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Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland home | news & media | careers | site map FEDERAL RESERVE BANK o f CLEVELAND A bout U Tours For the Public News & Media Com munit y D e velopm ent S tream ing Media Forefront M agazine Speakers Bureau I Our IRegion I Research I Ban kin g I Learning Center Savings Bonds Home > For th e Public > News and Media > Speeches > 2009 > Steps tow ard a New Financial R egulatory- SHARE ^ f ... Steps toward a New Financial Regulatory Architecture Additional Information Sandra Pianalto Introduction T o d ay, w e a r e s till in th e m id st o f th e g r e a te s t fin a n c ia l s tr e s s o u r e c o n o m y has s e e n sin c e th e G re a t D ep ressio n . T h e e x t e n t o f th e d is ru p tio n s is v e ry b ro a d —fro m c o m m e rc ia l p a p e r to c o n s u m e r an d b u sin ess lo a n s to a s s e t- b a c k e d s e c u r itie s , in te r b a n k le n d in g , a n d risk m a n a g e m e n t p ro d u c ts . M any b o rro w e rs a r e fin d in g it d iffic u lt to o b ta in a c c e ss to c r e d it u n d e r te rm s an d c o n d itio n s th e y w o u ld fin d in h e a lth ie r tim e s. P resident and CEO, Federal Reserve Bank o f Cleveland Ohio Bankers' Day C olum bus, Ohio April 1, 2009 You as b a n k e rs a r e w e ll a w a re t h a t y o u r in d u stry has b e e n u n d e r s ie g e d u rin g th e p a s t y e a r an d a h a lf, e v e n th o u g h o n ly a re la tiv e h a n d fu l o f in s titu tio n s o u t o f m an y th o u sa n d s n a tio n w id e h av e a c tu a lly b e e n in v o lv ed w ith th e u n d erly in g p ro b le m s t h a t la u n c h e d th e crisis. B u t th e w id e s p re a d fra g ility o f c r e d it m a rk e ts no w a f f e c ts us all, an d it is d e e p e n in g an d pro lo n g in g o u r re c e ssio n . So I th in k t h a t a ll o f us in th e ban k in g in d u stry as w e ll as th e re g u la to ry a r e n a h av e a ro le to p lay in re s to rin g p u b lic c o n fid e n c e a n d tr u s t in w h a t w e d o —w e m u st all w o rk to g e th e r . S ig n ifica n t m o n e ta ry an d fisc a l fo rc e s a r e a lre a d y a t w o rk to c o u n te r a c t th e re c e ssio n . A v e ry s iz a b le fisc a l stim u lu s p a c k a g e is n o w in p la c e , as w e ll as a c o m p re h e n siv e s tr a te g y fo r a d d re ss in g th e p lig h t o f m illions o f d is tre s s e d m o rtg a g e h o ld e rs. T h e F e d e ra l R eserv e is ag g re ssiv e ly using all o f th e to o ls a t o u r d isp o sal to p ro v id e liq u id ity to fin a n c ia l m a rk e ts an d to p ro m o te an e c o n o m ic rec o v ery . In my re m a rk s to d a y , I w ill b rie fly e x p la in my e c o n o m ic o u tlo o k and th e F e d e ra l R e se rv e ’s r e c e n t a c tio n s . T h en I w ill m a k e a fe w c o m m e n ts on c h a n g e s to th e fin a n c ia l re g u la to ry s y ste m . I w ill m ak e th e c a s e fo r a n e w fra m e w o rk fo r c a te g o riz in g fin a n c ia l in s titu tio n s b a s e d on th e d e g r e e o f risk th e y p o se to th e fin a n c ia l sy s te m , a n d I w ill a d d m y e n d o r s e m e n t to w h a t so m e h av e c a lle d m a c ro p ru d e n tia l su p e rv isio n . Of c o u rs e , th e v iew s I e x p re ss to d a y a r e m y ow n a n d do n o t n e c e s sa rily r e f le c t th e v iew s o f my c o lle a g u e s in th e F e d e ra l R eserv e S y stem . I. The Situation - Where Are We? L et m e s t a r t w ith w h a t I c o n s id e r to b e th e m o st im p o r ta n t a s p e c ts o f th e c irc u m s ta n c e s w e f a c e in th e e c o n o m y to d a y . S in ce th e b eg in n in g o f th e re c e ssio n in D e c e m b e r 2 0 0 7 , a b o u t 4 . 4 m illion A m erican jo b s h av e b e e n lo st, w ith w e ll o v e r h a lf o f th o s e losses c o m in g in j u s t th e p a s t fo u r m o n th s. W e h a v e also s e e n a h uge in c re a s e in th e jo b le s s r a te sin c e th e re c e ssio n b e g a n , ju m p in g fro m 4 .9 p e r c e n t to 8.1 p e r c e n t. H ere in O hio, p ro b le m s in th e http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM] Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland m a n u fa c tu rin g s e c to r h av e ta k e n th e ir to ll—o u r u n e m p lo y m e n t r a te n o w s ta n d s a t 9 . 4 p e r c e n t. A cross th e n a tio n , b u sin e sse s h av e b e e n sla sh in g p ro d u c tio n an d re d u c in g th e ir c a p ita l s p e n d in g p la n s. F or c o n s u m e rs, th e loss of w e a lth fro m th e c o lla p s e o f housing an d e q u ity p ric e s h as b e e n sta g g e rin g . L ast y e a r , th e n e t w o rth o f U.S. h o u se h o ld s d e c lin e d by m o re th a n 11 trillio n d o lla rs, o r by 18 p e r c e n t. To p u t t h a t in p e rs p e c tiv e , t h a t is c lo se to a y e a r ’s w o rth o f U.S. gross d o m e stic p ro d u c t. In p a s t re c e ssio n s, w e h av e b e e n a b le to re ly on in te r n a tio n a l m a rk e ts to cu sh io n a d o m e s tic slu m p , b u t t h a t ’s n o t th e c a s e th is tim e . P ro d u c tio n an d s p e n d in g a c tiv ity h av e b e e n d e c lin in g aro u n d th e w o rld . T h e In te rn a tio n a l M o n e tary Fund p r o je c ts t h a t th e w o rld e c o n o m y w ill c o n tr a c t in 2 0 0 9 fo r th e f ir s t tim e in 6 0 y e a rs . T h e housing s e c to r , w h ich le d us in to th e re c e ssio n , has n o t y e t re g a in e d its h e a lth . H ousing p ric e s a r e s till d e c lin in g in m an y p a rts of th e c o u n try , housing s ta r ts h a v e fa lle n by m o re th a n 6 0 p e r c e n t sin c e th e ir p e a k in 2 0 0 6 , a n d th e n u m b e r o f unsold h o m e s is s till q u ite la rg e r e la tiv e to th e p a c e o f s a le s . At th e c u r r e n t se llin g r a te , it w o u ld ta k e 1 0 m o n th s ju s t to c le a r th e in v e n to ry o f e x istin g h o m es. T h e se a r e all r a th e r grim s ta tis tic s . W e a r e e x p e rie n c in g a b ro ad ly b a s e d re c e ssio n t h a t is d e e p e r a n d t h a t has a lre a d y la s te d f a r lo n g e r th a n is ty p ic a l. B ut w e know t h a t re c e ssio n s do e n d , a n d th is o n e w ill, to o . I e x p e c t e c o n o m ic c o n d itio n s to s ta b iliz e by th e e n d o f th e y e a r an d th e n begin to re c o v e r n e x t y e a r as th e fisc a l stim u lu s b o o sts sp e n d in g an d as w e w o rk o ff e x c e s s in v e n to rie s . My f o r e c a s t fo r re c o v e ry also p re su m e s th e c u r r e n t a c tio n s u n d e r ta k e n by th e F e d e ra l R eserv e a n d th e g o v e rn m e n t a r e su c c e ssfu l in re s to rin g fin a n c ia l s ta b ility . In d e e d , m an y o f th e F e d e ra l R e se rv e ’s r e c e n t a c tio n s a r e fo c u se d d ire c tly on g e ttin g th e c r e d it m a rk e ts fu n c tio n in g a g a in . W e h av e lo w e re d o u r f e d e r a l fu n d s r a t e ta r g e t to a ra n g e o f 0 to 1 / 4 p e r c e n t. W e a r e also using o u r n o rm a l le n d in g a u th o rity to e x te n d c r e d it in s ig n ific a n t a m o u n ts to c o m m e rc ia l b an k s, a n d fo r lo n g e r te rm s , to h e lp you e x te n d c r e d it to y o u r c u s to m e rs fo r lo n g e r p e rio d s o f tim e . In a d d itio n , w e h a v e d e v e lo p e d a s e t o f policy to o ls to m o re d ire c tly s u p p o rt b o rro w e rs an d in v e sto rs in key c r e d it m a rk e ts . O ne e x a m p le is a fu n d in g fa c ility know n as TALF, o r th e T erm A sse t-B ac k ed S e c u ritie s Loan F acility . T h e TALF is d e s ig n e d to b rin g in v e sto rs b ack in to th e s e c u ritiz a tio n m a rk e ts , w h ich is a v ita l s te p to e n a b le fin a n c ia l in s titu tio n s to o rig in a te a n d se ll loans th e y do n o t w a n t to h old on th e ir b a la n c e s h e e ts . T h e TALF is a lre a d y s u p p o rtin g m a rk e ts fo r n ew ly issu ed c o n s u m e r c r e d it a n d fo r s tu d e n t, a u to , an d b u sin ess lo a n s. In a d d itio n , th e F e d e ra l R eserv e e x p e c ts to e x p a n d th e ra n g e o f e lig ib le s e c u ritie s w ith in th is fa c ility . T h e TALF co u ld b e e x te n d e d to in c lu d e o th e r m a rk e ts fo r n ew ly issu ed d e b t, as w e ll as m a rk e ts fo r c e r ta in s e c u r itiz e d lo a n s a lre a d y b ein g h e ld by fin a n c ia l in s titu tio n s . Y et a n o th e r F e d e ra l R e serv e policy to o l is th e d ir e c t p u rc h a s e of c e r ta in kinds o f lo n g e r-te rm s e c u r itie s fo r o u r p o rtfo lio . For e x a m p le , w e h a v e a n n o u n c e d p la n s to p u rc h a s e u p to $ 1 .2 5 trillio n o f m o rtg a g e -b a c k e d s e c u r itie s fro m g o v e rn m e n t-s p o n s o re d e n te r p ris e s by th e e n d o f th e y e a r . This p ro g ra m is in te n d e d to im p ro v e th e flo w o f c r e d it to h o m e b u y ers a n d to allo w e x istin g h o m e o w n e rs to r e fin a n c e a t lo w e r r a te s . W hen w e f ir s t a n n o u n c e d p la n s to p u rc h a s e th e s e s e c u r itie s , in la te N o v em b e r o f la s t y e a r , th e c o s t o f m o rtg a g e loan s b e g a n to d e c lin e , http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM] Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland an d r a te s c o n tin u e d to fa ll as w e b e g a n to p u rc h a s e th e s e c u ritie s . For e x a m p le , th e 3 0 - y e a r fix e d , c o n v e n tio n a l m o rtg a g e lo an r a te w as a little a b o v e 6 p e r c e n t la s t N o v em b er, an d as o f la s t w e e k , it a v e ra g e d j u s t u n d e r 5 p e r c e n t. W e a r e also b eg in n in g to s e e a re s u rg e n c e in re fin a n c in g a c tiv ity in th e r e s id e n tia l m o rtg a g e m a rk e ts , s p u rre d on by th e s e lo w e r r a te s . In a d d itio n , sa le s o f n ew an d p rev io u sly o w n e d h o m e s p ic k ed up in F e b ru a ry , d u e in p a r t to d e c lin e s in h o m e p ric e s, a n d in p a r t to th e ta x c r e d its o f fe re d to f ir s t- tim e h o m e b u y ers p ro v id e d in th e stim u lu s p a c k a g e . T h e se a re all e n c o u ra g in g signs. W e also a n n o u n c e d o u r in te n tio n to beg in p u rc h a sin g up to $ 3 0 0 billion o f lo n g e r-te rm T re a s u ry s e c u r itie s . T h e a n n o u n c e m e n t h ad an im m e d ia te e f f e c t on T re a s u ry y ie ld s. L ow er in te r e s t r a te s on th e s e s e c u r itie s e n c o u ra g e in v e sto rs to p u rc h a se o th e r kinds o f in v e s tm e n ts , w h ich w ill im p ro v e c o n d itio n s in th e p r iv a te c r e d it m a rk e ts . W e h av e ju s t r e c e n tly b eg u n to m a k e th e s e p u rc h a se s. T h e se policy to o ls -- le n d in g to fin a n c ia l in s titu tio n s , p roviding liq u id ity d ir e c tly to key c r e d it m a rk e ts , a n d buying lo n g e r-te rm s e c u r itie s - h a v e a co m m o n f e a tu r e . T h ey r e p r e s e n t o u r e f f o rts to lo w e r in te r e s t r a te s an d e a s e c r e d it c o n d itio n s in a ra n g e o f m a rk e ts e v e n w h e n th e f e d e r a l fu n d s r a t e is n e a r z e ro . C o llec tiv e ly , o u r a c tio n s h a v e b e e n a g g re ssiv e a n d u n p r e c e d e n te d . Since O c to b e r 2 0 0 7 , th e F e d e ra l R e se rv e ’s b a la n c e s h e e t h as grow n fro m $ 8 5 5 billion to a b o u t $ 2 trillio n , a n d w ith o u r r e c e n t a n n o u n c e m e n ts , w e a r e p r e p a re d to e x p a n d it f u rth e r . In a d d itio n to th e s e policy to o ls , w e c a n also u tiliz e o u r su p e rv iso ry re s o u rc e s a n d a u th o rity to im p ro v e b a n k le n d in g a n d th e flo w o f c r e d it. T h e F e d e ra l R e serv e an d o th e r b a n k re g u la to rs a r e s tre s s te s tin g th e la rg e s t b anks to e n s u re t h a t th e y h a v e th e c a p ita l th e y n e e d to o p e r a te sa fe ly . U ltim a te ly , th e s u r e s t sign t h a t fin a n c ia l m a rk e ts a r e on th e m en d w ill b e an in flo w o f p riv a te c a p ita l in to th e ban k in g sy ste m a n d a b ro a d -b a s e d rise in b a n k le n d in g . S ince th e b eg in n in g o f th e y e a r, c o m m e rc ia l an d in d u s tria l lo a n s, as w e ll as loan s fo r c o m m e rc ia l re a l e s t a t e , h av e d e c lin e d . On th e o th e r h a n d , c o n s u m e r a n d re s id e n tia l m o rtg a g e loans a r e ag a in in c re a sin g , p a rtic u la rly fo r re fin a n c in g . As e c o n o m ic c o n d itio n s s ta b iliz e , m o re h o u se h o ld s a n d b u sin e sse s w ill h av e th e c o n fid e n c e to b o rro w , a n d m o re b o rro w e rs w ill b e c o m e b e t t e r c r e d it risks. Both d e v e lo p m e n ts w ill c o n tr ib u te to e c o n o m ic g ro w th . II. Tiered Parity: A New Framework for Acknowledging and Addressing Systemic Risk As o u r e c o n o m y m oves to w a rd re c o v e ry , I b e lie v e i t is c r itic a l fo r us to s te p b a c k an d ta k e a c lo s e r look a t how th is tu rm o il c a m e a b o u t an d w h a t w e as re g u la to rs c a n do to m in im iz e th e risk o f su ch c rise s h a p p e n in g a g a in . T h e re has a lre a d y b e e n m uch p u b lic d iscu ssio n on th e s e p o in ts , an d m o re d iscu ssio n lies a h e a d . So, w h ile w e a r e all th in k in g th is th ro u g h , le t m e s h a re m y p re lim in a ry th o u g h ts on tw o d ire c tio n s fo r c h a n g e . T h e f ir s t is to a d v o c a te fo r a n e w risk -b a se d fra m e w o rk fo r c a te g o riz in g a n d re g u la tin g fin a n c ia l in s titu tio n s . T he se c o n d is to a ffirm th e b e n e f its o f m a c ro p ru d e n tia l su p e rv isio n . L et m e b e c le a r t h a t I do n o t th in k t h a t w e sh o u ld re ly on re g u la tio n , by its e lf, e i th e r a t th e m icro- o r m a c ro -le v e l, to p r e v e n t f u tu r e crise s. M ark ets c a n p ro v id e v e ry e f f e c tiv e d isc ip lin e on th e d ec isio n s o f fin a n c ia l m a rk e t p a r tic ip a n ts . Any n e w re g u la to ry fra m e w o rk sh o u ld b e d e s ig n e d to w o rk w ith , a n d n o t s u p p la n t, m a rk e t fo rc e s. It is n a tu ra l to e q u a te th e p ro b le m s in o u r fin a n c ia l sy ste m w ith th e http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM] Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland s e c u ritiz a tio n o f s u b p rim e m o rtg a g e s. B ut th e s e c u r itiz e d su b p rim e m a rk e t h a p p e n e d to b e th e e p ic e n te r , an d w e no w s e e t h a t th e f a u lt lin e re a lly ran fo r a v e ry long d is ta n c e an d s p a n n e d m a n y m a rk e ts an d m an y kinds o f fin a n c ia l in s titu tio n s - p a rtic u la rly th o s e t h a t w e re th e m o st c o m p le x an d th e m o st in te r c o n n e c te d . I know t h a t m o st o f o u r c o u n try ’s c o m m u n ity b an k s h av e h ad v ery lim ite d p a r tic ip a tio n an d e x p o s u re to th e s o rts o f c o m p le x fin a n c ia l in s tru m e n ts t h a t c o n trib u te d to th e c u r r e n t crisis. T h e size, c o m p le x ity , an d n a tu r e o f o p e ra tio n s o f m o st c o m m u n ity banks sim ply do n o t le n d th e m s e lv e s to th o s e ty p e s o f a c tiv itie s . Also, a s u b s ta n tia l a m o u n t o f g ro w th in th e fin a n c ia l s e c to r o v e r th e p a s t 2 0 y e a rs has o c c u rre d o u ts id e th e m o re highly r e g u la te d c o m m e rc ia l b an k in g in d u stry . So i t sh o u ld c o m e as no su rp ris e t h a t v e ry se rio u s p ro b le m s d e v e lo p e d in n o n -b a n k fin a n c ia l c o m p a n ie s —in th e fo rm of high le v e ra g e , a s s e t a n d lia b ility m a tu rity m is m a tc h e s , a n d risk m a n a g e m e n t sh o rtc o m in g s. T h e se p ro b le m s also e m e rg e d in th e sm all m in o rity o f c o m m e rc ia l b an k s t h a t w e r e am o n g th e m o st co m p lex . So, w h e n I r e f le c t on th e c a u s e s o f o u r fin a n c ia l crisis, I c o n c lu d e t h a t th e a r c h ite c tu r e o f th e fin a n c ia l sy ste m h a d d e v e lo p e d in su ch a w ay t h a t a re la tiv e ly sm a ll n u m b e r o f fin a n c ia l in s titu tio n s o c c u p ie d sy ste m ic a lly c r itic a l p o sitio n s. O nce th e s e in s titu tio n s g o t in to tro u b le , th e p u b lic ’s loss o f c o n fid e n c e in th e m sp ille d o v e r an d s p re a d to o th e r c o m p a n ie s in th e s a m e in d u stry a n d ac ro ss th e fin a n c ia l s e c to r th ro u g h v a rio u s linkages. T h e d e g r e e o f c o m p le x ity in o u r fin a n c ia l o rg a n iz a tio n s m a k es it im p e ra tiv e fo r us to c r a f t o u r re g u la to ry a n d su p e rv iso ry a p p ro a c h w ith g r e a t c a r e . C learly , th e risks p o se d by a $ 2 5 0 m illion, n o n c o m p le x in s titu tio n a r e d if f e r e n t fro m th o s e p o se d by a $ 5 0 b illion, m o d e ra te ly c o m p le x in s titu tio n . And th e highly c o m p le x , an d o f te n e x tre m e ly la rg e , in s titu tio n s t h a t p o se sig n ific a n t s y ste m ic risk a r e in a c a te g o ry all by th e m s e lv e s . T h e re fo re , I p ro p o se a fra m e w o rk t h a t I w ill c a ll “ tie r e d p a r it y .” In th is fra m e w o rk , I w o u ld c o n s tr u c t a sm a ll n u m b e r o f tie r s a n d assign e a c h fin a n c ia l c o m p a n y to o n e o f th e tie r s b a s e d on th e co m p le x ity o f its o p e r a tio n s a n d th e d e g r e e o f risk it p o se s to th e fin a n c ia l s y ste m . For e x a m p le , a t h r e e - ti e r e d fra m e w o rk co u ld h av e c a te g o rie s la b e le d “ n o n c o m p le x ,” “ m o d e ra te ly c o m p le x ,” a n d “sy ste m ic a lly im p o r ta n t,” w ith c o rre sp o n d in g d e g re e s o f re g u la to ry r e q u ire m e n ts an d su p e rv iso ry o v e rsig h t. W h e re an in s titu tio n is p la c e d co u ld d e p e n d on th e s itu a tio n a t h a n d . S om e h e d g e fu n d s, fo r e x a m p le , m ig h t d e s e rv e c lo s e r sc ru tin y d u rin g an a s s e t boom o r c o m m o d itie s s q u e e z e , b u t less o v e rsig h t d u rin g n o rm a l tim e s . In stitu tio n s w ith in e a c h tie r w o u ld re c e iv e th e s a m e re g u la to ry tr e a t m e n t an d su p e rv iso ry o v e rsig h t, th e re b y e n s u rin g p a rity in tr e a t m e n t w ith in e a c h tie r . B ut th e d iffe re n c e s in tr e a t m e n t b e tw e e n th e tie r s w o u ld b e b a s e d on th e d if fe r e n c e s in c o m p le x ity an d lin k ages- an d th e r e f o r e , risk to th e fin a n c ia l sy ste m . In th is fra m e w o rk , th e sy ste m ic a lly im p o r ta n t in s titu tio n s w o u ld b e s u b je c t to th e h ig h e st d e g r e e o f re g u la to ry sc ru tin y an d m o re rig o ro u s r e q u ir e m e n ts t h a t r e f le c t th e risk th e y p r e s e n t to th e fin a n c ia l s y ste m . In e f f e c t, w e n e e d to re c o g n iz e t h a t th e r e a r e d if fe r e n t p lay in g fie ld s fo r c o m m u n ity b an k s v e rsu s m o n e y -c e n te r fin a n c ia l c o n g lo m e ra te s , so th e ru le s an d re g u la tio n s g o v ern in g th o s e field s sh o u ld v a ry a c co rd in g ly . For e x a m p le , sy ste m ic a lly im p o r ta n t c o m p a n ie s p o se th r e a ts to th e e n t ir e e c o n o m y b e c a u s e o f th e sp illo v e r c o s ts t h a t c a n b e im p o sed on o th e rs if th e y fa il. G iven t h a t risk, th e s e c o m p a n ie s sh o u ld b e s u b je c t to a h ig h e r le v e l o f re g u la to ry re q u ir e m e n ts an d su p e rv iso ry o v e rsig h t. T he goals a r e n o t only to lim it th e a m o u n t o f risk th e s e c o m p a n ie s co u ld p o se on th e fin a n c ia l sy ste m o v e ra ll, b u t also to http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM] Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland d is c o u ra g e th e c o m b in a tio n o f siz e , c o m p le x ity , an d n a tu r e of o p e ra tio n s t h a t e n a b le d th e m to b e c o m e a sy ste m ic t h r e a t in th e f ir s t p la c e . In th e n ew r e g u la to ry a r c h ite c tu r e I am d e sc rib in g , a n y in s titu tio n t h a t is id e n tif ie d as sy ste m ic a lly im p o r ta n t sh o u ld b e s u b je c t to tig h te r re g u la tio n , as w e ll as c lo se su p e rv isio n o f its risk ta k in g , risk m a n a g e m e n t, a n d fin a n c ia l c o n d itio n . It sh o u ld also m e e t high c a p ita l a n d liq u id ity s ta n d a r d s . T h e o b je c tiv e , o f c o u rs e , is to e n h a n c e risk m a n a g e m e n t a t tw o levels: fo r th e fin a n c ia l sy ste m as a w h o le , a n d a t in d iv id u al fin a n c ia l in s titu tio n s . W e know t h a t risk m a n a g e m e n t fa ilu re s w e r e o n e o f th e m a jo r c o n trib u to rs to th e fin a n c ia l in s ta b ility w e h av e w itn e s s e d o v e r th e p a s t 1 8 m o n th s. So w e w a n t to f o rc e firm s to r e d u c e th e risk th a t th e y w ill im p o se c o s ts on th e r e s t o f th e sy ste m a n d th e ta x p a y e rs . I like to th in k o f re g u la tin g sy ste m ic a lly im p o r ta n t in s titu tio n s in th e w ay t h a t f ire d e p a r tm e n ts m in im ize th e risk o f fire s s ta rtin g a n d o f fire s sp re a d in g —th e y rely on m e a s u re s such as f ire c o d e s , s a fe ty in s p e c tio n s, a n d f ire d rills. And as a s o c ie ty , w e a c c e p t th e p rin c ip le o f p aying fo r fire in su ra n c e . I do n o t m e a n to im ply t h a t re g u la tio n sh o u ld pu n ish firm s fo r b ein g e f f ic ie n t an d in n o v a tiv e . In ste a d , i t sh o u ld o f f s e t o r re m o v e an y a d v a n ta g e s to b ec o m in g sy ste m ic a lly im p o r ta n t in th e f ir s t p la c e , p e rh a p s e n c o u ra g in g so m e in s titu tio n s to sh rin k , b e c o m e less o p a q u e , o r lo w e r th e ir risk p ro file s. III. Establishing Financial Stability Oversight L e t m e now s h ift to th e se c o n d d ire c tio n fo r c h a n g e , m a c ro p ru d e n tia l su p e rv isio n . T o d ay , su p e rv isio n is m ain ly g e a r e d to w a rd th e s a fe ty an d so u n d n e ss o f in d iv id u al banking in s titu tio n s —w h a t w e c a ll “ m ic r o p ru d e n tia l” su p e rv isio n . E ffe c tiv e m ic ro p ru d e n tia l su p e rv isio n re m a in s an e s s e n tia l c o m p o n e n t o f th e fin a n c ia l a r c h ite c tu r e . W ithin th e fra m e w o rk I am p ro p o sin g , a m ic ro p ru d e n tia l s u p e rv is o r w o u ld s till b e n e e d e d to s u b je c t th e c o n s o lid a te d e n titie s - b a n k an d n o n b a n k e n titie s a lik e - to th e s a m e le v e l o f o v e rs ig h t w ith in e a c h tie r . B ut w e n e e d m o re . I th in k w e n e e d to build m a c ro p ru d e n tia l o v e rsig h t in to th is n e w su p e rv iso ry fra m e w o rk . C h airm an B e rn an k e an d T re a s u ry S e c re ta ry G e ith n e r h a v e sp o k e n to th is a s p e c t o f th e re g u la to ry fra m e w o rk r e c e n tly , a n d I w o u ld like to a d d m y ow n c o m m e n ts to th e d iscu ssio n . As I en v isio n it, o n e o r m o re fin a n c ia l re g u la to rs w o u ld h av e th e re sp o n sib ility , a c c o u n ta b ility , an d a u th o rity to id e n tify a n d m itig a te risks p o se d to th e e n t ir e fin a n c ia l s y ste m . This m e a n s m aking s u r e t h a t sy ste m ic a lly im p o r ta n t fin a n c ia l in s titu tio n s h av e p r o p e r su p e rv isio n , b u t it also m e a n s looking a t p o ssib le lin k ag es am o n g firm s a n d a t m a rk e t p r a c tic e s t h a t m ig h t p o se sy ste m ic risk, su c h as th e desig n a n d d istrib u tio n o f a s s e tb a c k e d s e c u r itie s a n d th e o rg a n iz a tio n o f th e c r e d it d e f a u lt sw ap m a rk e t. M a c ro p ru d e n tia l su p e rv isio n su g g e sts t h a t w e e x a m in e th e sy ste m as a w h o le a n d look fo r s itu a tio n s t h a t le a d to fin a n c ia l in s ta b ility . For e x a m p le , w h e n p ric e s o f fin a n c ia l a s s e ts fa ll s te e p ly , fin a n c ia l in s titu tio n s o f te n n e e d to o b ta in liq u id ity a n d p re s e rv e c a p ita l. This p ro m p ts th e m to se ll a s s e ts th e y hold, w h ich f u r th e r d e p re s s e s m a rk e t p ric e s a n d s e ts in m o tio n a n e g a tiv e c h a in o f e v e n ts . In such an e n v iro n m e n t, in d iv id u al b an k s m ay a p p e a r h e a lth y , b u t th a t h e a lth c a n q uickly d e t e r io r a te if th e y a r e all a tte m p tin g to s tr e n g th e n th e ir b a la n c e s h e e ts a t th e s a m e tim e . S im ilarly, heav y re lia n c e on a sm a ll n u m b e r o f fin a n c ia l g u a ra n to rs sh o u ld p ro m p t a re v ie w o f th e ir a b ility to p e rfo rm u n d e r s tre s s . http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM] Steps toward a New Financial Regulatory Architecture :: April 1, 2009 :: Federal Reserve Bank of Cleveland E stab lish in g a fa ilu re re so lu tio n p ro ce ss fo r n o n b a n k fin a n c ia l c o m p a n ie s sh o u ld go h a n d -in -h a n d w ith th e e s ta b lis h m e n t of m a c ro p ru d e n tia l su p e rv isio n . T he sy ste m ic e f f e c ts t h a t a ris e fro m th e fa ilu re o f a sin g le firm a r e so m e tim e s m a d e w o rs e b e c a u s e th e r e is no c le a rly d e fin e d m e th o d fo r g o v e rn m e n t a u th o ritie s to in te r v e n e an d re so lv e th e s itu a tio n . In th e c a s e o f th e p o te n tia l fa ilu re o f a c o m m e rc ia l b an k , th e g o v e rn m e n t, th e g e n e ra l p u b lic , th e b a n k ’s c r e d ito r s , a n d p o te n tia l in v e sto rs c le a rly u n d e rs ta n d th e ru le s o f th e g a m e . O n ce w e m ove o u ts id e t h a t a r e n a , w e a r e in u n c h a rte d te r r ito r y . T ru e , th e r e is alw ay s th e o p tio n o f a b a n k ru p tc y filin g , b u t b a n k ru p tc y o f a sy ste m ic a lly im p o r ta n t fin a n c ia l c o m p a n y in a tim e of crisis co u ld b e p ro fo u n d ly d e s ta b iliz in g . T h a t is w h e r e th e e s ta b lis h m e n t o f b o th m a c ro p ru d e n tia l su p erv isio n an d a m o re r o b u s t fa ilu re re so lu tio n p ro c e ss co u ld m a k e a r e a l d if f e r e n c e —to h e lp e n s u re t h a t th e g o v e rn m e n t has th e to o ls and a u th o rity to re so lv e c rise s a t sy ste m ic a lly im p o r ta n t n o n b an k fin a n c ia l in s titu tio n s in w ay s sim ila r to th o s e t h a t c u r r e n tly e x is t fo r b an k in g o rg a n iz a tio n s. H elping th e p u b lic an d in s titu tio n s u n d e rs ta n d th e n e w ru le s o f th e g a m e a n d how th e y w ill b e a p p lie d m ay b e a c h a lle n g e , b u t t h a t u n d e rs ta n d in g is c r itic a l to gain th e fu ll b e n e f its o f th e p ro g ra m . O ne w ay to beg in is to fo llo w th e e x a m p le o f so m e fo re ig n c e n tr a l b an k s an d fin a n c ia l a u th o ritie s , by p u b lish in g fin a n c ia l s ta b ility r e p o r ts . All fin a n c ia l su p e rv iso rs, b u t e s p e c ia lly th e m a c ro p ru d e n tia l su p e rv is o rs, sh o u ld re g u la rly d e s c rib e th e ir o b je c tiv e s , th e risks th e y s e e , a n d th e a c tio n s th e y a r e ta k in g to a d d re s s th o s e risks. By d oing so, su p e rv iso rs w ill also re c e iv e in fo rm e d f e e d b a c k from b a n k e rs a n d th e p u b lic re g a rd in g th e goals, e f f e c tiv e n e s s , an d c o n s iste n c y o f su p e rv iso ry a c tiv itie s . By e s ta b lish in g a d ia lo g u e w ith th e p u b lic —in v itin g th e m in to th e ro o m , so to s p e a k --su p e rv is o ry a g e n c ie s w ill e m p o w e r all c o n c e rn e d p a r tie s to m a k e m o re k n o w le d g e a b le d e c isio n s. E n h an c ed c o m m u n ic a tio n h as b e n e f ite d th e m o n e ta ry policy p ro c e ss, an d I b e lie v e it w ill b e n e f it th e su p e rv iso ry p ro c e ss as w ell. Conclusion T h e F e d e ra l R e serv e is w o rk in g h a rd to re so lv e th e c u r r e n t fin a n c ia l tu rm o il, b u t i t is n o t to o e a rly to look a h e a d a t w ay s to fix th e u n d erly in g p ro b le m s in th e sy ste m . I b e lie v e th e n e w fra m e w o rk I h av e su g g e s te d fo r c a te g o riz in g fin a n c ia l in s titu tio n s a n d a d d re ssin g th e sy ste m ic risk th e y p o se to th e fin a n c ia l sy ste m w ill p ro v id e a so lid f o u n d a tio n . This a p p ro a c h w ill a d d th e c la r ity a n d fo cu s w e n e e d to lim it th e a d v a n ta g e s o f b ein g sy ste m ic a lly im p o r ta n t, th e r e b y re d u c in g th e t h r e a t th e s e in s titu tio n s p o se to th e fin a n c ia l s y ste m . T h e e s ta b lis h m e n t o f o n e o r m o re m a c ro p ru d e n tia l su p e rv iso rs, w ith th e a d e q u a te to o ls to re so lv e c rise s, w ill h e lp to id e n tify a n d m itig a te s ig n ific a n t risks to th e fin a n c ia l sy ste m . T h e se e le m e n ts a r e c ritic a l to an y re fo rm s o f o u r re g u la to ry sy stem an d s tr u c tu r e , an d I w e lc o m e y o u r th o u g h ts an d p a rtic ip a tio n as th e p ro c e ss m oves fo rw a rd . Careers | Diversity | Privacy | Terms of Use | Contact Us | Feedback | RSS Feeds http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2009/Pianalto_20090401.cfm[4/29/2014 2:00:31 PM]
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