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Some Lessons from the Crisis
|October 13, 2009|
William C. Dudley, President and Chief Executive Officer
Remarks at the Institute of International Bankers Membership Luncheon, New York City
Thank you for having me here to speak today. It is a real pleasure to have this opportunity to discuss the challenges ahead in making our banking and financial system more resilient and robust. We have learned a great deal over the past two years about our financial system and its vulnerabilities. The challenge ahead is to put these lessons to good use.
As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.
Although some of these practices might appear sensible from the narrow perspective of an individual firm or market, this crisis has shown us that when all firms or market participants simultaneously take an action that appears to be in their immediate, narrow interest, the collective impact on the system as a whole can be disastrous. We need to find ways to weaken or eliminate these reinforcing mechanisms and we need to introduce new dampening mechanisms into the financial system.
The recent financial crisis has shown that parts of the regulatory capital framework were not calibrated properly to account for the most complex instruments. Our efforts to revise the capital rules should emphasize the need to include these and other risks that were not appropriately captured in recent years.
In many circumstances, an emphasis on improved risk-capture may be superior to simply raising the capital requirements across the board. There are two reasons for this. First, it may better tie capital to the risks being undertaken. This, in turn, would create more appropriate incentives for risk-taking. Second, it may reduce the risk of regulatory arbitrage. If the risks of some activities are not captured properly, then banks will have incentives to shift their business toward those particular activities.
The Basel Committee has made very good progress in revising the capital treatment of trading book positions and for structured credit products—two areas where the crisis revealed critical weaknesses in the regulatory capital regime. Revisions to the capital requirements for over-the-counter (OTC) derivatives exposures as proposed by the Obama administration also strike me as appropriate. Not only would this more effectively capture the risks that banks are taking, but it also would create incentives to move the trading and settlement of such instruments more rapidly to central clearing parties (CCPs) and to exchanges. The greater use of CCPs and exchanges should have several benefits, including reduction of risk through the multilateral netting of exposures and improved transparency with respect to the structure and pricing for such instruments.
More explicit supervisory standards regarding capital conservation would also be an important element of an efficient capital regime. During the crisis, some banks continued to pay out dividends even though their condition and market valuation metrics had sharply deteriorated. Banks did this to try to convince investors that their bank was “sound.” But by depleting capital, these actions made banks and the financial system weaker.
To mitigate these dynamics, regulators could require the reduction and possibly the cessation of dividend payments and share buybacks during adverse market environments when particular triggers were breached. For example, limits on dividend payments and share repurchases as a share of earnings could be mandated to occur when common equity ratios fell below certain levels (recognizing that credit and mark-to-market losses deplete the capital structure from below) or when market-based measures hit certain trigger values. Taking away the discretion of banks to deplete capital would strengthen the banks’ ability to withstand adverse environments.
In principle, such constraints could conceivably be extended to compensation and bonus payments. Some of the firms that encountered difficulties in 2008 paid out large bonuses early in 2008 despite the deterioration in market conditions and in their own financial performance. There is an opportunity to rethink capital preservation policies to ensure that banks’ incentives are consistent with the supervisory objectives of a safe and sound banking system.
Such capital conservation rules could operate on both sides of an economic downturn—conserving capital going into the downturn and rebuilding capital coming out. One example would be the imposition of constraints on the ability of banks to reinstate or increase dividends prematurely or to undertake share buybacks during a downturn or during the early stages of an economic recovery.
Higher Capital Requirement for Systemically Important Institutions
Currently, some large systemically important institutions may have a competitive advantage because they are perceived to be “too big to fail.” Unless we address this disparity, we will have an ongoing moral hazard problem and inevitable market structure distortions as institutions take steps to become systemically important in order to gain a competitive advantage.
The regulatory regime could lean against this in two ways. First, we could improve the resolution mechanisms for large, complex institutions and thereby reduce the costs associated with failure. A more robust resolution regime would make it more feasible to allow the failure of a large financial institution without that failure threatening the stability of the entire financial system. Second, we could impose higher capital requirements on large, systemically important institutions to offset the advantages such as lower funding costs that these institutions may garner by their perceived “too big to fail” status. This would recognize the interconnectedness of the financial system and the fact that the failure of a systemically important institution generates significant externalities, which are not, at present, borne fully by the equity and debt holders of such institutions. Increasing the size of the capital buffer would make the system more stable by reducing the incentive for firms to get big just to capture the perceived benefits from achieving “too big to fail” status.
The first change—an improved resolution mechanism—would presumably reduce the number of institutions that—at any point in time—would be systemically important. The second change—the imposition of higher capital requirements on large, systemically important institutions—would reduce the likelihood of failure of such institutions.
However, in assessing the efficacy of such changes, we need to be realistic about the difficulties in building a resolution regime that would be sufficiently robust to allow the failure of any institution under any circumstance and in designing a capital regime that imposes differential requirements on large, systemically important institutions. On the resolution regime side of the ledger, it is particularly difficult to build resolution regimes that can operate effectively across different geographic jurisdictions. Legal regimes are different; national authorities have different incentives; and coordinating resolution across multiple geographies in a way that treated counterparties in different jurisdictions equivalently would be a daunting mission.
Similarly, designing an effective capital surcharge for systemically important institutions will be very challenging. Broadly, there are two approaches. We could either require a set of firms identified to be systemically important to hold additional capital or we could introduce a capital surcharge for firms linked to measures of systemic risk. In broad terms, the factors that could be used to identify systemically important financial institutions would be related to a firm’s interdependence with the financial system and the impact on market confidence should the firm become distressed. Measures of size, leverage, liability structure and importance in credit formation and liquidity provision could all be indicators of systemic importance.
Developing a consistent, objective set of measures either to size a capital surcharge or to identify such firms is particularly difficult. For example, introducing a single measure to size a capital surcharge such as firm size, may create arbitrage opportunities and will almost certainly not capture the full extent that an individual firm may contribute to systemic risk. Moreover, identifying a set of systemically important institutions may reinforce concerns about moral hazard. We also have the difficulty that the particular metrics used to determine which firms are systemically important are likely to change over time with changes in market structure and in the evolution of particular financial institutions.
An ideal capital requirement regime should be efficient and should create the proper incentives for banking organizations to internalize the costs of their actions on the broader financial system and macroeconomy. Efficiency, which I’ll define here as minimizing the amount and cost of capital needed to ensure solvency under adverse conditions, is important because an inefficient system will inevitably encourage growth in activity outside the regulatory regime, and will likely drive up the overall cost of intermediation. Proper incentives are needed to control risk and better align the interests of management and shareholders with those of the public.
In both respects, the introduction of a contingent capital instrument seems likely to hold real promise. Relative to simply raising capital requirements, contingent capital has the potential to be more efficient because the capital arrives as equity only in the bad states of the world when it is needed. It also has the benefit of improving incentives by creating two-way risk for bank managements and shareholders. If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted. This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside.
Conceptually, contingent capital instruments would be debt instruments in “good” states of the world, but would convert into common equity at pre-specified trigger levels in “bad” states of the world. In principle, these triggers could be tied to deterioration in the condition of the specific banking institution and/or to the banking system as a whole.
There are many issues that would need to be worked out regarding how best to design such instruments, including how to determine their share of total capital as well as how to configure and publicly disclose the conversion terms and trigger. But, in my view, allowing firms to issue contingent capital instruments that could be used to augment their common equity capital during a downturn may be a more straightforward and efficient way to achieve a countercyclical regulatory capital regime compared to trying to structure minimum regulatory capital requirements (or capital buffers above those requirements) that decline as conditions in the financial sector worsen.
So what might such a contingent capital instrument look like? One possibility is a debt instrument that is convertible into common shares if and only if the performance of the bank deteriorates sharply. While, in principal, this could be tied solely to regulatory measures of capital, it might work better tied to market-based measures because market-based measures tend to lead regulatory-based measures. Also, if tied to market-based measures, there would be greater scope for adjustment of the conversion terms in a way to make the instruments more attractive to investors and, hence, lower cost capital instruments to the issuer. The conversion terms could be generous to the holder of the contingent capital instrument. For example, one might want to set the conversion terms so that the debt holders could expect to get out at or close to whole—at par value. This is important because it would reduce the cost of the contingent instrument, making it a considerably cheaper form of capital than common equity.
Consider the advantages that such an instrument would have had during this crisis. Rather than banks clumsily evaluating whether to cut dividends, raise common equity and/or conduct exchanges of common equity for preferred shares and market participants uncertain about the willingness and ability of firms to complete such transactions and successfully raise new capital, contingent capital would have been converted automatically into common equity when market triggers were hit.
If these contingent capital buffers were large, which they could be because the cost of these instruments should not differ much from straight debt, then the worst aspects of the banking crisis might have been averted. If shareholders had faced the potential of automatic and substantial dilution, they may have demanded better risk management and disclosure during the boom. If common equity had been automatically bolstered during the early part of crisis, investors would have been much less concerned about the risk of insolvency. Counterparty risk concerns would have been much less significant—potentially short-circuiting one of the important amplifying mechanisms of the crisis. Such instruments could have reduced the likelihood of failure of large, systemically important institutions, reducing the significance of the “too big to fail” problem and its associated moral hazard problems.
The Financial Stability Board and the Basel Committee are working hard and are making important progress on all these issues. But for these efforts to bear fruit, it is critical that the requirements that are imposed in terms of capital adequacy, liquidity and compensation be harmonized across regulatory regimes and applied in a consistent fashion. The absence of a level playing field would be a recipe for disaster.
A lack of harmonized standards would inevitably lead to balkanization and protectionism as different countries took steps to protect their particular banking champions. Potentially, this could lead to countries requiring capital and liquidity to be segregated locally. This would have a number of negative consequences. First and foremost, it could disrupt the ability for capital to flow freely across borders, interfering and inhibiting globalization in terms of financial intermediation. Second, it would reduce the diversification benefits that stem from banks that operate in different geographic locations. Third, it could undermine the safety and soundness of the financial system. In particular, the lack of harmonization in terms of regulatory regimes could lead to a “race to the bottom” as firms and businesses migrated to the most lax regulatory regime.
So what does this mean for my audience today—foreign banks operating in the United States? First, these institutions should not expect a return to “business as usual.” We are committed to implementing the reforms that will prevent a recurrence of the recent financial crisis.
Second, as most of the current reform agenda of the Financial Stability Board and the Basel Committee relates to the regulatory framework as applied by your home country, we expect that foreign banks’ operations in the United States will fully comply with these structures as they are put in place in their home country as well.
Third, we support the continued international banking presence of global banking institutions. National implementation must not jeopardize the economic benefits derived from cross-border banking. We need to be wary about nationalistic approaches to supervision.
Fourth, financial firms that operate in our markets should continue to be vigilant in meeting the expectations we have for strong risk management and compliance practices. It wasn’t too long ago that some foreign banking organizations faced supervisory discipline for failing to meet those standards. Given the lessons of the crisis, I would expect that our focus and attention on these areas would only intensify going forward.
Fifth, we will be particularly focused on how the new supervisory framework will apply to the U.S. personnel associated with the operations of foreign banks in the United States. In particular, we will have substantial concern if these firms’ compensation practices are contrary to the text or spirit of the international agreements on compensation practices that are in the process of being hammered out. For example, multi-year guaranteed bonus payments would raise a red flag for us as not likely being consistent with the evolving consensus on sound compensation practices.
Thank you for your kind attention. I would be happy to take a few questions.