NEWS Release - Speech - Governor Daniel K. Tarullo - At the Federal Reserve Bank of Cleveland and Office of Financial Research 2016 Financial Stability Conference, Washington, D.C.
Last summer, when I accepted President Loretta Mester's invitation to speak at this conference, I thought it would be a good occasion to step back and assess where we stand in our post-crisis efforts to promote financial stability in the United States.
This morning I will offer such an assessment. I will begin by reviewing what has been accomplished. Then I will suggest how to approach the work that remains--including both tackling continuing vulnerabilities to financial stability and rationalizing the measures that have already been taken.
The Crisis and Its Aftermath
To understand where we stand today, we should recall why we embarked on these efforts in the first place. There is little mistaking the motivation--it was the magnitude of the destruction wrought by the financial crisis and the Great Recession that followed it. The resulting losses in employment were on a scale not seen since the Great Depression. One model used by Federal Reserve staff1 estimates that cumulative loss in output relative to potential over the period was on the order of one quarter of a year's worth of economic output.2 While we cannot be certain that these losses were due solely to the financial crisis, losses of this magnitude appear broadly in line with estimates of the effects of prior financial crises.3 Moreover, the shortfalls in jobs and income relative to potential may understate the total losses, as many current estimates of potential output are significantly below levels expected prior to the Great Recession. This may be due to the declines in investment, business dynamism, and labor force attachment brought about by the shortfall in aggregate demand through hysteresis effects.4
As evidenced by a continuing stream of scholarship, many factors contributed to the unsustainability and fragility of the pre-crisis financial system. But the inadequacy of regulation and supervision was clearly among them. Large banking firms had insufficient levels of high-quality capital; excessive amounts of short-term, wholesale funding; too few high-quality, liquid assets; and inadequate risk measurement and management systems. Systemically important nonbank financial firms whose failure could threaten the stability of the financial system were effectively outside the regulatory perimeter. Governments did not have resolution regimes that could provide for an orderly resolution of a systemically important financial firm. Shadow banking--which was funding long-term assets with short-term wholesale liabilities--exposed the financial system to a systemwide liquidity run.
Although we all lived through the fall of 2008, let me dwell for a moment on that frightening period. Six months had passed since the demise of Bear Stearns in March. Over that summer, it may have appeared as though the fallout from this episode had been contained. But by the fall, it became clear that other large, non-prudentially regulated financial firms threatened financial stability. American International Group (AIG) received direct government support. Two large freestanding investment banks converted themselves into bank holding companies to gain market confidence from the imprimatur of regulatory oversight by the Federal Reserve. Merrill Lynch and Bear Stearns itself ceased to exist as independent entities and were absorbed into existing bank holding companies, with some form of government benefit facilitating the acquisition.5 And, of course, as Fannie Mae and Freddie Mac teetered on the brink of failure, they were placed into government conservatorship, with accompanying full government guarantees of their liabilities. The absence of an option for orderly resolution was faced head-on in the case of Lehman Brothers, whose bankruptcy in September moved the financial crisis to its most acute phase.
Even insured depository institutions such as Wachovia and Washington Mutual, for which special resolution procedures were available, were merged into existing banks with, again, government benefits to make the absorption of these failing banks worthwhile for the acquiring institutions.6 And a number of very large bank holding companies were under grave stress. Meanwhile, financial markets of all sorts had either ceased functioning or come dangerously close to it.
Unlike in some bank crises of the past, direct connections among large financial firms were only part of the problem. At the heart of the crisis were contagion effects among firms holding similar assets--particularly, tradable assets--and the withdrawal of much of the short-term wholesale funding on which many large financial firms and the shadow banking system had come to rely. Needless to say, the larger the firm with lots of tradable assets and runnable funding, the greater the additional threat to the system.
If anyone harbored remaining doubts, it was clear by October that the nation's financial system faced not just severe liquidity problems, but a solvency crisis. In response, following enactment of the Troubled Asset Relief Program by Congress, Secretary Henry Paulson oversaw the injection of government capital into the nation's largest financial firms, as well as into many smaller banking firms. This first step toward stability was reinforced in early 2009 when Secretary Timothy Geithner initiated the stress test exercise to determine how much capital these firms needed to remain viable financial intermediaries and, perhaps as importantly, to share this information with markets. In the succeeding months, the Federal Reserve obliged the firms to raise enough private capital to replace the government capital and to meet the minimum capital levels established by the stress tests.
By the latter part of 2009, the U.S. financial system had been stabilized, but only with substantial injections of taxpayer capital and the complementary support of other guarantees and lending facilities variously provided by the Federal Reserve, the Treasury, and the Federal Deposit Insurance Corporation (FDIC)--both to banks and to non-bank financial actors. And the nation had meanwhile been plunged into the deepest economic downturn since the Great Depression.
Demands were widespread, both in the country and the Congress, for a regulatory response to protect against the reemergence of the conditions that had led to the crisis. While there were different views on exactly what should be done, on how much new authority was needed for the regulators who had not fully exercised their existing powers, and on the degree to which regulators should be required--rather than just empowered--to take certain actions, there was agreement that action was needed. Throughout 2009, discussion and debate ensued not just between, but within, the political parties on how best to respond. If there was one powerful, widely held view that underlay the public debate, it was that the system needed to change to avoid a repeat of the taxpayer bailouts of so many large financial institutions.
It was only toward the end of the legislative exercise that resulted in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that the process took a more partisan turn. Indeed, the Dodd-Frank Act contains measures that commanded fairly wide consensus, such as the need for higher capital requirements for the largest banks. Furthermore, the origins of some features of the legislation rested as much or more with Republican than Democratic legislators, such as the section 165 requirement for resolution plans that will make systemically important firms resolvable in bankruptcy without requiring taxpayer support or resulting in major disorder in the financial system.
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