Other regulatory efforts to improve the resiliency and resolvability of GSIBs
The financial crisis made clear that policy makers must devote significant attention to the potential threat to financial stability posed by our most systemic financial firms.
Accordingly, the Federal Reserve has been focused on developing regulatory proposals that are designed to reduce the probability of failure of a GSIB to levels that are meaningfully below those for less systemically important firms and materially reduce the consequences to the broader financial system and economy in the event of failure of a GSIB.
Our goal has been to establish regulations that force GSIBs to internalize the large negative externalities associated with their disorderly failure and that aim to offset any remaining too-big-to-fail subsidies these firms may enjoy.
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GSIB risk-based capital surcharges
A key component of the Federal Reserve's program to improve GSIB resiliency is our forthcoming proposal to impose graduated common equity risk-based capital surcharges on GSIBs.
This proposal will be based on the GSIB capital surcharge framework developed by the Basel Committee, under which the size of the surcharge for an individual GSIB is a function of the firm's systemic importance.
We currently are working on the implementing regulation for the Basel Committee GSIB risk-based capital surcharge framework and expect to issue a proposal fairly soon.
By further increasing the amount of the most loss-absorbing form of capital that is required to be held by the firms that potentially pose the greatest risk to financial stability, we intend to reduce the probability of failure of these firms to offset the greater negative externalities their failure would have on the financial system and to offset any funding advantage such firms may have because of their perceived status as too-big-to-fail.
GSIB leverage surcharges
To further bolster the regulatory capital regime for the most systemic U.S. banking firms, the Federal Reserve and the other U.S. banking agencies have proposed to strengthen the internationally agreed-upon Basel III leverage ratio as applied to U.S. GSIBs.
This proposal would require U.S. GSIBs to maintain a tier 1 capital buffer of at least 2 percent above the minimum Basel III supplementary leverage ratio of 3 percent, for a total of 5 percent.
In light of the significantly higher risk-based capital rules for GSIBs under Basel III, imposing a stricter leverage requirement on these firms is appropriate to help ensure that the leverage ratio remains a relevant backstop for these firms.
And we have calibrated the proposed GSIB leverage surcharge thresholds to raise the leverage standards for these firms by an amount that is roughly commensurate with the Basel III increase in the risk-based capital thresholds for these firms. We expect to finalize this proposal in the coming months.
We also intend to incorporate in the United States the revisions to the Basel III leverage ratio recently agreed to by the Basel Committee. These changes would strengthen the ratio in a number of ways, including by introducing a much stricter treatment of credit derivatives.
Resolvability of GSIBs
Our enhanced regulation of GSIBs also includes efforts to improve their resolvability. The Federal Reserve's resolvability efforts include work with the Federal Deposit Insurance Corporation (FDIC) to improve the bankruptcy resolution planning of large banking firms and work to assist the FDIC in making large banking firms more resolvable under the Orderly Liquidation Authority (OLA) of the Dodd-Frank Act.
The Federal Reserve is consulting with the FDIC on a proposal that would require the largest, most complex U.S. banking firms to maintain a minimum amount of long-term unsecured debt outstanding at the holding company level.
While minimum capital requirements are designed to cover losses up to a certain statistical probability, in the event that the equity of a financial firm is wiped out, successful resolution without taxpayer assistance would be most effectively accomplished if a firm has sufficient long-term, unsecured debt to absorb additional losses and to recapitalize the business transferred to a bridge operating company.
The presence of debt explicitly identified for possible bail-in on a "gone concern" basis should help other creditors clarify their positions in an orderly liquidation process.
A requirement for long-term debt could have the benefit of improving market discipline, since the holders of that debt would know they faced the prospect of loss should the firm enter resolution.
In addition, this requirement should have the effect of preventing the erosion of the current long-term debt holdings of GSIBs, which, by historical standards, are currently at fairly high levels.
Absent a minimum requirement of this sort, there likely would be declines in these levels as the flatter yield curve of recent years steepens.
We have recently seen some evidence of the beginnings of such declines. At the international level, the Federal Reserve is working through the Basel Committee and the Financial Stability Board (FSB) to develop an international proposal for gone concern loss absorbency requirements for GSIBs.
Regulatory reform, shadow banking, and short-term wholesale funding
"Shadow banking" is a term used to describe a wide variety of activities involving credit intermediation and maturity transformation outside the insured depository system.
These activities are often funded through collateralized borrowing arrangements known as "securities financing transactions", a term that generally refers to repos and reverse repos, securities lending and borrowing, and securities margin lending.
Some of this activity involves the short-term funding of highly liquid securities, and directly supports the current functioning of important markets, including those in which monetary policy is executed. Securities financing transactions can also directly or indirectly fund less liquid instruments.
In normal times, lending through securities financing transactions, even when backed by less-liquid instruments, appears low-risk because of the fact that the transactions are usually short-term, over-collateralized, and exempt from the automatic stay in insolvency proceedings.
But during times of stress, lenders may become unwilling to lend against a wide range of assets, including very high-quality securities, forcing liquidity-strained institutions to rapidly liquidate positions.
The rapid constriction of large amounts of short-term wholesale funding and associated asset liquidations in times of stress in the financial markets can result in large fire sale externalities, direct and indirect contagion to other financial firms, and disruptions to financial stability.
A dynamic of this type engulfed the financial system in 2008.
While the term "shadow banking" suggests activity outside of the banking system, reality is more complex. In many cases, shadow banking takes place within, or in close proximity to, regulated financial institutions.
Most of the largest banking organizations rely to a significant extent on securities financing transactions and other forms of short-term wholesale funding to finance their operations, and if such a firm were to come under stress, the fire sale externalities could be very similar to those we saw during the financial crisis.
Banking organizations also participate in shadow banking by lending to unregulated shadow banks, and by providing shadow banks with credit and liquidity support that enhances their ability to borrow from other market participants.
In still other cases, unregulated shadow banks are able to operate without coming into contact with the banking system. As prudential requirements for regulated firms become more stringent, it is likely that market participants will face increasing incentives to move additional activity beyond the regulatory perimeter.
Since the crisis, regulators have collectively made progress in addressing some of the close linkages between shadow banking and traditional banking organizations.
We have increased the regulatory charges on support that banks provide to shadow banks; for example, by including within the LCR requirements for banks to hold liquidity buffers when they provide credit or liquidity facilities to securitization vehicles or other special purpose entities.
Changes have also been made to accounting and capital rules that make it more difficult for banks to reduce the amount of capital they are required to hold by shifting assets off balance sheet.
We are also addressing risks from derivatives transactions, which can pose some of the same contagion and financial stability risks as short-term wholesale funding in the event that large volumes of derivatives positions must be liquidated quickly.
Standardized derivatives transactions are currently in the process of moving to central clearing, while non-standardized trades will be subject to margin requirements.
In September 2013, the Basel Committee and the International Organization of Securities Commissions adopted final standards on margin requirements that will require financial firms and systemically important nonfinancial entities to exchange initial and variation margin on a bilateral basis for non-cleared derivatives trades.
The Federal Reserve and other federal financial regulatory agencies are now working to modify the outstanding U.S. proposals on non-cleared derivatives margin requirements to more closely align them with the requirements in this landmark global agreement.
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.
One option to address concerns specific to large, complex banking firms would be to pursue modifications to bank liquidity standards that would require firms that have matched books of securities financing transactions to hold larger liquid asset buffers or maintain more stable funding structures.
The Basel Committee has recently proposed changes to its Net Stable Funding Ratio that would move in this direction.
A complementary bank regulatory option would be to require banking firms that rely on greater amounts of short-term wholesale funding to hold higher levels of capital.
The rationale behind this approach would be that while solid requirements are needed for both capital and liquidity adequacy at large banking firms, the relationship between the two also matters.
For example, a firm with little reliance on short-term wholesale funding is less susceptible to runs and, thus, to need to engage in fire sales that can depress capital levels at the firm and impose externalities on the broader financial system.
A capital surcharge based on short-term wholesale funding levels would add an incentive for firms to use more stable funding and, where a firm concluded that higher levels of such funding were nonetheless economically sensible, the surcharge would increase the loss absorbency of the firm.
Such a requirement would be consistent with, though distinct from, the long-term debt requirement that the Federal Reserve is developing to enhance prospects for resolving large firms without taxpayer assistance.
Turning to policies that could be used to address concerns about short-term collateralized borrowing arrangements more broadly throughout the financial system, the Federal Reserve is also carefully analyzing proposals to establish minimum numerical floors for collateral haircuts in securities financing transactions.
In its most universal form, a system of numerical haircut floors for securities financing transactions would require any entity that wants to borrow against a security to post a minimum amount of excess margin to its lender that would vary depending on the asset class of the collateral. Like minimum margin requirements for derivatives, numerical haircut floors for securities financing transactions would serve as a mechanism for limiting the build-up of leverage at the transaction level, and could mitigate the risk of pro-cyclical margin calls.
In August, the FSB issued a consultative document that outlined a framework of minimum margin requirements for securities financing transactions.
The FSB's current proposal has some significant limitations, however, including (1)a scope of application that is limited to transactions in which a regulated entity lends to an unregulated entity against non-sovereign collateral, and (2)a relatively low calibration.
If the scope of the FSB's proposal was expanded to cover a much broader range of firms and securities and the calibration of the proposal was strengthened, the FSB proposal could represent a significant step toward addressing financial stability risks in short-term wholesale funding markets.
Information security at financial institutions
Before closing, I would like to discuss briefly the Federal Reserve's expectations with regard to information security at the financial institutions it oversees, as recent events have led to an increased focus on the potential for cyber attacks on the information technology infrastructures of these institutions.
Cyber attacks on financial institutions and the data they house pose significant risks to the economy and to national security more broadly.
While some attacks are conducted with the intent of disrupting customer access and normal business operations of financial institutions, other attacks include malicious software implanted to destroy data and systems, intrusions to gain access to unauthorized information, and account takeovers for financial fraud. The varied and evolving nature of these attacks make them a continuing challenge to address.
The Federal Reserve requires the financial institutions it regulates to develop and maintain effective information security programs that are tailored to the complexity of each institution's operations and that include steps to protect the security and confidentiality of customer information.
In addition, to address any data breaches that occur, the Federal Reserve requires supervised financial institutions to develop and implement programs to respond to events in which individuals or firms obtain unauthorized access to customer information held by the institution or its service providers.
Specifically, when a financial institution becomes aware of an incident of unauthorized access to sensitive customer information, the institution should conduct a reasonable investigation to promptly determine the likelihood that the information has been or will be misused;
assess the nature and scope of the incident; identify the types of information that have been accessed or misused; and undertake risk mitigation, which can include notifying customers, monitoring for unusual account activity, and re-issuing credit and debit cards.
The Federal Reserve's approach to information security supervision leverages internal firm expertise, published guidance, and collaboration between the Board, the Reserve Banks, and other U.S. banking agencies to promote effective protection of data and systems by supervised institutions.
The Reserve Banks employ examiners specializing in information technology supervision to conduct the bulk of their information security examination activities. Federal Reserve staff has also developed guidance, some collaboratively with other banking regulators, to define expectations for information security and data breach management.
Nine significant information security guidance documents have been issued since July 2001.
We are continuing to focus on this risk through our participation in the Federal Financial Institutions Examination Council's recently established working group aimed at enhancing supervisory initiatives on cybersecurity and critical infrastructure protection.
Although many agencies throughout the U.S. government are working to address problems posed by cyber attacks - in part as a result of initiatives such as the executive order issued last February that directed the National Institute of Standards and Technology to develop a cybersecurity framework –
we believe there should be increased attention and coordination across the federal government to support the security of the nation's financial infrastructure.
In particular, we support efforts to leverage the technical capabilities of law enforcement and national security agencies with respect to cyber threats and attacks at financial institutions.
Financial regulators set expectations for security programs and controls at financial institutions, and they help to validate that these expectations are being met.
However, financial regulators do not maintain the technical capacity to identify many of the most sophisticated threats, to respond to threats as they occur, or to evaluate the alternatives for immediate and effective responses to new types of viruses or attacks.
We appreciate the efforts of U.S. government agencies to date and encourage continued coordination across agencies to ensure the safety and security of the financial system.
The financial regulatory architecture is considerably stronger today than it was in the years leading up to the crisis, but work remains to complete the post-crisis global financial reform program.
Over the coming year, the Federal Reserve will be working with other U.S. financial regulatory agencies, and with foreign central banks and regulators, to propose and finalize a number of the important remaining initiatives. In this continuing endeavor, our goal is to preserve financial stability at the least cost to credit availability and economic growth.
We are focused on reducing the probability of failure of systemic financial firms, improving the resolvability of systemic financial firms, and monitoring and mitigating emerging systemic risks.
Thank you for your attention. I would be pleased to answer any questions you might have.