Last month, President Obama signed into law a comprehensive set of reforms to our financial system that will lay a firm foundation for growth and prosperity in the years ahead.
Last week in Charlotte, I focused on getting the balance right on consumer protection while fostering innovation and growth. Today I want to focus on the task of ending "too- big-to-fail."
The Dodd-Frank reforms will help to make sure that risks taken by banks do not threaten the health of the economy as a whole. These reforms require the largest financial firms to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on their riskiest financial activities. These reforms bring transparency to the shadow banking system and fully regulate our derivatives markets. And these reforms create a mechanism for the government to shut down failing financial firms without putting taxpayers at risk. The import of the Act is clear: in the future, no financial firm will be "too big to fail."
For much of the last century, the American financial system was the envy of the world--surpassing other major developed economies in innovation and productivity growth. It provided investors and consumers with the strongest protections. Its regulatory checks and balances helped create a remarkably long period of relative economic stability. And the financial system was consistently better at directing investment towards the companies and industries where the returns would be the highest.
But over time those great strengths of our financial system were undermined. The careful mix of protections we created eventually eroded. Huge amounts of risk moved outside the banking system to where it was easier to increase leverage. In the period leading up to the recent crisis, we saw the significant growth of large, highly leveraged, and substantially interconnected financial firms. These firms benefited from the perception that they were "too-big-to-fail"-- a presumption that they would receive government assistance in the event of failure. This was an advantage for them in the marketplace. Creditors and investors believed that large firms could grow larger, take on more leverage, engage in riskier activity – and avoid paying the consequences should those risks turn bad. It was a classic problem of moral hazard.
The adverse effects of "too-big-to-fail" are numerous. Such a presumption reduces market discipline and encourages excessive risk-taking by firms. It provides an artificial incentive for firms to grow. It creates an unlevel playing field with smaller firms. And as we've recently seen, the government had no effective tools to respond to the distress of major non-bank financial firms, whose failures had devastating effects that rippled throughout the economy.
Without meaningful reform, the government's actions in the recent financial crisis, while necessary to prevent the implosion of our financial system, would have likely magnified the market's expectations of government support in times of severe economic stress. Any continuation of this presumption would have been a serious threat to financial stability and free and fair markets. That is why we had to enact reform, and that is why we must move quickly to demonstrate credibly that, with the passage of the Dodd-Frank Act, the conditions that once gave rise to this presumption have been permanently ended.
The new resolution authority, and the constraints on other emergency authorities, have critically undercut any reasonable presumption that a major financial firm can fail without significant pain being inflicted on its shareholders, creditors and management. We will--once and for all--fully end the market's perception of "too-big-to-fail" firms, when we build a system that is capable of absorbing the failure of the next AIG or Lehman Brothers; a system that constrains risk-taking by major financial firms, strengthens the basic shock absorbers and transparency in the financial system, and provides the government with credible tools to manage effectively the failure of major financial firms while at the same time safeguarding the broader economy.
On the foundation provided by the Dodd-Frank Act, we must now build that system--with speed and diligence--and restore the American economy as the world's most reliable engine for economic growth and innovation.
Monitoring and Mitigating Systemic Risk
In the recent crisis, a key enabler of the "too-big-to-fail" presumption was the inability to sufficiently monitor emerging concentrations of risk throughout the financial system. Regulators cannot constrain risk if they cannot see it.
To address these risks, the Dodd-Frank reforms focus on three major tasks: 1) providing an effective system for monitoring and responding to systemic risks or threats to financial stability as they arise; 2) creating a single point of accountability for tougher and more consistent supervision of the largest and most interconnected institutions; and 3) tailoring the system of regulation to cover the full range of risks and actors in the financial system, so that risks can no longer build up without oversight or ability to monitor.
First, these reforms create accountability and provide new authority to identify and manage systemic risk in a way that we could not do before.
The Act establishes the Financial Stability Oversight Council, with clear responsibility for examining emerging threats to our financial system regardless of where they come from. The Council is chaired by the Secretary of the Treasury and its membership includes the heads of the financial regulatory agencies. The Council has a critical role in the management of systemic risk: to designate firms for heightened supervision by the Federal Reserve and to make recommendations to the Fed and other federal financial regulators concerning the establishment of heightened prudential standards.
The Act also establishes an Office of Financial Research (OFR) within the Treasury Department – to support the Council through the collection and analysis of data concerning risk in the financial system. The OFR will be able to gather critical financial information not available elsewhere – looking across the whole financial system, and providing insight to the Council and its member agencies, Congress, and the public.
Second, these reforms provide for clear, accountable, strong and consolidated supervision and regulation by the Federal Reserve of any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.
Third, the reforms will shine sunlight on the shadow worlds of derivatives and the parallel banking system, which played such major roles in almost pushing us into a second Great Depression.
The recent crisis has clearly demonstrated that risks to the system can emerge from all corners of the financial markets and from any of our financial institutions. That's why these reforms bring over-the-counter derivatives markets into a comprehensive and rigorous regulatory framework; provide for consistent and tough regulatory oversight for critical clearing, payment, and settlement systems; strengthen the regulation of markets for securitization; and require the registration of all hedge funds and other private pools of capital over a minimum threshold in size.
In the lead-up to the recent crisis, we needed a system that let regulators see risks as they emerged across the financial system. The reforms we've enacted achieve that aim.
Basic Reform of Capital, Supervision, and Resolution Authority
To fully end "too-big-to-fail" we need to make our financial system safer for failure. We cannot rely on the hope of perfect foresight--whether by regulators, or by managers of firms, private sector gatekeepers, or other market participants. Financial activity involves risk, and no one will be able to identify all risks or prevent all future crises.
However, robust capital, leverage, and liquidity requirements can prevent the build-up of risk, ex ante, and insulate the system from unexpected shock events, ex post. Imposing higher prudential standards on the largest, most interconnected firms will require them to internalize the risks they impose on the system by virtue of their size and complexity.The largest and most interconnected firms cause more damage to the system when they fail, so they need to hold more capital against risk. That is based on a principle of fairness and also of economic efficiency. It internalizes their costs of failure and provides incentives for firms to limit their size and reduce their leverage.
Internationally, we are working to raise capital requirements so that financial firms can withstand future crises as severe as the one we have just gone through, and do so without government support. In the Basel III negotiations, we are pushing hard to set minimum capital ratios at a level that will represent a significant increase in firms' requirements. These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock. Such restrictions will help shore up a firm's capital base before it reaches a point of no return.
Not only are we raising the ratios, but just as importantly, we are raising the standards on the quality of capital that underlie them. The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis. There will be strict limits on minority interests, as well as on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.
In addition to increasing the quality of the capital that firms hold, we are increasing the capital required for banks' riskiest activities, such as their trading positions and their counterparty credit exposures. Capital calculations for trading exposures will now have to be based on stressed market conditions, and the charges for securitization exposures will be increased substantially. In both derivatives and secured lending transactions, firms will now also be subject to a capital charge for losses associated with a deterioration in the credit worthiness of their counterparties.
Under Basel III we will also be introducing a new, internationally applied, leverage ratio requirement that, for the first time, includes firms' off balance sheet commitments and exposures.
The combination of these changes – higher capital ratios, new capital requirements, tougher and more extensive measurement standards – will help ensure that firms have sufficient capital to weather the next crisis.
In addition to new capital requirements, we will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains. Under the new rules, firms will have to hold enough highly liquid assets to meet potential net cash outflows over a 30 day stress scenario. Through the Basel Committee we are also working on developing a liquidity requirement that will require a minimum amount of stable funding over a one year time period, relative to a firm's assets, commitments and obligations. These liquidity requirements will be crucial in helping to mitigate severe strains like those that we saw on the financial sector at the time of the collapse of Bear Stearns and Lehman Brothers during 2008.
Taken together, these heightened standards will provide positive incentives for major financial firms to reduce their size, leverage, complexity, and interconnectedness.
The financial crisis has shown that a narrow supervisory focus on the safety and soundness of individual firms can result in a failure to detect and thwart emerging threats to financial stability that may cut across many institutions or have other systemic implications. Under these reforms, federal financial regulators will have the responsibility to supervise our major financial firms in a manner that is designed to protect overall financial stability. The federal financial regulators will engage in a searching review of the bank and nonbank subsidiaries of our major financial firms.
Regulators must supplement existing approaches to supervision with mandatory "stress tests," credit exposure reporting, and "living wills," so that they can adequately assess the potential impact of the activities and risk exposures of these firms on each other, on critical markets, and on the broader financial system.
When, despite reforms, a major financial firm fails, the government simply must have the necessary tools to wind-down a failing financial firm without exposing taxpayers to losses and without pushing the economy to collapse. While we have long had a tested and effective system for resolving failed banks, there was no effective legal mechanism to resolve a large non-bank financial institution or bank holding company. The Dodd-Frank Act fills this gap in our legal framework by providing a emergency tool modeled on our existing system under the Federal Deposit Insurance Act--a tool that replaces the untenable choice between taxpayer bailouts and market chaos. Resolution authority is a linchpin of ending "too-big-to-fail."
Both our financial system and this crisis have been global in scope. So our solutions have been and must continue to be global. International reforms must support our efforts at home, including strengthening the capital and liquidity frameworks; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools. We have not waited for the international community to act before building a new foundation in the Dodd-Frank Act, and we will not accept an international race to the bottom on regulatory standards.
Path Forward on Implementing Financial Reform
These reforms will help us restore market discipline to a financial system distorted by the moral hazard associated with "too-big-to-fail." And that process is already underway.
Let me give you a brief introduction to the steps taking place over the next several months.
We are already hard at work. The agencies involved in implementing financial reform are in the process of establishing timelines for moving forward on the scores of studies, regulations, and other regulatory actions required by the Dodd-Frank Act. In some critical areas, the agencies are already drafting proposed rules for public comment.
In September, when the Financial Stability Oversight Council first meets, we will establish an integrated road map for the first stages of reform and put that in the public domain.
We are going to move quickly to begin shaping reforms of the derivatives market. In this process, we will work with the Fed, the SEC and the CFTC to develop specific quantitative targets and timelines for moving the standardized part of the over-the-counter derivatives business onto central clearing houses. And we must accelerate the international effort to put in place common global standards for transparency, oversight, and the prevention of manipulation and abuse of these critically important markets.
We're going to stand-up the Office of Financial Research, which in the coming months will work closely with regulators and market participants to assess the financial data reporting needs and challenges for better monitoring of firm-specific and systemic risk, to streamline current regulatory data reporting requirements imposed on financial firms, to improve data sharing among regulators, and to enhance the utility of existing data sources.
As I mentioned, we are now finalizing an international agreement that will require financial firms to hold both more and higher quality capital than they did before the crisis. Those are some of the key areas regarding prudential reforms where we – the Treasury, the financial regulators – will be focused in the coming months. I'd also like to briefly highlight our work on consumer protection.
We are moving quickly to give consumers simpler disclosures, so that they can make better choices, borrow more responsibly, and compare costs.
For example, in place of the two separate, inconsistent and overly-complicated federal mortgage disclosure forms that borrowers receive today, there should be one clear, simple, user-friendly form.
In addition, we will be inviting public comment on new national underwriting standards for mortgages, so that we can begin to shape the reforms of the mortgage market.
And we are working quickly to get the CFPB up and running, to consolidate rule-making, supervision, and enforcement responsibilities that today are split, inefficiently and ineffectively, among seven different regulatory agencies.
On all fronts, we are committed to moving with speed, with transparency, and with a commitment to ensuring that our financial system remains the most competitive financial system in the world.
But reform is a shared responsibility. And so to those in the financial industry, I encourage you not to wait on Washington before embracing change. As we work together to rebuild our financial system, responsible private sector leadership is every bit as important as responsible regulation and supervision.
Conclusion
The Dodd-Frank reforms represent a comprehensive, coordinated response to the moral hazard challenge posed by our largest, most interconnected financial institutions: strong, accountable supervision; the imposition of higher standards, both to deter excessive risk and to force firms to better protect themselves against failure; a strong, resilient, well-regulated financial system that can better absorb failure; and a strong resolution authority to enable the government to wind down major financial firms in a financial crisis in an orderly manner that protects financial stability. These reforms fully protect taxpayers, and by contrast, enable shareholders and creditors to take their losses when failure occurs.
As we go about the task of implementing these reforms, we will be criticized by some for going too far and by some for not going far enough. This distinction is stuck in a debate that presumes that regulation--and efficient and innovative markets--are at odds.
In fact, the opposite is true. Markets rely on faith and on trust. Markets require transparency. The discipline of the market requires clear rules. The President's reforms lay a new foundation for financial regulation that will once again help to make our markets vital and strong. And for all our sakes and that of our economy, we must implement the Dodd-Frank Act and thereby fully end "too-big-to-fail" once and for all.
Thank you very much.