to clear, including energy swaps and new index products.  These changes will reduce the risk that a default spreads across counterparties and will also enhance investor protection through increased disclosure.  In addition to increased transparency and credit risk mitigation, firms can start to benefit from the possibility of netting offsetting contracts that trade through CCPs.   

 

Our financial market infrastructure has also been bolstered by the development of trade repositories and a new supervisory framework over financial market utilities (FMUs).  Under Title VII of the Dodd-Frank Act, trade repositories for each asset class will give regulators a more comprehensive understanding of the size, makeup, and distribution of exposure in the swap markets.  In turn, this additional level of oversight should help mitigate the possibility of outsized risks building up in our financial system without anyone noticing. 

 

Our payment, clearing, and settlement systems will also be strengthened by enhanced federal oversight.  In July, the FSOC designated eight systemically important FMUs, subjecting them to heightened supervision and new risk-management standards.  As we encourage more of these entities to handle higher volumes and manage risk throughout the system, supervisors should ensure they are adequately capitalized and subject to strong oversight and heightened risk-management practices. 

 

More and more, I’m convinced that the concrete steps that we have taken to strengthen the foundation of our financial system are starting to pay dividends for stronger economic growth.  We reversed a staggering 8.9 percent decline in economic output in the fourth quarter of 2008 and have posted 13 straight quarters of GDP growth.  This helped create more than 5 million private sector jobs since the trough of the labor market in February 2010, including more than 500,000 in the manufacturing sector.

 

We have also seen the stock market more than double since the low point of early 2009.  Indeed, its performance over the last four years stands out when compared to the major equity market indices in Europe and Asia.

 

And in many parts of the country, the housing market is coming back to life.  Today, fewer borrowers are falling behind on their mortgage payments, and foreclosures in many areas are falling.  And most recently, home sales, housing starts, and home prices have all improved on a national level.

 

As a long-time investor before I joined Treasury, I will be the first to acknowledge that these market developments are open to many different interpretations.  We should never rely on one measure either to assess our progress or the challenges ahead.  Indeed, resolution of the impending fiscal cliff as well as the ongoing uncertainty regarding the European debt crisis, represent two pressing concerns.  I believe, however, that the healing of the financial and housing markets over the last few years at least partially reflects a much stronger financial system – one that is better able to withstand economic stress and set us on a course for greater prosperity.

 

LOOKING AHEAD

 

We still have more work to do.  So, over the next few minutes, I would like to set out a few key near-term priorities.    There are four areas that strike me as particularly important:

 

• Completing the Dodd-Frank Act mortgage-finance related rules in order to reinvigorate the private lending market;
• Reforming the short-term funding markets to improve investor confidence and reduce the risk of unnecessary market volatility;
• Delivering a set of derivatives rules that can be efficiently implemented and serve as a leading global standard; and
• Finalizing the Basel capital rules to help banks expand their lending activities with more confidence.

 

Let me provide more detail on each.

 

First, we must bring more clarity to the housing market by finalizing the mortgage finance rules required by the Dodd-Frank Act.  This is critical to helping us bring more private investors back into the mortgage market to take credit risk, minimize taxpayer exposure by reducing the government’s footprint, and improve access to mortgage credit—all priorities of the President and the Treasury Secretary.

 

In the coming weeks, we expect the CFPB to finalize the qualified mortgage rule, also known as “QM.”  We expect this rule to provide a clear and standard definition for what qualifies as a quality mortgage for both lenders and borrowers.  Once the QM rule is completed, it will be important to finalize the asset-backed securities risk retention rule, another rule in Dodd-Frank that affects mortgages and includes the qualified residential mortgage definition.

 

Once finalized, these rules should help enhance lender clarity at the point of mortgage origination.  The rules should also improve investor confidence in the underlying credit characteristics of the loans investors might purchase in the secondary market.  This, in turn, can help re-start a more robust private securitization market for mortgages.

 

Reopening this market on a stronger footing is absolutely critical for achieving mortgage finance reform.  Furthermore, private capital will be critical to expanding access to mortgage credit, particularly to first-time homebuyers and those who are working to rebuild their credit in the aftermath of the crisis.  That is why we remain committed to a future system where private markets – subject to strong oversight and standards for consumer and investor protection – will be the primary source of mortgage credit and bear the burden for losses.

 

Second, we must address the structural vulnerabilities of the short-term funding markets, including money market funds, so they do not put the health of our broader financial system at risk.

 

Indeed, money market funds provide a significant source of short-term funding for financial institutions, businesses, and governments.  They are an important cash-management vehicle for both institutional and retail investors.  However, the crisis demonstrated that money market funds are susceptible to runs and can be a source of financial instability with serious implications for broader financial markets and the economy.

 

To reduce this risk, we need to adopt reforms that strengthen money market funds’ loss absorption capacity and reduce the risk of destabilizing investor runs.   This week, the FSOC released for public comment its proposed recommendations for reform. We look forward to hearing from a range of market participants over the next few months as the FSOC process moves ahead.   

 

We must also continue to improve the safety and soundness of our repurchase markets, which underpin another crucial source of short-term funding.   Market participants and regulators need to complete the work of the Tri-Party Repo Infrastructure Reform Task Force.  We need to finalize a framework that reduces reliance on intra-day credit, adopts appropriate haircuts on less-liquid collateral, and improves the operational systems technology in tri-party repo.  Having deep and liquid repo markets are important for financial markets to operate efficiently, but they can also introduce risks to financial stability if they are not appropriately managed and monitored.

 

Third, we must be focused on completing derivatives rules that work domestically and internationally.  Our reforms should be guided by the key pillars of derivatives market reform noted earlier: (i) trades should be cleared where appropriate and subject to a strong margin regime, (ii) the most standard derivatives should move to trade execution platforms, (iii) we should develop prudential regulations of large dealers and large market participants and provide enhanced disclosure to the public and regulators.  In the near term, we will work with the market regulators to help adopt rules that are driven by these core principles.   

 

The derivatives market is global and highly mobile, and as a result one regulator or one jurisdiction cannot effectively enact reforms alone.  We strongly support efforts by U.S. market regulators to align their rules on transactions that are subject to regulation under the Dodd-Frank Act.   To provide certainty to global market participants, many of whom are hedging risks that are integral to their core operations, the U.S. market regulators should strive to establish consistent standards that apply to cross-border transactions of similar types.  We also support our regulators’ work with their international counterparts to develop robust frameworks for effective substituted compliance wherever appropriate, while always keeping in mind the risks of regulatory arbitrage and the need for transparency.  U.S. market regulators should also continue to work with their foreign peers to develop consistent frameworks to avoid unnecessary and unproductive conflicts that inhibit the development of coordinated global rules.  This will help increase confidence in markets. 

 

Finally, it is important for the banking regulators to finalize the regulations implementing the new Basel III standards for capital and liquidity.  Having clear, final rules will give banking institutions the clarity and confidence to expand their lending activities.  This past June, the Federal Reserve, OCC, and FDIC jointly issued the final market risk capital rules and also issued three notices of proposed rulemaking (NPRs) that would help implement the new Basel capital rules as well as certain aspects of the Dodd-Frank Act.  Regulators are now reviewing the nearly 1,500 comment letters on the three NPRs as they work toward completing the rule-making process.

 

As many of you know, these regulations were expected to be phased in starting January 2013 through January 2019.  However, earlier this month, the banking agencies formally announced they do not expect the proposed rules to become effective on January 1, 2013.  They also offered some assurance that institutions will have time for transition after the rules take effect.

 

In the meantime, our banking agencies should work closely with their international counterparts towards Basel III implementation.  Currently, only eight of the 27 Basel committee members have issued final Basel III regulations.   U.S. banking regulators should be mindful of divergences with their international peers, which may lead to regulatory arbitrage and uncertainty on the part of firms trying to manage capital resources.  In addition, we encourage our international counterparts to implement the Basel III leverage ratio to ensure that there is a simple backstop against excessive risk and to promote a level playing field.

 

In Treasury’s conversations with community banks and with our colleagues at the regulatory agencies, it has become clear that the standards established in Basel III may have different implications for different types of institutions.  While we strongly believe that finalizing the regulations is critically important for certainty and planning, we also believe there are merits to considering alternative, simpler approaches to rules that apply to community banks.  For example, prudent mortgage lending by institutions like community banks and savings associations are critical to many communities.  Our rules should recognize the important roles these institutions play. 

 

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WHY IT MATTERS

 

Why am I so intent on laying out these priorities?  Because finalizing the mortgage finance rules, derivatives regulations, and the Basel capital rules as well as protecting short-term funding markets are not just goals unto themselves.  Clarity engenders confidence in our financial system, and it is a crucial ingredient for job creation and economic growth.  That is why it is so important that we press forward with financial reform.

 

I recognize that this is not easy.  Reform is hard.  Memories of the financial crisis fade.  And we have some tough assignments ahead that require coordination not just among banking and market regulators, but also with our international counterparts.  [The term “level playing field” is often invoked, but is hard to achieve in practice.]   While we strive for simplicity in our reform efforts, we must recognize that we have a complex and globally interconnected financial system.

 

But I think the importance of getting the rules right goes directly to the theme of this conference, and more broadly, the work that we do at the Treasury Department every day.    Quite simply, our financial policies matter because of the critical role that financial institutions and markets play in our everyday lives.

 

They matter for the small business seeking to borrow funds to hire and expand.

 

They matter for families seeking to send their children to college or purchase a home.

 

They matter to governments that must finance public services. 

 

And they matter for workers who are investing for retirement.

 

We’ve made significant progress since the crisis four years ago.  Our financial system is better off.  But we still must complete the charge that we laid out in 2009.   If we get reform right, we will not only continue to strengthen our financial system but bolster the prospects for a stronger recovery in the months and years ahead. 

 

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