“I have not reached any conclusion that a particular bank needs to be broken up or anything like that,” Mr. Powell said at a banking conference. The point is to “raise capital requirements to the point at which it becomes a question that banks have to ask themselves.”

As I listened to the wide range of views on the merits and costs of higher capital, it struck me that we could increase capital requirements in a straightforward way to address TBTF. As we saw in my earlier comments about the behavior of legal structures in a crisis, there is a strong argument that simpler solutions are more likely to be effective than complex ones, so I see virtue in focusing on increasing common equity to assets, which seems the simplest and potentially the most powerful in terms of safety and soundness.

More capital has another advantage. We have seen extraordinary structural changes in our financial system over the past several decades. We have to be prepared for more change. More capital will absorb losses even from activities we cannot anticipate today.

Thinking back to my earlier comments about risk spreading between banks in the 2008 crisis, I realize that capital by itself is not a direct firewall to contain risk, but at a minimum, it does not intensify the spreading of risk from bank to bank. If all of the largest banks had enough capital that investors were confident in their strength, even during an economic shock, such concerns about shared risks could be substantially reduced.

If a shock or event occurs, and banks prove to be not sufficiently resilient, it is critically important to proactively recapitalize the banking sector as quickly as possible while at the same time avoiding collateral damage from tighter credit standards. Put another way, with respect to the capital-to-assets ratio, it is vital to increase the capital (the numerator of the ratio) rather than allowing the adjustment to occur primarily through a reduction in assets, i.e. loans (the denominator).

In general, the macroprudential tools can be classified into two categories: structural tools and cyclical tools. The structural tools aim to build the resiliency of the financial system throughout the business cycle. These tools include the Basel III risk-based capital requirements, minimum liquidity requirements, central clearing for derivatives, and living will resolution plans.

In contrast, the cyclical tools are aimed at mitigating the systemic risk that can build up over the business cycleMacroprudential tools aimed at addressing these emerging risks include the countercyclical capital buffer, the capital conservation buffer, and stress test scenarios. The countercyclical capital buffer allows regulators to increase risk-based capital requirements when credit growth is judged to be excessive and leading to rising systemic risk. The capital conservation buffer ensures that banks raise capital above regulatory minimums in good times so that when they cover losses in bad times, their capital ratio will stay at or above the regulatory minimum. The stress tests can include scenarios that become more severe during strong economic expansions. Other possible cyclical tools, not yet established in the U.S. but used in other countries, include loan-to-value ratio limits and debt-to-income ratio limits that vary over the cycle. In some countries, these macroprudential tools have been targeted at particular sectors like housing credit or household credit. For example, Canada tightened loan-to-value and debt-to income limits on mortgage lending over the 2009 to 2012 period.3 Beginning in 2010, Israel also implemented a package of macroprudential tools to restrict the supply of housing credit.4 Spain introduced dynamic loan-loss provisioning in 2000.5 This method builds up reserves during good economic times according to the historical losses experienced by the asset classes held in the banks portfolio. This buffer is then available to absorb losses in bad times.

The financial turbulence of 2008 was largely defined by the dangers of runs--realized, incipient, and feared.... In the first instance, at least, this was a liquidity crisis. Its fast-moving dynamic was very different from that of the savings and loan crisis or the Latin American debt crisis of the 1980s. The phenomenon of runs instead recalled a more distant banking crisis--that of the 1930s.

Despite this defining characteristic of the last crisis, measures to regulate liquidity have by-and-large lagged other regulatory reforms, for at least two reasons. First, prior to the crisis there was very little use of quantitative liquidity regulation and thus little experience on which to draw... A second reason liquidity regulation has followed other reforms is that judicious liquidity regulation both complements, and is dependent upon, other important financial policies--notably capital regulation, resolution procedures, and lender-of-last-resort (LOLR) practice. Work on liquidity regulations has both built on reforms in these other areas and occasioned some consideration of the interaction among these various policies.

But while perhaps a bit drawn out, the work has proceeded. A final version of a Liquidity Coverage Ratio (LCR) was agreed internationally and has been adopted by regulation in the United States. The Basel Committee's recently announced final Net Stable Funding Ratio (NSFR) is another significant milestone in building out a program of liquidity regulation.

MCHENRY: I have a question. In 2010 you spoke that banks may be required in their debt stack, in their capital to use a convertible instrument that in good times has a debt nature, and in bad times converts to equity. You said that they may be required to do this.
Is this your intention to use this instrument?
YELLEN: So I think when I gave the speech at that time, I was broadly considering possible regulations or shifts in the focus of supervision that might be helpful. I think there is still this focus on something like that.
I think to improve the resolvability of a large banking organization, something that the Federal Reserve, and other regulators are contemplating, is a requirement that bank holding companies hold a sufficient amount of long-term debt.
It would play a role similar to the contingent capital instruments you've described.
MCHENRY: So you mentioned that in your opening statement, about this requirement on long-term debt. Would it be your intention to have this contingent convertible capital as a part of that long-term debt requirement?
YELLEN: Well, I think it bears -- this type of debt would bear some similarities. It's not exactly the same, but it bears some similarities to contingent debt in that it is a source of gone concern of value that would be there if an organization got in trouble that would serve to recapitalize it. And the existence of such a class of debt, I think would give proper incentives to monitor risk taking in these organizations.
MCHENRY: So are you still broadly favorable towards these towards these contingent convertible?
YELLEN: I mean, there are a number of issues associated with that kind of debt, what would trigger it and so forth. But I think it remains an interesting possibility in this proposal
MCHENRY: An interesting possibility.
Well, that's a fair admission from a chair of the Federal Reserve.
So I'll take that as somewhat favorable, if I may.

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. 

...

As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace--occasioned as it is by the rather complicated domestic and international decisionmaking processes--may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all the new regulations, the Federal Reserve has already used its stress-test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation's 18 largest bank holding companies, which hold more than 70 percent of the total assets of all U.S. bank holding companies. The weighted tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from $393 billion to $792 billion during the same period.

Given the centrality of strong capital standards, a top priority this year will be to update the bank regulatory capital framework with a final rule implementing Basel III and the updated rules for standardized risk-weighted capital requirements… I think there is a widespread view that the proposed rule erred on the side of too much complexity…

The Federal Reserve also intends to work this year toward finalization of its proposals to implement the enhanced prudential standards and early remediation requirements for large banking firms... Once finalized, these comprehensive standards will represent a core part of the new regulatory framework that mitigates risks posed by systemically important financial firms and offsets any benefits that these firms may gain from being perceived as "too big to fail."

We also anticipate issuing notices of some important proposed rulemakings this year. The Federal Reserve will be working to propose a risk-based capital surcharge applicable to systemically important banking firms. This rulemaking will implement for U.S. firms the approach to a systemic surcharge developed by the Basel Committee, which varies in magnitude based on the measure of each firm's systemic footprint...

Another proposed rulemaking will cover implementation by the three federal banking agencies of the recently completed Basel III quantitative liquidity requirements for large global banks. The financial crisis exposed defects in the liquidity risk management of large financial firms, especially those which relied heavily on short-term wholesale funding. These new requirements include the liquidity coverage ratio (LCR), which is designed to ensure that a firm has a sufficient amount of high quality liquid assets to withstand a severe standardized liquidity shock over a 30-day period…

I think there is a widespread view that the proposed {Basel III} rule erred on the side of too much complexity.

Strong capital requirements must be at the center of the post-crisis period regulatory regime.

For all the regulatory changes that are in place, in process, or under consideration, I believe that capital regulation remains the single most important element of prudential financial regulation.

The emphasis in Basel III on improving the quality and quantity of capital is an important regulatory response to the financial crisis. Clearly we need to focus on the narrow definitions of capital – that which can readily absorb losses.

Basel III is not a perfect agreement, of course. There are things we would have done differently if we were writing a capital regulation on our own... But it is a major step forward for capital regulation. It will raise minimum requirements substantially, ensure that regulatory capital is truly loss absorbing, and discourage some of the risky activities for which the pre-crisis regime required far too little capital.

Instead of more regulation, we need better-designed regulation that recognizes incentives and tries to address moral hazard so that market discipline can work. Overly proscriptive regulation is counterproductive - it increases the incentives to evade it, which ultimately defeats it. Financial innovation spurred by the desire to evade regulation and relocating activities outside of regulation’s reach are not productive, but they are an expected outcome if regulations are not well designed. Market discipline is an essential part of our market-based economy, and regulation should be designed to enhance it, not thwart it.

This requires scaling back some of the safety net subsidies that have risen over the years and increasing capital requirements.

There’s no question in my mind that there’s going to be some consequences for lending margins. Careful review of this suggests that the adjustment to lending margins is going to be quite modest.

So what about the long-run consequences [of higher capital standards]? It would be prudent to assume that requiring banks to hold more capital and higher cost capital is likely to result in somewhat higher lending spreads.

Although any increase will be a real cost, this appears to be a necessary and appropriate price to pay for a much more resilient financial system. The cost represented by higher lending spreads has to be weighed against the benefits of a more robust and resilient banking system. Recent years have surely taught us that easy access to credit that is underpriced because it is not backed by sufficient capital is not a sustainable route to prosperity. Indeed, to the extent that tougher standards reduce the misallocation of resources in the real economy that often accompanies periods of financial excess, ensure more consistent access to finance over time and encourage investment by holding out the prospect of greater economic stability, the new standards could be consistent with a more rapid sustainable growth rate over the long run.