Bernanke does bank regulation and supervision | FT Alphaville

Bernanke does bank regulation and supervision

Has Ben Bernanke been taking a leaf out of Lord Turner‘s banking regulation book?

The Federal Reserve chairman has been speaking on the dual subjects of financial regulation and supervision post-crisis.

Much like the UK’s Financial Services publication on Thursday — the possibility of a surcharge on capital crops up, as do possible liquidity regulations. Perhaps most intriguing, however, Bernanke talks about the need for legislative changes to the way banks are regulated — including, potentially, bailout costs borne by the financial industry instead of the American taxpayer.

You can read the whole speech here, but below are a few excerpts.

Additional steps are necessary to ensure that all banking organizations hold adequate capital. Internationally, the Financial Stability Board has called for significantly stronger capital standards, and the Group of Twenty has committed to develop rules to improve both the quantity and quality of bank capital.5 The Federal Reserve supports these initiatives. The structure of capital requirements should also be reviewed. For example, to reduce the tendency of current capital requirements to promote credit growth in booms and to restrict credit during downturns, the Federal Reserve has supported international efforts to develop capital standards that would be countercyclical. Countercyclical standards would require firms to build larger capital buffers in good times and allow them to be drawn down–but not below prudent levels–during more-stressed periods. We also are working with our domestic and international counterparts to develop capital and prudential requirements that take account of the systemic importance of large, complex firms whose failure would pose a significant threat to overall financial stability. Options under consideration include assessing a capital surcharge on these institutions or requiring that a greater share of their capital be in the form of common equity. For additional protection, systemically important institutions could be required to issue contingent capital, such as debt-like securities that convert to common equity in times of macroeconomic stress or when losses erode the institution’s capital base.  

The crisis also highlighted weaknesses in liquidity management by major firms. Short-term secured funding of long-term, potentially illiquid assets–through repurchase agreements and asset-backed commercial paper conduits, for example–became unavailable or prohibitively costly during the worst phases of the crisis, both here and abroad. In response, the Federal Reserve helped lead the Basel Committee’s development of revised principles for sound liquidity risk management, which in the United States are being incorporated into new interagency guidance that reemphasizes the importance of rigorous stress testing to determine adequate liquidity buffers.6 Together with our domestic and international counterparts, we are also considering quantitative standards for liquidity exposures similar to those for capital adequacy, with the goal of ensuring that internationally active firms can fund themselves even during periods of severe market instability. With supervisory encouragement, large banking organizations have, for the most part, already significantly increased their liquidity buffers and are strengthening their management of liquidity risk.

. . .

First, recent experience confirms the value of supervision of financial holding companies–especially the largest, most complex, and systemically critical institutions–on a consolidated basis, supplementing the supervision that takes place at the level of the holding company’s subsidiaries. Large financial institutions manage their businesses in an integrated manner with little regard for the corporate or national boundaries that define the jurisdictions of functional supervisors in the United States and abroad. For example, a nonbank subsidiary of a financial holding company may originate a mortgage loan, sell it to an investment banking affiliate to be packaged and distributed as a security, which in turn may be purchased by an investment vehicle supported by a liquidity facility from a bank affiliate. Because financial, operational, and reputational linkages span large and complex financial firms, the risks borne by such firms cannot be adequately evaluated through supervision focused on individual subsidiaries alone. Instead, effective supervision must involve greater coordination among consolidated and functional supervisors and an integrated assessment of risks across the holding company and its subsidiaries.

In recognition of these points, the Federal Reserve Board issued guidance a year ago that updated our approach to consolidated supervision, tying it more explicitly to the systemic significance of individual holding companies and their business lines, such as core clearing and settlement activities and activities in critical financial markets.9 Strengthened consolidated supervision also supports improved oversight of institutions’ compliance with consumer protections. Indeed, building on a pilot project we launched in 2007, we recently announced a consumer compliance examination program for nonbank subsidiaries of bank holding companies, as well as of foreign banking organizations.10

Second, our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. The extraordinary pressure on financial firms last fall underscored how profoundly interconnected firms and markets are in our complex, global financial system. Thus, any effort to address systemic risks will require a more systemwide, or macroprudential, approach to the supervision of systemically critical firms. More generally, supervisors must go beyond their traditional focus on individual firms and markets to try to identify possible channels of financial contagion and other risks to the system as a whole.

. . .

Though the Federal Reserve and other supervisors in the United States and abroad are strengthening the existing regulatory and supervisory framework, it remains critical for the Congress to close regulatory gaps and provide supervisors with additional tools for anticipating and managing systemic risks. The recent financial crisis clearly demonstrated that risks to the financial system can arise not only from banks, but also from other financial firms–such as investment banks or insurance companies–that traditionally have not been subject to the type of regulation and consolidated supervision applied to bank holding companies. To close this gap, the Congress should ensure that all systemically important financial institutions are subject to a robust regime for consolidated prudential supervision. Large, complex financial firms that do not own a bank, but that nonetheless pose risks to the overall financial system, must not be permitted to avoid comprehensive and effective supervisory oversight. Consolidated supervision of systemically important institutions, together with tougher capital, liquidity, and risk-management requirements for those firms, is needed not only to protect the firms’ stability and the stability of the financial system as a whole, but also to reduce firms’ incentive to grow very large in order to be perceived as too big to fail.

To further ameliorate the too-big-to-fail problem, the Congress should create a new set of authorities to facilitate the orderly resolution of failing, systemically important financial firms. In most cases, federal bankruptcy laws work appropriately for the resolution of nonbank financial institutions. However, the bankruptcy code does not always protect the public’s strong interest in avoiding the disorderly collapse of a nonbank financial firm that could destabilize the financial system and damage the economy. In light of the experience of the past year, it is clear that we need an option other than bankruptcy or bailout for such firms.

A new resolution regime for nonbanks, analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks, would permit the government to wind down a failing systemically important firm in a way that reduces the risks to financial stability and the economy. Importantly, to restore a meaningful degree of market discipline and to address the too-big-to-fail problem, it is essential that there be a credible process for imposing losses on the shareholders and creditors of the firm. Any resolution costs incurred by the government should be paid through an assessment on the financial industry and not borne by the taxpayers.

Related links:
Banks too big to (excessively) bonus, FSA says – FT Alphaville
What Goldman thinks of regulation – FT Alphaville
Musings on regulation and risk, from the Morgan Stanley CFO – FT Alphaville
Why curbing finance is hard to do – Martin Wolf, FT