The crisis showed that liquidity problems can be an independent source of severe stress, perhaps even for firms that might otherwise have remained solvent. But it was also evident that the specifics of pre-crisis capital regulation fell far short of what this prudential instrument can achieve. The Basel I and Basel II capital requirements relied almost exclusively on capital ratios that were essentially snapshots of balance sheets and thus all too often a lagging indicator of a bank's condition.
Declines in asset values--particularly of non-traded assets--were often not reflected in capital calculations for some time. Though already well-known before the crisis, this phenomenon was particularly problematic as asset values declined rapidly, causing both markets and supervisors alike to regard regulatory capital ratios as providing only limited information about a firm's current financial condition. In addition, minimum capital levels had simply been set too low, in general and with respect to particular assets.
One of the most obvious examples was the capital requirement for asset-backed securities in the trading books of banks. The requirement was based on returns over a day holding period, used a one-year observation period that had been characterized by unusually low price volatility, and did not adequately account for the credit risks inherent in these traded instruments.
Furthermore, at least some of the instruments that qualified as "Tier 1 capital" for regulatory purposes were not reliable buffers against losses, at least not on a going concern basis. It is instructive that during the height of the crisis, counterparties and other market actors looked almost exclusively to the amount of tangible common equity held by financial institutions in evaluating the creditworthiness and overall stability of those institutions.
They essentially ignored the Tier 1 and total risk-based capital ratios in regulatory requirements. In the fall of , there was widespread doubt in markets that the common equity of some of our largest institutions was sufficient to withstand the losses that those firms appeared to be facing. This doubt made investors and counterparties increasingly reluctant to deal with those firms, contributing to the severe liquidity strains that characterized financial markets at the time.
Finally, the crisis validated the concerns expressed by some academics and by policy staff at the Bank for International Settlements that the effectiveness of capital regulation was limited by its exclusively microprudential focus. Capital requirements had been set with reference solely to the balance sheet of a specific firm. The risk weights assigned to the firm's assets were calculated with reference to ordinary times, whether through a supervisory determination or a combination of supervisory formulas and a firm's own modeling.
This microprudential focus did not take into account the potential impact of a shock to the value of widely-held assets--whether exogenous, caused by the distress sales of such assets by a large firm suffering particularly severe problems, or, as in the financial crisis, a lethal interaction between these two factors.
The limits of the microprudential approach were particularly evident with respect to very large, interconnected firms. There would be very substantial negative externalities associated with the disorderly failure of any such firm, distinct from the costs incurred by the firm and its stakeholders. The failure of one large firm, especially in a period of stress, significantly increases the chances that other financial firms will fail, for two reasons. First, direct counterparty impacts can lead to a classic domino effect.
Second, because losses in a tail event are much more likely to be correlated for firms deeply engaged in trading, structured products, and other capital market instruments, all such firms are vulnerable to accelerating losses as troubled firms sell their assets into a declining market.
Reform of Capital Regulation in the Post-Crisis Period It is obvious that the post-crisis regulatory system will not be as dependent on capital requirements as the pre-crisis regime.
Dodd-Frank itself is testimony to this fact, as are a number of changes already made by the bank regulatory agencies. There is now increased emphasis on market discipline, liquidity regulation, activities restrictions, and more effective supervision, in addition to capital requirements.
Reforms for money market funds and the triparty repo market, as well as more general attention to wholesale funding models for financial intermediation, are still needed. But the crisis reinforces the point that robust capital requirements should continue to be a central component of the financial regulatory system.
The U. In response to the shortcomings of the pre-crisis capital regulatory regime, there have been three complementary threads of reform. First is improvement of the traditional, individual-firm approach to capital regulation. This strand mostly originates in the work of the Basel Committee. Basel 2.
Basel III upgraded the quality and increased the quantity of minimum capital requirements, created a capital conservation buffer, and introduced an international leverage ratio requirement. Second is the introduction of a macroprudential component of capital regulation. Although Basel III does contain a few features responsive to macroprudential concerns, it remains principally microprudential.
This second thread is linked both to the requirement in section of the Dodd-Frank Act for enhanced risk-based capital standards for large bank holding companies and to the Basel Committee's effort to develop a framework for the assessment of a capital surcharge based on the global systemic importance of the largest, most interconnected banking organizations. Third is establishment of regular stress testing and capital planning.
These complementary supervisory tools serve two related functions. First, they make capital regulation more forward-looking by subtracting losses in asset values and earnings estimated to be sustained in an adverse macroeconomic scenario, in order to determine whether firms would have enough capital to remain viable financial intermediaries.
Second, they contribute to the macroprudential dimension of capital regulation by examining simultaneously the risks of all large financial institutions in the face of the adverse scenario.
This reform thread is sourced in the Dodd-Frank requirement for stress testing at large banks, but more generally in the Federal Reserve's establishment of a formal annual capital planning requirement for these firms.
The development and implementation of these three threads of capital reform are at different stages, so it may be useful to review where each stands.
As to the first--improving the traditional, individual-firm approach to capital regulation--Basel 2. In addition, the so-called "Collins amendment" in Dodd-Frank requires that banking organizations maintain capital at levels no lower than those set by "generally applicable" requirements, which include a standardized approach to risk-weighting.
In practice, the Collins amendment provides a safeguard against declines in minimum capital requirements in a capital regime based on internal modeling. The Basel Committee completed work on Basel 2. Implementation of these two frameworks into national legislation or regulations is underway in the jurisdictions represented on the committee.
Two issues concerning implementation in the United States bear mentioning. First, while U. The complication here, and with part of Basel III implementation, lies in the use of agency credit ratings.
Dodd-Frank requires the removal of agency credit ratings from all regulations throughout the government. Thus, the banking agencies have had to develop substitutes for agency ratings in each of the quite different contexts in which they are used within the capital standards. This has not been the easiest of tasks, but I believe we are now close to convergence on the approaches we will take in fashioning these substitutes. We should soon be able to draft a proposed regulation for the rest of Basel 2.
Work on the Basel III rule has had to compete for staff time with all the other rulemakings currently underway at the banking agencies, but I would expect a proposed regulation in the first quarter of The second issue pertains to the six-year transition period for Basel III, which by its terms phases in the requirements for both the improved quality and increased quantity of capital in somewhat backloaded stages beginning in January Questions have arisen as to supervisory expectations for capital levels during this rather lengthy period.
Specifically, there has been some uncertainty as to whether supervisors intend to "pull forward" the various transition points outlined in Basel III. While the Federal Reserve intends to ensure that firms are on a steady path to full Basel III compliance, we do not intend to require firms to raise external capital or to reduce their risk-weighted assets in order to meet any new requirement earlier than at the time specified in the Basel III transition schedule.
However, because this issue is complicated somewhat both by certain expectations stated in Basel III and by the relationship of Basel III implementation to the Federal Reserve's requirement for annual capital planning by certain large bank holding companies, it may be useful to provide some further details on our expectations.
The GHOS said that banks should "maintain prudent earnings retention policies" so as to meet both the new minimum equity standard and the conservation buffer "as soon as reasonably possible.
In practical terms, we will monitor their progress through the annual capital planning exercise, about which I shall have more to say a bit later in these remarks. We will be comfortable with proposed capital distributions only when we are convinced they are consistent with a bank holding company readily and without difficulty meeting the new capital requirements as they come into effect.
Turning now to the second thread of capital regulation reform, the introduction of a capital requirement keyed to the systemic importance of financial firms, I am sure you are all aware that last Friday the Basel Committee released its framework for calibrating capital surcharges for banks of global systemic importance.
This initiative is consistent with the Federal Reserve's obligation under section of the Dodd-Frank Act to impose more stringent capital standards on systemically important financial institutions, including the requirement that these additional standards be graduated based on the systemic importance of the bank. Both the Dodd-Frank provision and the Basel framework are informed by the fact that the failure of a systemically important firm would have substantially greater negative consequences on the financial system than the failure of other firms, even quite sizeable ones.
Yet obviously such a firm has no incentive to take account of these negative externalities. An ancillary rationale is that additional capital requirements could help offset any funding advantage derived from the perceived status of such institutions as too-big-to-fail. The surcharge attempts to reduce the chances of a global systemically important bank's G-SIB's failure so as to bring the expected impact of the failure of such a firm--that is, the expected damage to the system upon its failure discounted by the possibility that it will, in fact, fail--more in line with that of other sizeable firms.
Moreover, the metrics for determining G-SIB status are heavily weighted toward the kind of interconnectedness features that pose macroprudential risks. The framework includes a range of surcharges in the 1. For illustrative purposes, the Basel Committee used data to generate a list of banks that were of global systemic importance and, based on the criteria developed from that data, a hypothetical set of "buckets" associated with the different surcharge rates.
It is important to note, however, that this list, which was published last week, will not be used to determine any bank's surcharge. The list of banks to be covered and the surcharge buckets into which they will be placed when the surcharge begins to take effect in will be based upon data collected in This is as it should be, since the inclusion and ordering of the firms should be based upon the characteristics of the banks as they have evolved closer to the effective date.
The first Basel Accords, or Basel I, was finalized in and implemented in the G10 countries, at least to some degree, by It developed methodologies for assessing banks' credit risk based on risk-weighted assets and published suggested minimum capital requirements to keep banks solvent during times of financial stress.
Basel I was followed by Basel II in , which was in the process of being implemented when the financial crisis occurred. Basel III attempted to correct the miscalculations of risk that were believed to have contributed to the crisis by requiring banks to hold higher percentages of their assets in more liquid forms and to fund themselves using more equity, rather than debt.
It was initially agreed upon in and scheduled to be implemented by but, as of December , negotiations were still ongoing over a few contentious issues.
One of these is the extent to which banks' own assessments of their asset risk can differ from regulators'; France and Germany would prefer a lower "output floor," which would tolerate greater discrepancies between banks' and regulators' assessment of risk.
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