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02 May 2012

Daniel K Tarullo: Regulatory reform since the financial crisis


Mr Tarullo, Member of the Board of Governors of the Federal Reserve System, reviewed the vulnerabilities in the financial system that contributed to the crisis and compel regulatory response. He outlined some key reforms adopted to date, and identified important tasks that remain.

There were two major regulatory challenges revealed by the crisis. First was the problem of too-big-to-fail financial firms, both those that had been inadequately regulated within the perimeter of prudential rules and those like the large, free-standing investment banks that lay outside that perimeter. Second was the problem of credit intermediation partly or wholly outside the limits of the traditional banking system. This so-called shadow banking system involved not only sizeable commercial and investment banks, but also a host of smaller firms active across a range of markets and a global community of institutional investors.

To date, the post-crisis regulatory reform programme has been substantially directed at the too-big-to-fail problem, and more generally at enhancing the resiliency of the largest financial firms. First, the Dodd-Frank Act established the Financial Stability Oversight Council (FSOC), which has the authority to bring within the perimeter of prudential regulation any non-bank financial firm whose failure could be the source of systemic problems. The FSOC has just issued a final rule that will guide the process of assessing and designating such firms. Of course, the formerly free-standing investment banks have already been either converted or absorbed into bank holding companies.

Second, the serious shortcomings of pre-crisis capital requirements for banking firms have been addressed through several complementary initiatives. While robust bank capital requirements alone cannot ensure the safety and soundness of our financial system, they are central to good financial regulation, precisely because they are available to absorb all kinds of potential losses, unanticipated as well as anticipated. With the encouragement and support of the US bank regulatory agencies, the Basel Committee has strengthened the traditional, individual-firm approach to capital requirements: raising risk-weightings for traded assets, improving the quality of loss-absorbing capital through a new minimum common equity ratio standard, creating a capital conservation buffer, and introducing an international leverage ratio requirement.

A third reform, also related to capital, is directed specifically at the unusual systemic importance of certain institutions. The Basel Committee has released a framework for calibrating capital surcharges for banks of global systemic importance, an initiative consistent with the Federal Reserve’s obligation under section 165 of Dodd-Frank to impose more stringent capital standards on systemically important firms. It is important to note that this requirement has a motivation different from that of traditional capital standards: The failure of a systemically important firm would have substantially greater negative consequences for the entire financial system than the failure of other, even quite large, firms.

A fourth reform, intended to ensure that no firm is too big to fail, was the creation by Dodd-Frank of orderly liquidation authority. Under this authority, the FDIC can impose losses on a failed institution’s shareholders and creditors and replace its management, while avoiding runs by short-term counterparties and preserving, to the degree feasible, the operations of sound, functioning parts of the firm.

A fifth reform is a proposed set of quantitative liquidity requirements. As seen during the crisis, a financial firm – particularly one with significant amounts of short-term funding – can become illiquid before it becomes insolvent, as creditors run in the face of uncertainty about the firm’s solvency. While higher levels and quality of capital can mitigate some of this risk, it was widely agreed that quantitative liquidity requirements should be developed. The Basel Committee generated two proposals: one, the Liquidity Coverage Ratio (LCR) with a 30-day timeframe; the other, the Net Stable Funding Ratio (NSFR) with a one-year timeframe.

The LCR has been actively reconsidered within the Basel Committee over the last year or so. As this work proceeds, I think we should be considering three types of additional changes: First, some of the assumptions embedded in the LCR about run rates of liabilities and the liquidity of assets might be grounded more firmly in actual experience during the crisis. The current LCR seems to me to overstate in particular the liquidity risks of commercial banking activities. Second, it would be worthwhile to pay more attention to the liquidity risks inherent in the use of large amounts of short-term wholesale funding. Third, the LCR should be better adapted to a crisis environment as, for example, by making credibly clear that ordinary minimum liquidity levels need not be maintained in the midst of a crisis. As currently constituted, the LCR might have the unintended effect of exacerbating a period of stress by forcing liquidity hoarding.

Full speech



© BIS - Bank for International Settlements


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