What Changes Are Needed in the U.S. Financial System?
This is a "pseudo-interview" with William Dudley, President of the Federal Reserve Bank of New York, based upon a lightly edited version of a speech he gave recently in Australia entitled "The U.S. Financial System: Where We Have Been, Where We Are and Where We Need to Go."
Before we start the interview, let me check on something. When I post this, can I say you represent the official view of the Federal Reserve System?
As always, my views are my own and do not necessarily reflect those of the Federal Open Market Committee or the Federal Reserve System.I was trying -- unsuccessfully -- to be funny, but I guess that's not something you can joke about.
Let's get right to it. I want to ask you about the Fed's regulatory response to the crisis, and how the response will reduce the chances of another financial crisis occurring. But first, let's talk about what caused the crisis and the Fed's past failures as a regulator.
What caused the financial crisis?
It is important to recognize that the financial crisis occurred for a host of reasons and, thus, there is no single silver bullet to avoid such crises in the future.Is there one factor that is more important than the others?
At the heart of the crisis was a tremendous buildup in leverage, which our regulatory framework failed to prevent.I see leverage as something that made the crisis much worse once it started, but I don't believe leverage was the cause of the crisis. But high leverage surely made the system vulnerable to collapse once a shock hit, and the limitation of leverage is a key safety factor going forward.
But I think I interrupted you -- you were talking about the build up of leverage and the subsequent collapse of the financial system. Why didn't regulators see the potential damage that high leverage ratios could produce?
As a general matter, regulators did not appreciate beforehand how vulnerable the system was to shocks. In particular, there was a failure to appreciate the important interconnections among the banking system, capital markets, and payment and settlement system.I've been arguing for some time now that interconnectedness was an important factor. In addition to the regulation of leverage, I'd like to see interconnectedness monitored. That will require us to develop measures of connectedness, to determine the critical threshold for connectedness, and then not allow that limit to be crossed.
But we'll get to regulatory responses later. Let me ask again, why didn't regulators understand the dangers that high leverage and high degrees of interconnectedness pose?
Regulators did not adequately understand how the dynamics of the system tended to exacerbate shocks, rather than dampen their impact.Was the lack of adequate understanding of leverage and connectedness the only place regulators failed? Or were there other problems as well?
Regulatory gaps were another important factor in causing the crisis. American International Group, Inc. (AIG) is a case in point. AIG Financial Products, a subsidiary of the AIG parent company, provided guarantees against default on complex collateralized debt obligations, leveraging the AAA rating of the AIG parent company in the process. This activity was conducted with inadequate regulatory oversight, poor risk management and insufficient capital.That was certainly a problem, and it comes under the general failure to bring the shadow banking system under the same regulatory umbrella as the traditional banking system, something that must be fixed going forward. But I was thinking more along the lines of the failure to use regulation to eliminate bad incentives within the system. Wasn't that a problem too?
Many of the incentives built into the system ultimately undermined its stability. The problems with incentives were evident in a number of areas, including faulty compensation schemes and risk management that was too narrowly focused on one business area without regard for the broader entity. These incentives created important externalities in which participants did not bear the full costs of their actions.I was also thinking of the bad incentives within the ratings agencies. The ratings agencies were being hired and paid by the firms they were rating. If they gave the asset the firm hired it to rate a bad rating, they might not get hired again. That's something that still needs to be fixed.
I should also note that you did not mention the Fed's low interest rate policy or a global savings glut as causes of the crisis, but let's move on to something else.
After the crisis, policymakers stepped in and tried to prop up the financial system. Have they been successful? Where does the financial system stand today?
The U.S. financial system is in much better shape today than it was a year ago. The capital markets are generally open for business--with the important exception of some securitization markets--and the major securities dealers that survived the crisis have seen a sharp recovery in profitability. The largest U.S. bank holding companies have more and better quality capital.But isn't the worry with medium and smaller sized banks?
Many smaller and medium-sized banks remain under significant pressure.What's behind these problems?
This reflects several factors. First, such institutions hold assets that are carried mainly on the books on an accrual basis. Compared with mark-to-market assets, such assets adjust much more slowly to changes in market conditions and the economic environment. Second, many of these banks have a much more concentrated exposure to commercial real estate, a sector that remains under considerable pressure. Loan losses in commercial real estate and consumer and mortgage loans seem likely to continue to pressure smaller banks for some time to come. This in turn means that credit availability to households and small businesses will still be curtailed.The commercial real estate market is worrisome. I've heard many assurances that any failures due to bad commercial real estate loans will be easy to contain, but I heard the same reassurances before the financial crisis. I hope the people doing the reassuring are right this time.
Let's look to the future. What do we need to do to prevent the next crisis from happening?
We need to build a strong and resilient financial system. In my opinion, three broad sets of actions are needed:How important is macroprudential supervision?
- Effective macroprudential supervision. By this, I mean conducting supervision not just vertically institution by institution, but also horizontally across institutions and markets. We need to better understand how the system operates as a whole and how problems in one area can affect financial stability elsewhere. This means both how the overall system affects individual firms and how the activities of a single firm or market affects the entire financial system.
- Make financial institutions and market infrastructures more robust to withstand shocks and become less prone to failure.
- Change the system so that no financial firm is "too big to fail."
Macroprudential supervision is essential for two reasons. First, it addresses the problem of gaps in the regulatory regime and the regulatory arbitrage that such gaps can encourage. Second, macroprudential supervision is needed because the financial system is interconnected. Siloed regulatory oversight is not sufficient. Supervisory practices must be revamped so that supervision is also horizontal--looking broadly across banks, nonbanks, markets and geographies. This also means that regulatory standards need to be harmonized across different regions. Without harmonization, there will inevitably be a "race to the bottom" and regulatory arbitrage will be encouraged, rather than inhibited.That's one of the reasons why I favor a single regulator rather than multiple agencies. With multiple agencies and potentially overlapping jurisdictions, competition among agencies leads all too easily to a regulatory "race to the bottom."
What about the second point. How do you make the system less prone to failure?
Many steps are needed to make financial institutions and infrastructure more robust. For example, we need to strengthen bank capital requirements, improve liquidity buffers and make financial market infrastructures more resilient to shocks when individual firms get into trouble.And when you say you'd increase capital requirements, I assume you also mean to add that it would limit leverage?
In terms of capital requirements, many changes are needed, including an overall leverage limit.One problem in the current crisis is that taxpayers had to foot the bill for the bailout. Would any of your proposals help with that problem?
It would also be very desirable to develop a mechanism to bolster the amount of common equity available to absorb losses in adverse economic environments. This might be done most efficiently by allowing the issuance of debt instruments that would automatically convert to common equity in stress environments, under certain pre-specified conditions.There are many other problems as well such as executive compensation...
There is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk-taking.We're almost out of time, so I was actually leading to a different issue. What about the too big to fail problem, what can be done about that?
It is critical that we ensure that no firm is too big to fail. This is about both fairness and having proper incentives in the financial system. Having some firms that are too big to fail creates moral hazard. These firms are able to obtain funding on more attractive terms because debt holders expect that the government will intervene rather than allow failure. In addition, too big to fail creates perverse incentives. In a too-big-to-fail regime, firms have an incentive to get large, not because it facilitates greater efficiency, but instead because the implicit government backstop enables the too-big-to-fail firm to achieve lower funding costs.What's the solution?
To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.
Second, we need to reduce the likelihood that systemically important institutions will come close to failure in the first place. This can be done by mandating higher capital requirements, improving the risk capture of those requirements and by requiring greater liquidity buffers for such firms.You didn't say anything about breaking big banks up or setting size limits, so I'll assume that's not part of your plan. Unfortunately, we're out of time so I can't follow up on that point. Maybe next time.
In the few seconds that are left, do you have anything else you want to add?
Although the raging crisis appears to be over, our work is not close to being complete. Making sure this work keeps moving forward and is coordinated internationally is hugely important. Differences in views across countries and regions should not divert the international community from the more important prize--taking the actions collectively that will ensure a robust and resilient financial system.I agree with the importance of international cooperation. But right now I'll settle for enough domestic cooperation among our political parties to produce effective legislation, though I can't say I'm encouraged by what has come out of congress so far.
However, there is quite a bit the Fed can do that does not require congressional approval. I have more hope for the Fed than I do for congress, but it's not yet clear that the Fed will be as tough as it needs to be, especially on the too big to fail issue.
Thanks.
