Beverly Hirtle International Conference “Reforming Financial Regulation and Supervision: Going Back to Basics” Banco de España June 15, 2009 Thoughts on Financial Regulatory Reform

2 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.

3 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.

4 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?

5 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.

6 Four Focuses of Regulatory and Supervisory Reform  Indentifying systemically important financial institutions  Those with the greatest potential to impact others, especially in stressful conditions  Regulatory capital regime  The regulatory rules and supervisory expectations about capital  Internalizing and limiting externalities  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

7 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, inter- connectedness)?  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?

8 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 pre- specified 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?

9 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?

10 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”

11 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.

12 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.

13 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.  Facilitates comparison, gives basis for assessment of each firm’s numbers, provides strong base for discussions with firms.  Importance of bringing together many forms of expertise (examiners, financial analysts, accounting experts, economists).  Important for results to be credible to multiple constituencies  Importance of transparency in process and results for credibility and confidence.

14 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.