Daniel Tarullo

Nevertheless, as Chairman Bernanke has noted, effectively identifying and addressing systemic risks would seem to require some involvement of the Federal Reserve.  As the central bank of the United States, the Federal Reserve has a critical part to play in the government's responses to financial crises.  Indeed, the Federal Reserve was established by the Congress in 1913 largely as a means of addressing the problem of recurring financial panics.  The Federal Reserve plays such a key role in part because it serves as liquidity provider of last resort, a power that has proved critical in financial crises throughout modern history.  In addition, the Federal Reserve has broad expertise derived from its other activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives.

The Federal Reserve has been involved in a number of exercises to understand and document the risk-management lapses and shortcomings at major financial institutions, including those undertaken by the Senior Supervisors Group, the President's Working Group on Financial Markets, and the multinational Financial Stability Forum.¹

Based on the results of these and other efforts, the Federal Reserve is taking steps to improve regulatory requirements and risk management at regulated institutions.  Our actions have covered liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit exposures, and commercial real estate.  Liquidity and capital have been given special attention. 

Going forward, we will need changes in the capital regime as the financial environment returns closer to normal conditions.  Working with other domestic and foreign supervisors, we must strengthen the existing capital rules to achieve a higher level and quality of required capital.  Institutions should also have to establish strong capital buffers above current regulatory minimums in good times, so that they can weather financial market stress and continue to meet customer credit needs.  This is but one of a number of important ways in which the current procyclical features of financial regulation should be modified, with the aim of counteracting rather than exacerbating the effects of financial stress.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete.  We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008.  Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm.  The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline.

Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that critical payment and settlement systems have the necessary procedures and controls in place to manage their risks.  By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems.  Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many payment and settlement systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.  

[A]t the onset of the current crisis, the financial regulatory system had accommodated the growth of capital market alternatives to traditional financing by relaxing some restrictions on bank activities and virtually all restrictions on affiliations between banks and non-bank financial firms. In place of the superseded restrictions were capital requirements focused on credit and market risk, along with a greater emphasis on supervision and risk management, especially at larger firms. These legal changes facilitated a wave of mergers and acquisitions that created a number of very large, highly complex financial holding companies centered on a large commercial bank. These were subject to prudential regulation. At the same time, there was a group of very large, significantly leveraged "free-standing" investment banks whose market practices were regulated by securities laws, but were not subject to prudential regulation.

Let me...review in summary fashion what we regard as the key components of a legislative agenda to contain systemic risk.

First, there should be a statutory requirement for consolidated supervision of all systemically important financial firms--not just those affiliated with an insured bank as provided for under the Bank Holding Company Act of 1956 (BHC Act).

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Second, there should be a resolution regime for systemically important non-bank institutions to complement the current regime for banks under the Federal Deposit Insurance Act.

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Third, there should be clear authority for special regulatory standards--such as for capital, liquidity, and risk-management practices--applicable to systemically important firms.

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Fourth, there should be an explicit statutory requirement for analysis of the stability of the U.S. financial system.

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Fifth, additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems.

As has been widely observed in recent weeks, there are signs that the rapid decline in economic activity of the past few quarters is slowing. The latest data give some reason to hope that we are approaching a bottom in economic activity and that growth will resume later this year. Yet stabilization or improvement would begin from very low levels compared with those that prevailed in recent years. Recovery may be painfully slow, and the economy will remain unusually vulnerable to new shocks.

Solving the boundary problem alone will not counterbalance contemporary sources of systemic risk. The rapid development of market-based financial intermediation has also highlighted the need for a macroprudential regulatory approach to complement more conventional prudential supervision.

[C]ompensation systems that incentivize employees to take actions that entail excessive risk in light of expected returns and costs can also have adverse effects on firm safety and soundness. While there is reason to proceed carefully in this area, there is a real need for additional supervisory action to strengthen previous guidance on compensation. The Board is currently developing proposals that will help ensure that compensation systems take appropriate account of the riskiness of the firm's activities as well as the firm's financial performance.

If we have learned anything from the present crisis, it is that systemic risk was very much built into our financial system.  This situation was the outcome of a decades-long trend, during which traditional bank lending, trading, and other capital markets activities were increasingly integrated.

[T]he importance of traditional financial intermediation services, and hence of the smaller banks that typically specialize in providing those services, tends to increase during times of financial stress.  Indeed, the crisis has highlighted the important continuing role of community banks. 

The differences in the business models of systemically important financial firms and community banks are obvious.  Yet the financial crisis and ensuing recession have revealed deficiencies in risk management in institutions of both types.  Changes in competitive environments require banks to respond with changes in their business strategies.  But the financial crisis has also revealed the importance of banks adopting risk-management strategies appropriate to these strategic changes, and of bank regulatory agencies adapting their supervisory models to both these kinds of changes in financial institutions.

The Federal Reserve's participation in this decisionmaking process {resolution process for nonbank financial firms} would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large banking organizations. The Federal Reserve, however, is not well suited, nor do we seek, to serve as the resolution agency for systemically important institutions under the new framework.

[A]ddressing the pervasive problem of pro-cyclicality in the financial system will require efforts across financial sectors. To help address these issues, the Administration has proposed the establishment of a Financial Services Oversight Council composed of the Treasury and all of the federal financial supervisory and regulatory agencies, including the Federal Reserve.

See further comments on an oversight council:
Sheila Bair's Testimony ; Mary Schapiro's Testimony

While effective consolidated supervision of potentially systemic firms is not, by itself, sufficient to foster financial stability, it certainly is a necessary condition. The Administration's recent proposal for strengthening the financial system would subject all systemically important financial institutions to the same framework for prudential supervision on the same consolidated or group-wide basis that currently applies to bank holding companies. In doing so, it would also prevent systemically important firms that have become bank holding companies during the crisis from reversing this change and escaping prudential supervision in calmer financial times.

[W]e are prioritizing and expanding our program of horizontal examinations to assess key operations, risks, and risk-management activities of large institutions. For the largest and most complex firms, we are creating an enhanced quantitative surveillance program that will use supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms.

A graphic illustration of what can happen when the central bank is not involved in supervision was observed a couple of years ago in the United Kingdom.  The Bank of England, the central bank, was not involved in supervision at all, and when a significant financial institution, Northern Rock, failed, the Bank of England was not in a position to be able to make judgments about a: the failure of Northern Rock and b: the ripple effects within the system.

As reported by Reuters.

A loophole in current law, however, permits any type of firm--including a commercial company or foreign bank--to acquire an FDIC-insured ILC chartered in a handful of states without becoming subject to the prudential framework that the Congress has established for the corporate owners of other full-service insured banks. Prior to the crisis, several large firms--including Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley, GMAC, and General Electric--took advantage of this opportunity by acquiring ILCs while avoiding consolidated supervision under the BHC Act.

The Federal Reserve has long supported closing this loophole, subject to appropriate "grandfather" provisions for the existing owners of ILCs. Such an approach would prevent additional firms from acquiring a full-service bank and escaping the consolidated supervision framework and activity restrictions that apply to bank holding companies. It also would require that all firms controlling an ILC, including a grandfathered firm, be subject to consolidated supervision.

The financial crisis has underscored the importance of the original motivation for creating what is now the FSB. The connections among financial market sectors, and between macroeconomic policy and financial markets, mean that efforts to ensure international financial stability must incorporate a breadth of perspectives and include communication among the various international groups in which regulatory cooperation takes place.

One critical area for improvement is that of increasing capital requirements for many forms of traded securities, including some securitized assets...The Basel Committee is also working on proposals for an international leverage ratio to act as a supplement to risk-based capital ratios. The FSB has also devoted considerable energies to exploring sources of procyclicality in the financial system, which are those practices and structures that tend to amplify rather than dampen the cycles characteristic of financial markets, and to identifying possible strategies to reduce their effects, which were often quite visible during the recent crisis. One such strategy is to include a countercyclical capital buffer in the capital requirements for financial firms. Work on such a buffer is under way, though the technical challenges of devising an effective buffering mechanism are significant.

I want to make a few more general comments on changes, actual or potential, in credit markets. These remarks are prompted in part by the conversations I often have with bankers, business people, and consumers. During these discussions I have realized that just about everyone understands we will never return to the credit markets of the middle part of this decade, but very few people believe they understand what the "new normal" will look like once the crisis has fully passed and the economy is on a sustained recovery path. I suspect that this uncertainty is itself an impediment to stronger growth, since it makes financial planning more difficult.

This turnaround is certainly welcome, but it should not be overstated. Although we can expect positive growth to continue beyond the third quarter, economic activity remains relatively weak.

A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions.

The government-arranged and subsidized absorption of Bear Stearns into JPMorgan Chase draws attention to two additional features of the too-big-to-fail problem. First, no matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention. Second, once a government has obviously extended the reach of its safety net, moral hazard problems are compounded, as market actors may expect similarly situated firms to be rescued in the future. Both these observations underscore the importance of adopting robust policies in non-crisis times that will diminish the chances that, in some future period of financial distress, a government will believe it must intervene to prevent the failure of a large financial institution.

For example, some firms gave loan officers incentives to write a lot of loans, or traders incentives to generate high levels of trading revenues, without sufficient regard for the risks associated with those activities. The revenues that served as the basis for calculating bonuses were generated immediately, while the risks might not have been realized for months or years after the transactions were completed. When these or similarly misaligned incentive compensation arrangements were common in a firm, the very foundation of sound risk management could be undermined by the actions of employees seeking to maximize their own pay. There is thus significant overlap between the interests of shareholders and of supervisors in the area of employee compensation.

Some additional potential regulatory devices are already under active consideration, both among U.S. bank supervisors and in international forums. These include proposals to create special charges on firms based on their systemic importance, to require contingent capital that would be available in periods of stress, and to counter pro-cyclical tendencies by establishing special capital buffers that would be built up in boom times and drawn down as conditions deteriorate. Each of these ideas has substantial appeal. A number of thoughtful proposals are being discussed, though each idea presents considerable challenges in the transition from good idea to fully elaborated regulatory mechanism.

Yet to gain traction are proposals for what might be termed structural measures--that is, steps that would directly affect the nature and organization of the financial services industry. But discussion of such concepts is clearly increasing.

One suggested approach is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions, although separating trading from hedging and other prudent practices associated directly with lending is not an altogether straightforward proposition.

In any case, this strategy would seem unlikely to limit the too-big-to-fail problem to a significant degree. For one thing, some very large institutions have in the past encountered serious difficulties through risky lending alone. Moreover, as shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat. Still, imposition of higher capital and liquidity requirements for riskier trading and other capital market activities can, if well devised and implemented, achieve some of what proponents of this approach seem to have in mind.

Even as we improve and reorient regulation, we must not lose sight of the ultimate goal. Today we are all mindful of the economic devastation that can ensue when a financial system goes badly awry. But financial stability alone is not the aim of financial regulation. It is instead a stable financial system within which capital is efficiently directed to creditworthy consumers and businesses who need it, as well as a system that offers good savings and investment vehicles for individuals and organizations.

I would further suggest that the importance of proposed requirements that each large financial firm produce a so-called living will is that this device could better tie the supervisory and resolution processes together.

I believe that the most useful steps toward creating a practical, macroprudential supervisory perspective will be those that connect the firm-specific information and insight gained from traditional microprudential supervision to analysis of systemwide developments and emerging stresses. Here, precisely, is where our SCAP experience has helped lead the way.

[T]here should be a clear expectation that the shareholders and creditors of the failing firm will bear losses to the fullest extent consistent with preserving financial stability. To personalize things for this audience, we must ensure that if you have invested money in a large financial firm that runs aground, you will suffer losses. Shareholders of the firm ultimately are responsible for the organization's management (or mismanagement) and are supposed to be in a first-loss position upon failure of the firm. Shareholders, therefore, should pay the price for the firm's failure and should not benefit from a government-managed resolution process.

Another means by which an intensification of financial turmoil in Europe could affect U.S. growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of U.S. merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on U.S. economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of U.S. financial institutions.

Although the sovereign debt crisis in Europe may have appeared to erupt virtually overnight, its origins were long in the making. For years many market participants had assumed that an implicit guarantee protected the debt of euro-area members. For a number of euro-area countries, including those most under pressure now, this presumption may have led to a systematic underpricing of risk, which made debt cheaper to issue than it probably should have been. Although strictures against excessive fiscal deficits and debts were built into the Maastricht Treaty, the European Union (EU) has had relatively weak mechanisms to enforce them, as EU officials themselves have recently acknowledged.

The liquidity lines, which were authorized by a unanimous vote of the Federal Open Market Committee, are structured similarly to those that were put in place during the financial crisis. As you know, central bank swap transactions have a long and well-established history, and their use by the Federal Reserve and other central banks goes back to the Bretton Woods era of fixed exchange rates. In their current vintage, they are used by foreign central banks to relieve or forestall temporary liquidity pressures in their local dollar funding markets. Foreign central banks draw on these lines by selling foreign currency to the Federal Reserve in exchange for dollars. The foreign central banks then lend these dollars to financial institutions in their jurisdictions. At maturity, the foreign central bank returns the dollars back to the Federal Reserve in exchange for its own currency at the same exchange rate that prevailed at the time of the initial draw, and pays interest as well.

The loans provided by the foreign central banks to institutions abroad are offered at rates that would be above market rates in normal times. As such, when market conditions are not greatly strained, demand for dollar liquidity through the swap lines should not be high, as market alternatives would be more attractive. Likely for that reason, the dollar liquidity offerings by foreign central banks to date have elicited only a modest demand.³ However, even in such instances, the existence of these facilities can reassure market participants that funds will be available in case of need, and thus help forestall hoarding of liquidity, a feature that exacerbated stresses during the global financial crisis.

[T]here are aspects of the Dodd-Frank Act that are unlikely to become part of the international financial regulatory framework. For example, the act generally prohibits U.S. banking firms (and the U.S. operations of foreign banking firms) from engaging in proprietary trading and from investing in or sponsoring private investment funds. The act also prohibits U.S. depository institutions from entering into certain types of derivatives transactions. In the United States, activity restrictions have long been a part of the bank regulatory regime, serving to constrain risk-taking by banking firms, prevent the spread of the market distortions caused by the federal bank safety net to other parts of the economy, and mitigate potential conflicts of interest generated by the combination of banking and certain other businesses within a single firm. Many other countries follow a universal banking model and are unlikely to adopt the sorts of activity restrictions contained in the act.

To date, reform in financial regulation and supervision has focused mainly on large regulated institutions: Three examples are the just-announced Basel III capital rules, much of the Dodd-Frank Act, and the Federal Reserve's revamping of its large holding company supervision. Of course, attention has also been paid to the second source of systemic risk, notably in Dodd-Frank's provisions for prudential supervision of payments, clearing, and settlement systems. But more will need to be done in this area, particularly as new constraints applicable to large regulated institutions push more activity into the unregulated sector.

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.

[T]he problems are sufficiently widespread that they suggest structural problems in the mortgage servicing industry. The servicing industry overall has not been up to the challenge of handling the large volumes of distressed mortgages. The banking agencies have been focused for some time on the problems related to modifying mortgage loans and the large number of consumer complaints by homeowners seeking loan modifications. It has now become evident that significant parts of the servicing industry also failed to handle foreclosures properly.

[B]ecause of the specific language contained in the [Dodd-Frank] act, this exemption for traditional bank derivatives activities does not apply to foreign banking firms that have access to the Federal Reserve's discount window through their U.S. branches. A possibly unintended effect of the act's push-out provision may be to require some foreign firms to reorganize their existing U.S. derivatives activities to a greater extent than U.S. firms.

Important as it is, moral hazard is not the only worry engendered by very large, highly interconnected firms in financial markets. Assuming that a government overcomes time-consistency problems and credibly binds itself not to rescue these institutions, their growth would presumably be somewhat circumscribed. But it is possible, perhaps likely, that some combination of scale and scope economies, oligopolistic tendencies, path dependence, and chance would nonetheless produce a financial system with a number of firms whose failure could bring about the very serious negative consequences for financial markets described by the domino and fire-sale effects.

It would be unrealistic, even dangerous, to believe that asset bubbles, excessive leverage, poor risk assessment, and the crises such phenomena produce can all be prevented. The goal of the regulatory regime should be to reduce the likely incidence of such crises and, perhaps more importantly, to limit their severity when they do occur. This argues for fostering a financial sector capable of withstanding systemic stresses and still continuing to provide reasonably well-functioning capital intermediation through lending and other activities. The aim is not to avoid all losses or any retrenchment in lending and capital markets. It is to prevent financial markets from freezing up as they did in the latter part of 2008.

[T]he challenge facing the Board is to enhance supervision, oversight, and prudential standards of major derivatives market participants in a manner that promotes more-effective risk management and reduces systemic risk, yet retain the significant benefits of derivatives to the businesses and investors who use them to manage financial market risks.

Tarullo said looking at so-called core inflation, which strips out volatile food and energy items and remains below the Fed's informal 2.0% target, is better to set monetary policy, which acts with a lag.   "In the U.S. context ... it's proven a more appropriate metric since there's a better correlation between core inflation today and inflation tomorrow," Tarullo said.

As reported by Dow Jones

Federal Reserve Governor Daniel Tarullo said he sees no need to either terminate the central bank’s program of large-scale asset purchases before it’s scheduled to end in June or to increase its size.

As reported by Bloomberg News

The regulatory structure for [systematically important financial institutions] should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant. There is little evidence that the size, complexity, and reach of some of today's SIFIs are necessary in order to realize achievable economies of scale and scope. Some firms may nonetheless believe there are such economies. For them, perhaps, the highest level of an additional SIFI capital charge may be worth absorbing.

Two tendencies in particular suggest that the U.S. labor market has lost some of the dynamism that had long contributed to its resilience. First, it is apparent that job reallocation--that is, the sum of the jobs created at some businesses and lost in others--has been in secular decline since the late 1990s. It may seem counterintuitive to include lost jobs in a measure of labor market health, and on its own it is obviously not such an indicator. But when combined with new jobs, it forms part of the dynamic of job reallocation, an important part of the "creative destruction" that contributes to long-run economic growth--for example, as jobs shift from less-productive firms to more-productive ones.

Second, the amount of employee movement across jobs has fallen over time. Specifically, the rate at which workers move from one firm to another has declined. So has the rate at which workers quit jobs, an indication of the degree to which they believe there are better jobs available for them. In what may be a related trend, geographic mobility across counties and states has decreased.

In sum, I do not think arguments suggesting that structural factors account for most of the increase in unemployment are persuasive, either individually or collectively. Our efforts to quantify the increase in structural unemployment since the onset of the recession find that it accounts for less than one-fourth of the difference between today's unemployment rate and that which prevailed in the pre-crisis years.

With short-term rates already about as low as they can go, the FOMC has also taken some unconventional measures to provide additional monetary accommodation. The combined effect of these monetary policies helped stabilize financial markets in 2009, hold deflation at bay in 2010, and support a modest recovery. But, in the absence of favorable developments in the coming months, there will be a strong case for additional measures.

Some have argued that monetary policy should do no more, and that the political branches of government should adopt fiscal or other policies to encourage increased economic activity and job creation. I certainly do not disagree that well-conceived policies by other parts of the government could produce gains in employment, investment, and spending. But the absence of such policies cannot be an excuse for the Federal Reserve to ignore its own statutory mandate…even when we know that monetary policy alone cannot solve all the economy's problems.

Within the FOMC and in the broader policy community, there has been considerable discussion of possible additional accommodative measures, from communication strategies such as forward guidance on the likely path of the federal funds rate to additional balance sheet operations. I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.

Strong capital and liquidity standards are central to an effective financial regulatory system. Well-crafted capital standards provide a buffer against loss from any activities of a bank, while good liquidity standards help provide assurance that a firm will have breathing space during a period of financial stress, whether idiosyncratic or systemic. But we cannot rely solely on these standards, important as they are, to provide a stable financial system. A necessary supplement is a strong resolution mechanism for systemically important firms, both to counter too-big-to-fail perceptions and to contain the harm to the financial system that would be caused by the failure of one of these firms.

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.

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

One of the more difficult tasks in implementing the statutory prohibitions is distinguishing between prohibited proprietary trading activities and permissible market-making activities. This distinction is important because of the key role that market makers play in facilitating liquid markets in securities, derivatives, and other assets.

U.S. regulators will need to carefully consider the concerns that have been raised and the broader international implications of the Volcker Rule as we work to finalize our implementing rules.

It is sobering to recognize that, more than four years after the failure of Bear Stearns began the acute phase of the financial crisis, so much remains to be done--in implementing reforms that have already been developed, in modifying or supplementing these reforms as needed, and in fashioning a reform program to address shadow banking concerns. For some time my concern has been that the momentum generated during the crisis will wane or be redirected to other issues before reforms have been completed.

Almost by definition, prudential reforms are injunctions to firms or markets about what they should not do. Even affirmatively stated requirements to maintain specified capital ratios can be understood as prohibitions upon extending more credit, purchasing another instrument, or distributing a dividend unless the minimum ratio would be maintained. Prohibition and constraint are quite appropriately at the center of a regulatory system. Yet the policies that underlie regulation should embody a more affirmative set of social goals

Finance and financial intermediation are not ends in themselves, but means for pursuing savings, investment, and consumption goals. Our debate about what we don't want intermediaries and financial markets doing must be informed by a better articulated view of what we do want them doing.

Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge. Indeed, the increased regulation of the major securities firms may well encourage the migration of some parts of the shadow banking system further into the darkness--that is, into largely unregulated markets.

"If a firm said, 'We're doing this because it's a hedge,' they would be required to explain to themselves, importantly, as well as to the primary supervisor, what the hedging strategy was, how it was reasonably correlated with the positions that they were hedging, and how they would make sure that they didn't give rise to new kinds of exposures," Mr. Tarullo said.

J.P. Morgan would have to provide regulators with documentation showing this, he added.

The shadow banking system today is considerably smaller than at the height of the housing bubble six or seven years ago. And it is very likely that some forms of shadow banking most closely associated with that bubble have disappeared forever. But as the economy recovers, it is nearly as likely that, without policy changes, existing channels for shadow banking will grow, and new forms creating new vulnerabilities will arise.

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We should create greater transparency with respect to the various transactions and markets that comprise the shadow banking system. For example, large segments of the repo market remain opaque today. In fact, at present there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions--that is, transactions not settled using the triparty mechanism. It is encouraging that the Treasury Department's new Office of Financial Research is working to improve information about this market, while the Securities and Exchange Commission is considering approaches to enhanced transparency in the closely related securities lending market.

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A second phase of triparty reform is now underway, with the Federal Reserve using its supervisory authority to press for further action not only by the clearing banks, who of course manage the settlement process, but also by the dealer affiliates of bank holding companies, who are the clearing banks' largest customers for triparty transactions. But this approach alone will not suffice. All regulators and supervisors with responsibility for overseeing the various entities active in the triparty market will need to work together to ensure that critical enhancements to risk management and settlement processes are implemented uniformly and robustly across the entire market, and to encourage the development of mechanisms for orderly liquidation of collateral, so as to prevent a fire sale of assets in the event that any major triparty market participant faces distress.

 At the risk of some oversimplification, one can classify most uses of the financial stability concept in Dodd-Frank into four categories: (1) as a goal for a new regulatory authority, (2) as an instruction for ongoing analysis and monitoring, (3) as a direct legal standard, and (4) as a factor for consideration in decisions on applications for various proposed actions subject to regulatory approval.

To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow. There is, then, a case to be made for specifying an upper bound.

In these circumstances, however, with the potentially important consequences of such an upper bound and of the need to balance different interests and social goals, it would be most appropriate for Congress to legislate on the subject. If it chooses to do so, there would be merit in its adopting a simpler policy instrument, rather than relying on indirect, incomplete policy measures such as administrative calculation of potentially complex financial stability footprints. The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis...

Of course, the difficult question would be the applicable percentage of GDP. The answer would depend on a judgment as to how much of an impact the economy could absorb. It would also entail a judgment as to how large and complex a firm needs to be in order to achieve significant economies of scale and scope that carry social benefit... And depending on how Congress answered all these questions, there could well be need for defining transition periods and compliance margins. Even good answers to all these questions would produce a policy instrument that could seem excessively blunt to some. But this is a debate well worth having.

This profile of foreign bank operations in the United States changed in the run-up to the financial crisis. Reliance on less stable, short-term wholesale funding increased significantly. Many foreign banks shifted from the "lending branch" model to a "funding branch" model, in which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to upstream to their parents. These "funding branches" went from holding 40 percent of foreign bank branch assets in the mid-1990s to holding 75 percent of foreign bank branch assets by 2009. Foreign banks as a group moved from a position of receiving funding from their parents on a net basis in 1999 to providing significant funding to non-U.S. affiliates by the mid-2000s--more than $700 billion on a net basis by 2008.

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Finally, we should note that one of the fundamental elements of the current approach--our ability, as host supervisors, to rely on the foreign bank to act as a source of strength to its U.S. operations--has come into question in the wake of the crisis. The likelihood that some home-country governments of significant international firms will backstop their banks' foreign operations in a crisis appears to have diminished. It also appears that constraints have been placed on the ability of the home offices of some large international banks to provide support to their foreign operations. The motivations behind these actions are not hard to understand and appreciate, but they do affect the supervisory terrain for host countries such as the United States.

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At the same time, in modifying our regulatory regime for foreign banking organizations, we must remain mindful of the benefits that foreign banks can bring to our economy and of the important policies of national treatment and comparable competitive opportunity. Thus, we should chart a middle course, not moving to a fully territorial model of foreign bank regulation, but instead making targeted adjustments to address the risks I have identified. In basic terms, three such adjustments are desirable.

First, a more uniform structure should be required for the largest U.S. operations of foreign banks--specifically, that these firms establish a top-tier U.S. intermediate holding company (IHC) over all U.S. bank and nonbank subsidiaries. An IHC would make application of enhanced prudential supervision more consistent across foreign banks and reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations. Because U.S. branches and agencies are part of the foreign parent bank, they would not be included in the IHC. However, they would be subject to the activity restrictions applicable to branches and agencies today as well as to certain additional measures discussed below.

Second, the same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs...

Third, there should be liquidity standards for large U.S. operations of foreign banks... 

Proponents of breaking up firms by business line may reply that the next financial crisis will not likely have the same genesis as the last, and that separating commercial from investment banking could at least mitigate the risks of extending the safety net provided depository institutions to underwriting, trading, and other activities of very large firms. But an industrial organization perspective suggests that the proposal could entail substantial costs. The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options--from lines of credit to public equity offerings--depending on a client's needs and market conditions. Moreover, many banks that are far too small ever to be considered too big to fail do provide some capital market services to their clients--often smaller businesses--a convenience and possible cost savings that would be lost under Glass-Steagall prohibitions.

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.

Today, although some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared, non-deposit short-term funding remains significant. In some instances it involves prudentially regulated firms, directly or indirectly. In others it does not. The key condition of the so-called "shadow banking system" that makes it of systemic concern is its susceptibility to destabilizing funding runs, something that is more likely when the recipients of the short-term funding are highly leveraged, engage in substantial maturity transformation, or both…

First, the regulatory and public transparency of shadow banking markets, especially securities financing transactions, should be increased. Second, additional measures should be taken to reduce the risk of runs on money market mutual funds. The Council recently proposed a set of serious reform options to address the structural vulnerabilities in money market mutual funds.

Third, we should continue to push the private sector to reduce the risks in the settlement process for tri-party repurchase agreements. Although an industry-led task force made some progress on these issues, the Federal Reserve concluded that important problems were not likely to be successfully addressed in this process and has been using supervisory authority over the past year to press for further and faster action by the clearing banks and the dealer affiliates of bank holding companies.

While some of the more notorious pre-crisis components of the shadow banking system are probably gone forever, current examples include money market funds, the triparty repo market, and securities lending.

From the perspective of financial stability, the parts of the shadow banking system of most concern are those that create assets thought to be safe, short-term, and liquid--in effect, cash equivalents. For a variety of reasons, demand for such assets has grown steadily in recent years, and is not likely to reverse direction in the foreseeable future. Yet these are the assets whose funding is most likely to run in periods of stress, as investors realize that their resemblance to cash or insured deposits in normal times has disappeared in the face of uncertainty about their underlying value.

In the wake of the crisis, we need to consider carefully the view that central banks should assess the effect of monetary policy on financial stability and, in some instances, adjust their policy decisions to take account of these effects…

It is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification.

Here I want to mention some comments by my colleague Jeremy Stein a couple of weeks ago. After reviewing the traditional arguments against using monetary policy in response to financial stability concerns and relying instead on supervisory policies, Governor Stein offered several reasons for keeping a more open mind on the subject…[B]y altering the composition of its balance sheet, central banks may have a second policy instrument in addition to changing the targeted interest rate. So, for example, it is possible that a central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.

I think there's still a ways to go.  My concern, in particular, is the intersection of too-big-to-fail, our very large institutions, with very large wholesale funding markets that are subject to runs and, eventually then, to liquidity freezes.

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.

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way. The regularization and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large institutions.

At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalization by market actors of the systemic costs of this intermediation.

Second, to the degree that regulatory measures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.

...

[A]s a starting point, we would do well to consider measures that apply broadly. One option is to change minimum requirements for capital, liquidity, or both at all regulated firms so as to realize a macroprudential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage maturity-matched books...

Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indirect measure like a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding.

By definition, both liquidity and capital requirements would be limited to banking entities already within the perimeter of prudential regulation. The obvious questions are whether these firms at present occupy enough of the wholesale funding markets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle.

...

As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain.

The new requirements, while big improvements, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In coming years we may well seek changes. Indeed, I continue to be a strong advocate of establishing simpler, standardized risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification in the Basel Committee. And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions.The new requirements, while big improvements, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In coming years we may well seek changes. Indeed, I continue to be a strong advocate of establishing simpler, standardized risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification in the Basel Committee. And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions.

Fed. Gov. Daniel K. Tarullo said in testimony July 11 that the difference in treatment for insurers may come on the liability side. With a bank, there can be a rapid liquidation but insurance is very different, Tarullo said. There is no way to accelerate funding, he noted, referencing life insurance company payouts.

“People aren’t going to die more quickly if an insurance company is in trouble,” Tarullo said last week to demonstrate the limits of life insurance liquidations.

“With that constraint, we are working as much as we can in tailoring risk-weighting for insurance products but are a little confined here,” he said, adding to lawmakers' fears that the Fed’s hands are indeed tied for special insurance treatment.

“I think this does impose some difficulty for our oversight,” Bernanke said today of the Collins Amendment.

Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear.

First, we need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. Since the financial crisis, the ability of the Federal Reserve and other regulators to track the types of transactions that are core to shadow banking activities has improved markedly. But there remain several areas, notably involving transactions organized around an exchange of cash and securities, where gaps still exist. For example, many repurchase agreements and securities lending transactions can still only be monitored indirectly. Improved reporting in these areas would better enable regulators to detect emerging risks in the financial system.

Second, we need to reduce further the risk of runs on money market mutual funds. Late last year, the Council issued a proposed recommendation on this subject that offered three reform options. Last month, the SEC issued a proposal that includes a form of the floating net asset value (NAV) option recommended by the Council.

Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market are successfully completed. These marketwide efforts have been underway for some time and have already reduced discretionary intraday credit extended by the clearing banks by approximately 25 percent. Market participants, with the active encouragement of the Federal Reserve and other supervisors, are on track to achieve the practical elimination of all such intraday credit in the triparty settlement process by the end of 2014.

Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets.

[E]arlier this week the federal banking agencies jointly issued a proposal to implement higher leverage ratio standards for the largest, most systemically important U.S. banking organizations. We have already finalized the rules on resolution planning and stress testing, and we are working diligently this year toward finalization of the remaining standards.

[W]e should probably be skeptical as to how effective a macroprudential relaxation of regulatory requirements can be on the downside of economic cycles. Market discipline, which may have been lax in boom years, tends to become very strict when conditions deteriorate rapidly. Even if supervisors were to announce a relaxation in regulatory requirements, in stressed economic conditions, investors and counterparties may well look unfavorably on reductions in capital levels (even from higher levels) or relaxation of underwriting standards at any one firm, notwithstanding the potential benefits for the economy as a whole were all large firms to follow suit. Anticipating such a reaction, senior management of banks may thus have strong non-regulatory incentives to act as if microprudential regulation continued to dominate.

Although the amounts of short-term wholesale funding have come down from their pre-crisis peaks, this structural vulnerability remains, particularly in funding channels that can be grouped under the heading of securities financing transactions (SFTs). The use of such funding surely has the potential to increase again during periods of rapid asset appreciation and ready access to leverage. While SFTs are an important and useful part of securities markets, without effective regulation they can create a large run risk, and thus can increase systemic problems that may develop in various asset and lending markets.

The risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. Capital charges are low because credit risk is low. The Liquidity Coverage Ratio (LCR), recently adopted by the Basel Committee and soon to be implemented in the United States through a proposed rulemaking, is an important step forward for financial regulation, since it will be the first broadly applicable quantitative liquidity requirement for banking firms. But it, too, has a principally microprudential focus, since it rests on the implicit premise that maturity-matched books at individual firms present relatively low risks.

While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary's book of securities' financing transactions is perfectly matched, a reduction in the intermediary's access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary's customers are likely to be highly leveraged and maturity-transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high.

The dangers thus arise in the tail and apply to the entire financial market when normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A macroprudential regulatory measure should force some internalization by market actors of the systemic costs of this intermediation. As I have argued elsewhere, one or more such measures should be the highest priority in filling out reform agendas directed both at the largest institutions and at systemic risk more generally.25

One reason I place a high priority on initiatives to address the vulnerability created by short-term wholesale funding is that the development of these and other structural measures does not depend so heavily on identifying when credit growth or asset prices in one or more sectors of the economy have become unsustainable. Instead, an externality analysis can help identify the points of vulnerability and guide the fashioning of appropriate regulations. Indeed, what I described as structural policies may be better suited to containing certain kinds of risks than would policies requiring regular adjustment. Obviously, judgment will still be needed to determine the degree of constraint to be imposed on relevant activities of large banking organizations. But unlike real-time measures--where time will presumably be of the essence if those measures are to be effective--the adoption of structural constraints can proceed with the full opportunity for debate and public notice-and-comment that attends the rulemaking process.

The resolution mechanism created by Title II of Dodd-Frank is gaining greater operational credibility as the FDIC builds out its single-point-of-entry approach. With each rule, policy statement, cross-border agreement, and firm-specific resolution plan, that credibility is further increased. Additional measures such as those I have suggested today will continue to enhance this third option of orderly resolution, and relieve government officials of the Hobson's choice of bailout or disruptive bankruptcy for systemically important financial firms.

The most important systemic vulnerabilities that have not been subject to sufficient regulatory reforms are those created in short-term wholesale funding markets. In the recent financial crisis, severe repercussions were felt throughout the financial system as short-term wholesale lending against all but the very safest collateral froze up. Although short-term wholesale funding levels at major U.S. and foreign banking firms are lower than they were at the outset of the crisis, major global banks remain significant users. High levels of such funding increase the probability of severe funding problems at, and thus the failure of, major financial firms. They also complicate the orderly resolution of major financial firms in the event of failure.Indeed, precisely because an effective orderly resolution mechanism provides for continued funding of certain short-term creditors to staunch potentially calamitous runs, that type of funding will not be subject to the increased market discipline resulting from the creation of a credible resolution process. This fact only strengthens the case for measures to limit the potential of short-term wholesale funding to be an accelerant of systemic problems.

This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century.

The similarities between deposit runs and short-term wholesale funding runs have suggested to some that the policy responses should also be similar. Those taking this position argue for providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale funding, or both. Others, myself included, are wary of any such extension of the government safety net and would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding. Unlike deposit insurance, the savings of most U.S. households are generally not directly at risk in short-term wholesale funding arrangements. And, also unlike insured deposits, there is an argument in the short-term wholesale funding context that counterparties should be capable of providing some market discipline in at least some of the contexts in which such funding is provided.

Similarly, the LCR and, at least at this stage of its development, the Net Stable Funding Ratio (NSFR), both assume that a firm with a perfectly matched book is in a stable position. The LCR assumes a bank can call in reverse repos and other SFT assets that mature in less than 30 days or reuse the collateral that secures those assets for purposes of its own borrowing. Thus, reverse repos and other SFT assets generally are treated as completely liquid instruments. Under the initial version of the NSFR, firms would not need to hold any stable funding against reverse repos, securities borrowing receivables, or other loans to financial entities that mature in less than one year. Again, this may be a reasonable position from a microprudential perspective, geared toward more or less normal times. But here is where we need an explicitly macroprudential perspective that forces firms to internalize the tail-event financial stability risks associated with SFT matched books.

Among the first set of options, the idea that seems most promising is to tie capital and liquidity standards together by requiring higher levels of capital for large firms that substantially rely on short-term wholesale funding. The additional capital requirement would be calculated by reference to a definition of short-term wholesale funding, such as total liabilities minus regulatory capital, insured deposits, and obligations with a remaining maturity of greater than a specified term. There might be a kind of weighting system to take account of the specific risk characteristics of different forms of funding. The capital requirement would then be added to the Tier 1 common equity requirement already mandated by the minimum capital, capital conservation buffer, and globally systemic bank surcharge standards. However, this component of the Tier 1 common equity requirement would be calculated by reference to the liability side, rather than the asset side, of the firm's balance sheet.

It does not seem far-fetched to think that, with time and sufficient economic incentive, the financial, technological, and regulatory barriers to the disintermediation of prudentially regulated dealers could be overcome. Indeed, there have already been reports of some hedge funds exploring the possibility of disintermediating dealers by lending cash against securities collateral to other market participants.


For this reason, there is a need to supplement prudential bank regulation with a third set of policy options in the form of regulatory tools that can be applied on a market-wide basis. That is, regulation would focus on particular kinds of transactions, rather than just the nature of the firm engaging in the transactions. To date, over-the-counter derivatives reform is the primary example of a post-crisis effort at market-wide regulation.5 Given that the 2007–2008 financial crisis was driven more by disruptions in the SFT markets than by disruptions in the over-the-counter derivative markets, comparable attention to SFT markets is surely needed. Over the past two years, the Financial Stability Board (FSB) has been evaluating proposals for a system of haircuts and margin requirements for SFTs. In its broadest form, a system of numerical floors for SFT haircuts would require any entity that wants to borrow against any security to post a minimum amount of excess margin that would vary depending on the asset class of the collateral. Like minimum margin requirements for derivatives, numerical floors for SFT haircuts would be intended to serve as a mechanism for limiting the build up of leverage at the security level, and could mitigate the risk of procyclical margin calls.

Still, we have yet to address head-on the financial stability risks from securities financing transactions and other forms of short-term wholesale funding that lie at the heart of shadow banking. There are two fundamental goals that policy should be designed to achieve. The first is to address the specific financial stability risks posed by the use of large amounts of short-term wholesale funding by the largest, most complex banking organizations. The second is to respond to the more general macroprudential concerns raised by short-term collateralized borrowing arrangements throughout the financial system.

Tarullo said he has an “open mind” on whether the Fed should try to encourage lending by reducing the interest rate it pays banks on excess reserves.

“There’s been a good bit of back and forth on whether the rate should be lowered now, in an effort to push more lending out the door,” Tarullo said in response to an audience question. “I’ve got an open mind on that.”

Central banks, in turn, may want to build on some recent experience, adapted for more normal times, in addressing the desire to contain systemic risk without removing monetary policy accommodation to advance one or both dual mandate goals.
One example would be altering the composition of a central bank's balance sheet so as to add a second policy instrument to changes in the targeted interest rate. The central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.

While ad hoc supervisory action aimed at specific lending or risks is surely a useful tool, it has its limitations. First, it is a bit too soon to judge precisely how effective these supervisory actions--such as last year's leveraged lending guidance--have been. Second, even if they prove effective in containing discrete excesses, it is not clear that the somewhat deliberate supervisory process would be adequate to deal with a more pervasive reach for yield affecting many areas of credit extension. Third, and perhaps most important, the extent to which supervisory practice can either lean against the wind or increase the overall resiliency of the financial system is limited by the fact that it applies only to prudentially regulated firms. This circumstance creates an incentive for intermediation activities to migrate outside of the regulated sector.
…
As I have said previously, however, given that procyclicality is an important contributor to systemic risk, there is good reason to continue work on developing time-varying policies. I would devote particular attention to policies that can act as the rough equivalent of an increase in interest rates for particular sources of funding…
One example is the countercyclical capital buffer in Basel III, which provides for an increase in the risk-weighted capital requirements of prudentially regulated banking organizations of up to 2-1/2 percentage points when "credit growth is excessive and is leading to the buildup of system-wide risk."10 Because stricter capital requirements lead to higher levels of bank equity--which is typically more expensive than debt--they would likely result in higher funding costs for the bank-intermediated credit utilized by other market participants. In this regard, time-varying macroprudential policies can be thought of as addressing cyclical systemic risks via interest rates in a manner somewhat akin to a tightening of monetary policy, which by raising benchmark interest rates affects a similar increase in funding costs.
Clearly, time-varying macroprudential policies could not be viewed as a substitute for monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of transactions and, as such, would not "get in all the cracks" of the financial system, to use a phrase coined by my colleague Jeremy Stein. But, to shift metaphors, they could potentially provide something of a speed bump, while not producing the much broader effect on the economy that a federal funds rate increase would. Moreover, time-varying macroprudential policies may also give monetary policymakers more of an opportunity to assess whether the asset inflation is generalized and sustained enough to warrant a change in monetary policy.

We are paying close attention to the macroprudential risks posed by the low interest rate environment, particularly given the possibility that interest rates may remain historically low for some time even after the FOMC begins to increase its target for the federal funds rate.

One recent trend that is particularly disturbing is stagnation in the formation of new firms. Statistics from the Bureau of Labor Statistics (BLS) show that the number of establishments in operation for less than one year rose between the mid-1990s, when the data start, and the early 2000s. But, smoothing through the ups and downs of the business cycle, new firm formation has been roughly flat since then. Moreover, the number of individuals working at such firms stands almost 2 million below its peak in 1999. Given the role of innovation by entrepreneurs and the well-documented importance of successful young firms in creating jobs, these trends are disheartening.
…
One recent trend that is particularly disturbing is stagnation in the formation of new firms. Statistics from the Bureau of Labor Statistics (BLS) show that the number of establishments in operation for less than one year rose between the mid-1990s, when the data start, and the early 2000s. But, smoothing through the ups and downs of the business cycle, new firm formation has been roughly flat since then. Moreover, the number of individuals working at such firms stands almost 2 million below its peak in 1999. Given the role of innovation by entrepreneurs and the well-documented importance of successful young firms in creating jobs, these trends are disheartening.

The special regulatory aims for such institutions should reflect this systemic focus. The very large negative externalities associated with such failures could be realized through a classic domino effect or through contagion effects. As the financial crisis showed, losses in a tail event are likely to be correlated for large firms deeply engaged in trading, structured products, and other capital market instruments, and relying on similar sources of short-term funding. Thus, the regulatory framework should aim to reduce the chances of distress or failure at such firms to a greater extent than traditional, microprudential regulation would. Moreover, it should explicitly take into account the correlations and inter-dependencies in asset holdings and funding…

At the other end of the spectrum are community banks, conventionally defined as those with less than $10 billion in assets… While these banks will suffer the fallout from systemic problems, they are unlikely to cause such problems. The regulatory aim, therefore, is about as close as can be to the traditional microprudential bank regulatory aims of protecting the federal DIF and limiting the use of insured deposits by restricting the scope of bank activities. It is true that the relative lack of geographic and portfolio diversification in many community banks can make them vulnerable to localized economic problems. But that is just the kind of problem that traditional microprudential regulation has been concerned with addressing.

[P]re-crisis statutes and regulations reflected what I have termed a unitary approach to banking regulation. The core of banking regulation could be explained with a relatively simple narrative, by which deposit insurance and access to the discount window had been granted to depository institutions in order to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified everything from capital requirements to limitations on banks getting into nonbanking businesses. ..
Of course, banking law had not only tried to protect the DIF from the risky activities of banks and their affiliates. It had also, albeit far less explicitly, tried to protect banks from nonbank competition and, to some degree, from each other.3 Just as banks were supposed to stick to their knitting--the business of banking--so everyone else was supposed to stay out of that business..
The financial crisis has confirmed that the pre-crisis regulatory structure reflected a view of the financial system that was at once too broad and too narrow. It was too broad in that prudential rules generally applied to all banks and bank holding companies through a microprudential approach focused on the soundness of each individual bank. .. [T]he principles informing regulation were basically the same whether the institution was a community bank or a holding company with a $1 trillion balance sheet whose failure might shake the entire financial system.
The prudential regulatory structure was too narrow in that it did not extend to firms and activities outside of banking organizations, even those that could pose a threat to financial stability, because the soundness of the federal deposit insurance system was not implicated. Thus Lehman Brothers, whose failure did seriously shake the financial system, was not subject to even the microprudential standards applicable to bank holding companies…
…
One regulatory innovation in Dodd-Frank that is particularly salient for present purposes was the creation of different categories of banking organizations--largely, but not exclusively, on the basis of total assets--to which different regulatory requirements are to apply.

In implementing the section 165 requirement of increasing stringency for enhanced prudential standards applicable to banking organizations of increasing systemic importance, the Federal Reserve has essentially created several categories within the universe of banking organizations with $50 billion or more in assets. All firms in this universe will be subject to the basic enhanced standards, including supervisory stress tests, capital plan submissions, resolution plan requirements, single counterparty credit limits, and a modified form of the Liquidity Coverage Ratio (LCR) requirement that was part of Basel III. Firms with at least $250 billion in assets or $10 billion in on-balance-sheet foreign assets are also subject to the advanced approach risk-based capital requirements of Basel II, the Basel III supplementary leverage ratio, the full LCR requirement, and the countercyclical capital buffer provision of Basel III.6 The eight U.S. firms designated as global systemically important banks will be additionally subject to risk-based capital surcharges, the enhanced Basel III supplementary leverage ratio, tighter single counterparty credit limits, and a long-term debt requirement designed to support the effectiveness of orderly resolution processes. In addition, the supervision of these firms is overseen by the Large Institution Supervision Coordinating Committee (LISCC), an inter-disciplinary group created by the Federal Reserve Board in 2010.7
Thus, there are regulatory categories for banks with $10 billion or more in assets, with $50 billion in assets, with either $250 billion in assets or $10 billion in foreign assets, and with a combination of large asset holdings and other characteristics that have resulted in their being designated of global systemic importance. In fact, Dodd-Frank creates another category of banks in making its provision on incentive compensation applicable to banking organizations with at least $1 billion in assets. Clearly, the unitary approach of the pre-crisis period has been abandoned.

There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every notice of a "Matter Requiring Attention" (MRA) issued by supervisors must be reviewed, and compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards.

Born of necessity during the depths of the financial crisis as part of an effort to restore confidence in the U.S. financial system, supervisory stress testing has in the intervening five years become a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions. First, of course, it is a means for assuring that large, complex financial institutions have sufficient capital to allow them to remain viable intermediaries even under highly stressful conditions. More broadly, supervisory stress testing and the associated review of capital planning processes have provided a platform for building out a regulatory framework that is more dynamic, more macroprudential, and more data-driven than pre-crisis practice...

While some important features of capital planning are observable only during the formal CCAR process, most of the risk-management and capital planning standards incorporated in CCAR are operative and observable by supervisors throughout the year. These should be an important focus of ongoing supervisory oversight and of discussions between firms and supervisors. Only in unusual circumstances should supervisors learn for the first time during CCAR of significant problems in the quality of the capital planning processes, and only in unusual circumstances should firms be surprised at the outcome of the qualitative assessment.

We have already taken steps to further this integration of CCAR and regular supervision. At the end of each CCAR process our supervisors send to each firm a letter detailing their conclusions concerning the qualitative assessment. To the extent weaknesses or areas for improvement are identified, those letters provide a basis for regular stocktaking by both firms and supervisors. More generally, last year we released a paper on our expectations for all aspects of capital planning, providing greater detail than what is included in the annual CCAR instructions.

I anticipate that we will take additional steps to integrate ongoing supervisory assessments of risk-management and other internal control processes with the annual CCAR exercise, and to assure that communications in both directions are heard. One such step has just recently begun: The committee chaired by senior Board staff that is responsible for the oversight of CCAR, supported by the relevant horizontal assessment teams, will directly engage with firms during the course of the year to evaluate progress in remediating weaknesses or other issues identified in the post-CCAR letters. Increasingly, our regular supervisory work on topics such as risk-identification and internal audit will focus on processes that are critical to risk management and capital planning at the firms, areas of focus for CCAR. The aim of these and additional measures is to make CCAR more the culmination of year-round supervision of risk-management and capital planning processes than a discrete exercise that takes place at the same time as the supervisory stress tests...

Although strong capital regulation is critical to ensuring the safety and soundness of our largest financial institutions, it is not a panacea, as indeed no single regulatory device can ever be. Similarly, supervisory stress testing and CCAR, while central to ensuring strong capital positions for large firms, are not the only important elements of our supervisory program. Having said that, however, I hope you will take at least these three points away from my remarks today.

First, supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis.

Second, supervisory stress testing and CCAR have provided the first significant form of supervision conducted in a horizontal, coordinated fashion, affording a single view of an entire portfolio of institutions, as well as more data-rich insight into each institution individually. As such, these programs have opened the way for similar supervisory activities and continue to teach us how to organize our supervisory efforts in order most effectively to safeguard firm soundness and financial stability.

Finally, supervisory stress testing and CCAR are the exemplary cases of how supervision that aspires to keep up with the dynamism of financial firms and financial markets must itself be composed of adaptive tools. If regulators are to make the necessary adaptations, they must be open to the comments, critiques, and suggestions of those outside the regulatory community. For this reason, transparency around the aims, assumptions, and methodologies of stress testing and our review of capital plans must be preserved and extended.

[W]e believe that more needs to be done to guard against short-term wholesale funding risks. While the total amount of short-term wholesale funding is lower today than immediately before the crisis, volumes are still large relative to the size of the financial system. Furthermore, some of the factors that account for the reduction in short-term wholesale funding volumes, such as the unusually flat yield curve environment and lingering risk aversion from the crisis, are likely to prove transitory.

Federal Reserve staff is currently working on three sets of initiatives to address residual short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. GSIBs. The second involves proposed modifications to the BCBS's net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants. The third is numerical floors for collateral haircuts in securities financing transactions (SFTs)--including repos and reverse repos, securities lending and borrowing, and securities margin lending.

Federal Reserve staff is currently working on three sets of initiatives to address residual short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. GSIBs. The second involves proposed modifications to the BCBS's net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants. The third is numerical floors for collateral haircuts in securities financing transactions (SFTs)--including repos and reverse repos, securities lending and borrowing, and securities margin lending.

I want to observe that regulators can unwittingly reinforce what I have termed a mere compliance mentality. I would first note that the detail of many regulations means that attention to narrow issues of compliance is sometimes wholly understandable and, indeed, essential. Banks, like other regulated entities, need to be able to determine how a regulation actually applies to them. Beyond that kind of unavoidable focus on narrow compliance, however, management and line employees are more likely to adopt a mere compliance mentality where regulations appear to them to have been poorly drafted or implemented This is an outcome that regulators can avoid, and something with which the regulated firms themselves can assist by pointing out what they would regard as more sensible methods for achieving stated regulatory purposes.

For more than 75 years following passage of the Banking Act of 1933, the motivation for banking regulation was fairly simple: the government had granted deposit insurance and access to the discount window to depository institutions to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified prudential measures, including prohibitions on non-banking activities, aimed at maintaining safe and sound banks, which would in turn protect taxpayers.

There is now more widespread agreement that these aims should vary according to the size, scope, and range of activities of banking organizations. Most significantly, banks of a size and complexity such that serious stress or failure could pose risks to the entire financial system need regulation that incorporates the macroprudential aim of protecting financial stability. There is also a good argument that very large banks that fall short of this level of systemic importance should nonetheless be regulated with an eye to macroprudential aims, such as the ability of the banking system as a whole to provide credit.

Although individual community banks may be an important source of credit, particularly in local economies outside urban areas, neither systemic risk nor broad macroprudential considerations are significant in thinking about prudential regulation of community banks. So what should the aims of such regulation be? The basic answer is it should protect the deposit insurance fund. In other words, the traditional microprudential approach to safety and soundness regulation continues to be appropriate for these banks.

Beginning in the 1970s, deposits began to decline as a proportion of funding for credit intermediation, as the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down. During the succeeding three decades, these activities became progressively more integrated, as credit intermediation relied more heavily on capital market instruments sold to institutional investors. Over time, these markets became--like traditional commercial banks--an important locus of maturity transformation, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid.

When, in 2007, questions arose about the quality of some of the assets on which this intermediation system was based--notably, those tied to poorly underwritten subprime mortgages--a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop. In short, the financial industry in the years preceding the crisis had been transformed into one that was highly susceptible to runs on the short-term, uninsured cash equivalents that funded longer-term extensions of credit.

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.

Standing in front of this audience I feel secure in observing that we are all macroprudentialists now.
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In mapping out the range of macroprudential policies, analysts have developed various taxonomies. Common to most is the distinction between tools designed to prevent systemic risk from building by "leaning against the wind" and tools designed to increase the resiliency of the financial system should systemic risk nonetheless build and lead to broad-based stress As I have explained elsewhere, I think a distinction of equal--if not greater--importance is between structural or "through the cycle" tools, on the one hand, and time-varying tools, on the other. Structural macroprudential tools are put in place as a part of the ongoing regulatory structure, but they are designed specifically from a systemic, as opposed to a firm- or asset-specific, perspective.

Many proponents of macroprudential policy seem particularly attracted to time-varying measures for both resiliency and lean-against-wind measures. The aim is to regulate in an explicitly countercyclical fashion through measures that attempt to restrain rapid, unsustainable increases in credit extension or asset prices--either directly or through shifts in incentives--and to relax those measures as economic conditions deteriorate. One can readily understand the conceptual appeal of this approach, but it raises a fair number of significant issues--analytic, practical, institutional, and legal. These include the reliability of measures of excess or systemic risk, the appropriate officials to be making macroprudential decisions, the speed with which measures might realistically be implemented and take effect, and the right calibration of measures that will be efficacious in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy.

One policy response that the Federal Reserve has advocated and that has now been proposed by the Financial Stability Board (FSB), is for minimum margins to be required for certain forms of securities financing transactions (SFTs) that involve extensions of credit to parties that are not prudentially regulated financial institutions.6 This system of margins is intended to serve the macroprudential aim of moderating the build-up of leverage in the use of these securities in less regulated parts of the financial system and to mitigate the risk of procyclical margin calls by preventing their decline to unsustainable levels during credit booms.

Given the ease with which such transactions may move across borders, it is particularly important that the FSB has proposed a framework that could be applicable in all major financial markets. We will welcome comments on this proposal when, as I expect, the Federal Reserve issues a notice of proposed rulemaking to implement it domestically, probably by using the Federal Reserve's authority under the Securities Exchange Act of 1934 to supplement our prudential regulatory authorities. But it is also important to continue analysis of other macroprudential policy options that would address the risks associated with short-term wholesale funding. Indeed, even the FSB proposal does not extend to SFTs backed by government collateral, a very important source of short-term wholesale funds.

My third policy objective with a macroprudential component relates to central counterparties (CCPs). A key regulatory aim following the crisis, both in the United States and internationally, has been to encourage more derivatives and other financial transactions to be cleared through CCPs. There are important financial stability benefits to be gained from the progress that has been made toward this aim--including multilateral netting, standardized initial and variation margin requirements, and greater transparency.
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Notwithstanding the advances in CCP regulation, questions have been raised in international fora, in discussions among domestic financial and regulatory officials, and by some market participants over whether more needs to be done. To me, at least, some of the most important questions implicate macroprudential concerns. One discrete example is the possibility that CCP margining practices may have a significantly procyclical character that could be problematic in deteriorating financial conditions.

"There does seem to be something different” in bond markets right now, the official said. “Something does seem to have changed” in terms of things like the ability of a market participant to easily execute a large trade, he said.

As it now stands, “I don’t think there is at this point a very precise and convincing explanation for exactly what has happened,” Mr. Tarullo said. He noted signs of fragility could be tied to regulatory changes, the rise of high frequency trading and firms’ willingness to engage in the market as potential drivers of current market conditions.

From the point of view of authorities, “there may be action needed at the end of the day. But I wouldn’t jump the conclusion a bigger balance sheet equates to financial stability,” Mr. Tarullo said.

[T]he liability side of the balance sheets of firms that are all "insurance companies" can vary substantially, just as with firms that are called "banks" or "bank holding companies." Yet capital regulation currently applicable to insurance companies seems not to make some of the relevant distinctions.

Steve Liesman: Would you put yourself in the camp of one expecting a rate hike this year?

Dan Tarullo: I would -- you know, I do want to orient towards how I think about the economy. Based on what I just said and based also on what one might call a risk management approach of being concerned that a premature rise might be harder to deal with than waiting a little bit longer, right now my expectation is given where I think the economy would go I wouldn't expect it would be appropriate to raise rates. But I want to hasten to add that is an outlook that changes based on developments in the economy and our being forward looking about it. i do think there's been too much focus on a particular meeting and a particular date and not enough on the overall conditions of the economy.

Steve Liesman: I just have one question about all of this stuff Is it the policy of the Federal Reserve to force large banks to be smaller?

Dan Tarullo: It's not the policy to force them to be smaller. But I think it is the policy of our bank regulatory system as embodied in congressional legislation to make sure that large institutions of systemic importance do internalize the potential risks to the broader economy from their size and interconnectedness. So in essence, a firm has a choice which is that it can either maintain substantially higher capital levels or it can make a judgement that some forms of business or certain size of that business may not be worth the higher capital charge that takes account of those negative externalities. It really is up to the institution to make that evaluation but what we've tried to do it in a context that forces them to internalize costs.

There is a good bit of uncertainty right now, as you know, there's the debate between whether we've got an extended cyclical effect or whether there is some secular things going on in the economy that are changing growth potential and changing optimal policy. I don't think the FOMC is going to be able to disentangle that when -- before we have to make decisions. I do think under these circumstances it's probably wise not to be counting so much on past correlations, things like the Philips curve which haven't been operating effectively for ten years now. And instead to really look for some tangible evidence of, for example, hiccups in wages or inflation that allow us to make informed decisions based on the evidence.

One often hears complaints that the emphasis on financial stability will result in the balkanization of international banking. I would note first that it is not at all clear that developments since the crisis have on net balkanized banking.
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Second, I wonder how these critics can think that the pre-crisis situation of supposedly consolidated oversight and substantial bank flexibility was a desirable one. At least some of the flexibility enjoyed by banks in shifting capital and liquidity around the globe was deployed in pursuit of unsustainable activity that eventually ran badly aground.

While I favor assessment of the specific risks and costs associated with a particular form of nonbank intermediation, I also believe that the greatest risks to financial stability are the funding runs and asset fire sales associated with reliance on short-term wholesale funding, and thus I place particular emphasis on this factor. If there is one lesson to be drawn from the financial crisis, it is that the rapid withdrawal of funding by short-term credit providers can lead to systemic problems as consequential as those associated with classic runs on traditional banks

Some Fed officials, led by Vice Chairman Stanley Fischer, have argued that inflation will move back up close to 2 percent as the transitory effects of a strengthened dollar and oil’s price plunge fade.

Tarullo said he wasn’t in that camp.

“Others, myself included, have thought it might be better to wait for some more tangible evidence that we’re going in that direction” on inflation, he said.
Tarullo pointed to market-based and survey-based measures of inflation expectations, saying both had fallen to “historic lows.”

With Brexit, obviously, there’s just a lot of uncertainty... Obviously, if there are implications for growth over time, that’s something that would affect our ongoing monetary policy.”

“With Brexit, obviously, there’s just a lot of uncertainty,” Tarullo said in a Bloomberg Television interview Thursday, pointing to the question of whether the U.K. would vote in the June 23 referendum to remain in the EU or leave. “In the short term I think it’s more of a question of the immediate impact on markets. Obviously, if there are implications for growth over time, that’s something that would affect our ongoing monetary policy.”

The second approach [to Fed policy], which I’ve been a little bit more inclined towards, is to say, "Gee, you know, it’s not clear what full employment is, we’re in a global environment which is not inflationary, and we can perhaps get some more employment and some higher wages"... Are we at a point where there’s an affirmative reason to move?