Download Beverly Hirtle (New York Fed)

Thoughts on Financial Regulatory Reform
Beverly Hirtle
International Conference “Reforming Financial Regulation and Supervision:
Going Back to Basics”
Banco de España
June 15, 2009
Disclaimer
The views in this presentation are those of the author and
do not necessarily reflect the views of the Federal Reserve
Bank of New York or of the Federal Reserve System.
2
Regulatory Reform: the (many) devils in the details

Some amount of consensus around key failures and their
implications.

Many efforts underway to address these issues.

But many other suggestions and “big picture” ideas still to be
developed and implemented.

What are the key issues in following these through?

One example of something that’s already been done that might
offer some lessons and further insights.
3
Key Regulatory and Risk Management Failures

Fragmented and inconsistent consolidated supervision of
systemically important financial institutions.

Externalities not always recognized
 “Regulatory arbitrage”

Idiosyncratic, rather than macro, approach to risk management,
risk mitigation, and contingency planning.

Macroeconomic and financial market conditions?
 Conditions of other firms and other market participants?

Failure to recognize and curb incentives to take on “tail risk.”
Short historical horizon (“myopia”)?
 Recognition of risk but hiding in a crowd?
 Positive incentives to take tail risk?

4
Implications for Regulatory and Supervisory Reform

Important to consider macroeconomic conditions and conditions
of other firms in assessing risk, crafting risk mitigation strategies,
and determining policy.

Comprehensiveness is vital, both within and across firms.

The definition of “systemically important” can differ with
macroeconomic and financial market conditions.

“Clustering” in risk mitigation can be as risky as clustering in
position-taking or portfolio composition.
5
Four Focuses of Regulatory and Supervisory Reform

Indentifying systemically important financial institutions


Regulatory capital regime


The regulatory rules and supervisory expectations about capital
Internalizing and limiting externalities


Those with the greatest potential to impact others, especially in stressful conditions
The impact of individual firms on others
Macro-prudential supervisory approaches

The broad view of developments
 The intersection of firm-specific and market-wide perspectives and actions
6
Priorities for Reform: Identifying “Systemically Important”
Financial Institutions

Important if these firms are to receive differentiated regulation or supervisory
attention.

Important for ex ante policy development.

But…

How to capture different ways a firm can be systemically important?

How to measure key characteristics (size, leverage, complexity, interconnectedness)?

Identify specific measures that will withstand the test of time?

What are the (unintended) consequences of focusing on particular measures?

How to make the definition dynamic and evolutionary?

Are a wider set of firms “systemically important” in stressful conditions than in
normal conditions?

Should such firms be identified publicly?
7
Priorities for Reform: Regulatory Capital Regime

Current focus on counter-cyclical requirements (the denominator) or buffers (the
ratio)


Requirements that vary by the amount of leverage or credit growth (Genena Report)
Requirements that vary by state of real economic activity

but alternatively….

Contingent capital: preferred or sub debt that converts to common at some prespecified macro and/or firm-specific trigger (Flannery, Squam Lake Group).

Questions….

How to specify the trigger(s)?

How to structure the security so it isn’t “game-able” by market participants?

How much is enough and who decides? Does it vary over time?

Could the trigger event itself be de-stabilizing?
8
Priorities for Reform: Internalizing and limiting system risk
externalities

Rules or incentives or both?

Rules: direct limits on size, market share, corporate structure, activities,
geographic scope.

Incentives: regulatory “tax” (capital requirements, liquidity requirements,
disclosure/transparency requirements).

Questions….

How best to limit gaming and arbitrage?

Rules can be avoided or evaded.
 Incentives can be mis-calibrated in size or direction.

How to stop “rules cascade,” in which one rule begets another which begets
another…?

How to set the level of the “tax” correctly?
9
Macro-prudential supervision: One example

Many potential meanings for “macro prudential supervision”

A system-wide or market-wide view of developments
 Focus on the aggregate, not (just) the individual pieces
 Track trends in factors related to stability of the system (e.g., leverage)
 Track developments affecting systemically important firms and instituitons

One recent exercise that offers some insights:
 The
U.S. Supervisory Capital Assessment Program or the “stress
tests”
10
The Supervisory Capital Assessment Program (SCAP)

The SCAP was a supervisory exercise to determine the amount capital needed
to ensure bank holding companies (BHCs) remain well-capitalized in a stressed
economic environment.

19 large BHCs – two-thirds of assets and half of loans of U.S. banking system.

Two-year forward projection of losses, resources, and capital needs under two
macroeconomic scenarios: “baseline” and “more adverse”.

Do banks have “buffer” large enough to absorb losses in “more adverse”
scenario and still meet target capital ratios?

10 of 19 BHCs required to increase their capital buffers by a total of $75 billion,
predominantly common equity.
11
SCAP Process

BHC projections subjected to extensive review by supervisors, analysts, and economists.


Teams with specialists in accounting, regulatory capital, risk management, asset pricing.
Insights from on-site supervisory teams.

Developed a “top down” view of average loan loss rates and revenues based on work of
economists and analysis of historical data. This allowed us to benchmark the results for
individual banks and in the aggregate.

Additional data requests for detailed information on loan and securities portfolio
characteristics, revenue and expense sources, trading books, counterparty exposures,
hedges, capital action.

Independent benchmark models, including vendor models, existing supervisory models,
and newly developed models that used the detail data. Allowed for differentiation across
firms.

All combined into final loss estimates, revenue projections, and capital need calculations.
12
Lessons from the SCAP

Importance of having the macro (“top down”) view that
incorporates history, as well as the “bottom up”.

Importance of looking across many firms simultaneously.


Importance of bringing together many forms of expertise
(examiners, financial analysts, accounting experts, economists).


Facilitates comparison, gives basis for assessment of each firm’s numbers, provides
strong base for discussions with firms.
Important for results to be credible to multiple constituencies
Importance of transparency in process and results for credibility
and confidence.
13
Summary

For regulatory and supervisory reform, many devils in the details.

These are important to tackle, so that reforms create something
sustainable and lasting.

Look to lessons from approaches being taken during the crisis for
“normal” supervisory procedures.
14