Today, Federal Reserve Governor Daniel Tarullo spoke before the U.S. Monetary Policy Forum about the need for financial regulatory reform. He said "a fair degree of consensus" has been reached on the kind of reform that should be enacted, but that regulatory reform could not be considered successful unless it dealt with the problem of "too big to fail" financial institutions and reduced systemic risk. "Despite substantial disagreements over some reform proposals -- such as the creation of an independent consumer financial services protection agency and the possible reallocation of responsibilities among the regulatory agencies -- a fair degree of consensus has been reached on some elements of a legislative reform package," Tarullo said.
Among the areas of agreement, he cited the need for "minimum prudential rules," noting that "U.S. banking agencies are joining with our international counterparts in the Basel Committee to modify capital and liquidity requirements." He also said that "increased capital requirements for trading activities and securitization exposures have already been agreed," that "additional work on capital requirements for market risk is also under way," and that "the bank regulatory agencies are implementing strengthened guidance on liquidity risk management and weighing proposals for quantitative liquidity requirements."
In addition to building on existing rules, Tarullo said "several potential regulatory devices with a more direct systemic focus” have also been proposed, including (1) imposing special taxes or capital charges on firms based on their systemic importance, (2) requiring systemically important firms to issue contingent capital instruments that would convert to common equity in periods of stress, and (3) reducing “pro-cyclical tendencies” by establishing special capital buffers that would be “built up in boom times and drawn down as conditions deteriorate."
Tarullo noted that some proposals, including the legislation passed by the House of Representatives in December, "would extend the perimeter of regulation” to apply financial stability requirements “to firms that currently are not subject to prudential regulation because they do not own a commercial bank." In the area of market discipline, Tarullo pointed out the need to find a credible alternative to the current “Hobson's choice of bailout or disorderly bankruptcy,” noting that "most regulatory reform proposals have prominently featured a special resolution mechanism that would raise the real prospect of losses for investors and counterparties of even the largest failing institutions." However, he acknowledged that there remains "considerable continuing disagreement over the key features of some of these proposals, even when the basic idea is accepted," including "significant differences over the best form of resolution mechanism." However, in his view, a resolution mechanism is "critical to strengthening market discipline sufficiently so that it can truly take its place alongside rules and supervisory oversight as a strong third pillar of the financial regulatory system."
Tarullo cautioned that "even as we improve and re-orient regulation, we must not lose sight of the ultimate goal" -- a stable financial system that supports economic growth.
"Today we are all mindful of the economic devastation that can ensue when a financial system goes badly awry," he said. "But financial stability alone is not the aim of financial regulation. It is instead a stable financial system within which capital is efficiently directed to creditworthy consumers and businesses who need it, as well as a system that offers good savings and investment vehicles for individuals and organizations."