So we have finalized our Basel III capital requirements that significantly increase the quality and quantity of capital in the banking system. Even before we did that, through our stress tests we have worked to ensure that especially the largest and most systemic institutions have the ability to not only survive a very adverse stress to the system but also to lend and support the needs of the economy through such a stress. The amount of capital in the banking system has basically doubled since 2009.

MCKEE: What do you think of the Brown-Vitter legislation, a 15 percent capital ratio for the biggest banks?

DUDLEY: I think that this is all about costs versus benefits. You could - you could go with a proposal that raised capital requirements on large institutions a lot, which is what the Brown-Vitter legislation does. There are going to be consequences of that. It's going to drive up the cost of credit in the economy. It's going to probably tighten credit conditions for a while. And so you have to weigh that cost versus - versus the benefit of reducing the probability of these firms failing.

I think the - the Dodd-Frank Act basically envisions that there's a more efficient way to achieve the same outcome of ending too big to fail. We all want to end too big to fail, but we should also want to end it in the most efficient way possible, the way that causes the least damage to the economy, that causes the least increase in the spread between the cost of deposits and borrowing.

 Where do we stand with respect to fixing the problem of "too big to fail" (TBTF)? Are we making satisfactory progress, or it is time to think about further measures?

...While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint.

...

Suppose instead we attack the problem by imposing capital requirements that are an increasing function of bank size. This price-based approach creates some incentive for all three banks to shrink, but lets them balance this incentive against the scale benefits that they realize by staying big. In this case, we would expect A, with its significant scale economies, to absorb the tax hit and choose to remain large, while B and C, with more modest scale economies, would be expected to shrink more radically. In other words, price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decision on their own understanding of the synergies--or lack thereof--in their respective businesses.

...

Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board.11 As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

It gives me pause, for example, that after the recent devastating experience of the global banking crisis, regulatory authorities are already backing off initial attempts to strengthen international capital requirements for these largest banks and financial firms. The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of 3 percent. This is a 33-to-1 leverage ratio. Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable.

In the United States we have as a first line of defense we have a risk weighted capital ratio which is not a straight leverage ratio, it's an amount of capital we have to hold against assets where we have to hold more capital against riskier assets, which makes sense. The risk of the asset, the more capital you want to hold and we are, we the Federal Reserve and the other bank regulators are working very actively with other regulators around the world to strengthen the capital requirements. We've already made proposals to do that. We are going to get assessments from the banks about how big an impact that would have. And it's our intention to move forward with more conservative higher capital requirements. So that's the first thing.

The leverage ratio is kind of a back stop, a fail safe if you will, because it's a very simple ratio, it's just a ratio of capital against total assets without making much or any distinction between Treasury's versus loans to small businesses for example. And the United States has long had a leverage ratio as a backstop to our capital rules.

One of the interesting things that appears to be coming out of the international negotiations is that the U.S. leverage ratio, which never was used abroad now looks like it will be adopted by other countries as well, which is good for us because it'll create a more even playing field and create greater safety in the global banking system as well as here.

So the leverage ratio is part of these negotiations and discussions we're having internationally and there are proposals on the table. We haven't yet gone through the whole process of doing the quantitative analysis to figure out exactly what the right number is, so I can't tell you off hand you know what the final number will be, but we're certainly looking to make the leverage ratio part of the more conservative approach to making sure that banks have enough capital that they can absorb even in a severe crisis like one we've had they can absorb their losses.
So yes, that will be part of our proposal.

[T]he Federal Reserve, representing the United States, has been working with other countries, in the Basel committee and other contexts, to try to develop new standards. We have implemented a few of them, for example, for market trading, but at this point we have not completed the whole process of developing higher, more stringent capital standards for large firms.

A proposal has been put forward, which is now being tested. Banks are being asked to evaluate how much capital they would have to hold under these more stringent standards, so we can get a sense of what the implications would be for the leverage ratio. But I don't know that number yet. We're trying to figure out what will be safe. It would depend on the composition of the assets the bank has -- the riskier the assets, the higher, more capital you should have.

So we are working to try to, by the end of 2010, to try to have a very concrete proposal to -- that each country would then have to decide whether to adopt or not.

From the Q&A session

As you know, the federal bank regulatory agencies began conducting the Supervisory Capital Assessment Program in late February. The program is a forward-looking exercise intended to help supervisors gauge the potential losses, revenues, and reserve needs for the 19 largest bank holding companies in a scenario in which the economy declines more steeply than is generally anticipated. The simultaneous comprehensive assessment of the financial conditions of the 19 companies over a relatively short period of time required an extraordinary coordinated effort among the agencies.

The purpose of the exercise is to ensure that banks will have a sufficient capital buffer to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions are worse than expected. Following the announcement of the results, bank holding companies will be required to develop comprehensive capital plans for establishing the required buffers. They will then have six months to execute those plans, with the assurance that equity capital from the Treasury under the Capital Assistance Program will be available as needed.

The surest sign that a recovery is on its way and that financial markets are on the mend will be an inflow of private capital into the banking system and a broad-based increase in bank lending. Since the beginning of the year, we have seen declines in commercial and industrial loans as well as loans for commercial real estate. On the other hand, consumer and residential mortgage loans are again increasing, particularly for refinancing. As economic conditions stabilize, more households and businesses will have the confidence to borrow, and more borrowers will become better credit risks. Both developments will contribute to economic growth.

Banks with the lowest supervisory ratings have reduced their lending significantly more than have banks in better health.  Empirical research suggests that during previous banking crises this behavior was, to an important degree, explained by differences in the ability to supply credit not just differences in the demand for credit. [Footnote 5] Thus the evidence from Japan and previous problems in the U.S. indicates that allowing poorly capitalized banks to continue operations with insufficient capital is likely to exacerbate problems with credit availability.

I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs "through the cycle" to mitigate procyclicality. However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole.

Going forward, the ability and willingness of commercial banks and other intermediaries to extend credit depends in part on their capacity to expand equity capital internally and externally. The encouraging news is that large commercial banks, investment banks, and mortgage specialists have, to some extent, been able to issue new equity capital and to rebuild capital positions that have come under pressure from a combination of losses and growth in assets.

In view of this uncertain outlook, additional capital injections and the consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions.  Stronger capital positions also will allow banking institutions to participate in and support the rebound in lending that will accompany the strengthening of the U.S. economy.

Recent events have also demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets. I have been encouraged by the recently demonstrated ability of many financial institutions, large and small, to raise capital from diverse sources.  Importantly, capital raising and balance sheet repair allow for the extension of new credit, which supports economic expansion. I strongly urge financial institutions to remain proactive in their capital-raising efforts. Doing so not only helps the broader economy but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve.

Unlike the credit crunch in the early 1990s in the United States, many financial firms have raised significant capital. Unfortunately, while in many cases these equity issues have offset recent losses, they may leave little additional buffer should further credit losses occur. A number of large financial institutions have reduced their dividends, and given the potential for additional capital shortages it goes without saying that financial institutions should continue to assess whether further reductions or cessation of dividends would be advisable.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.