Balance of bank supervision and regulation
As we learned from the recent U.S. bank failures, responsive, efficient, and effective bank supervision is a strong mitigant for financial system risks and vulnerabilities. The failures revealed that shortcomings in bank supervision can heighten financial stability risks.
The primary focus of supervision should be to address a bank's critical shortcomings in a timely way.6 To effectively support financial stability, bank supervision cannot simply rely on pinpointing compliance issues, failed processes, or rule violations. It must go further to examine a bank's risk exposures while prioritizing core safety and soundness issues in the context of the bank's financial condition. If the supervisory process fails to identify and escalate critical risks, or to hold management accountable for known deficiencies, such as excess interest rate risk-taking, this raises the potential for supervisory shortcomings, including the ability to anticipate how the evolving macro-financial landscape can affect a bank's condition.
As the regulatory framework becomes more complex, we must ensure that supervisors and examiners are adequately equipped to implement and maintain the highest quality of supervision. Even as we focus on improvements to the bank regulatory framework, we should also ensure that supervision includes bank management and their boards of directors. As changes are made to supervisory activities, these changes should be open and transparent, and should be implemented with an appropriate consideration of the tradeoffs and unintended consequences. No regulatory or supervisory framework can be effective without accountability.
Regulatory capital requirements, no matter how conservatively calibrated they may be, are simply no substitute for sound risk management and strong, effective, efficient, and transparent supervision. The vast majority of improvements to supervisory functions could be accomplished without broad changes to the regulatory framework.
While some changes to the regulatory framework may be appropriate to promote financial stability, we should be careful to ensure that changes do not harm the long-term viability of banks, especially midsized and smaller banks. In my view, regulatory reform can pose significant financial stability risks, particularly if those changes to regulation fail to take sufficient account of the incentive effects and potential consequences. Regulatory actions also have the capacity to depress economic activity through the reduced availability of credit or by limiting the availability of financial products or services. These concerns are most acute when the reforms themselves may be inefficient or poorly targeted. For example, policymakers should carefully consider whether the contemplated significant increases in capital requirements in the United States related to the finalization of Basel III capital standards meet this standard for being efficient and appropriately targeted.
Regulatory approaches in the banking sector must also allow for innovation. Inhibiting innovation in the banking sector could push growth of certain products and services further into the nonbank sector, leading to much less transparency and potentially greater financial stability risk. A comprehensive regulatory approach must include enforcing existing regulation through effective supervision, expanding the regulatory perimeter, and addressing regulatory gaps.
Nonbank financial institution supervision and regulation
A key component of fostering financial stability is to ensure that every institution that engages in similar financial activities with similar risks is treated similarly under supervisory and regulatory authorities. Many nonbank financial institutions and products are subject to differing degrees of regulation, oversight, and monitoring. While it is important that the banking system is well-regulated and supervised, it is equally important that this is the case for other types of financial institutions, products, or services. Developing effective frameworks for regulating and supervising common financial markets and products is important for ensuring the protection of consumers and for the stability of the financial system. The Federal Reserve appreciates the work that the Financial Stability Board (FSB) has undertaken in this area and the strong support my co-panelist Governor Klaas Knot has provided in his role as chair of the FSB.
With respect to Treasury market functioning, it is also important that the U.S. continues to carefully consider proposals that could support Treasury market resilience and reduce the likelihood that the Federal Reserve would need to step in to restore market functioning during stressed conditions. For example, in the U.S. the largest banks are subject to a leverage ratio and global systemically important bank (G-SIB) surcharge that are set much higher than the international standard. These higher levels need to be reconsidered to ensure that dealers have adequate balance sheet capacity to intermediate Treasury markets in times of stress. Likewise, increasing data transparency on market pricing and flow should also be considered to encourage intermediary entry and competition.7
Central bank liquidity provision and lending facilities
Should financial stability risks materialize, central banks must be prepared to provide targeted liquidity to financial institutions during times of stress to restore market functioning and financial stability. The use of these lending programs during the pandemic demonstrated their effectiveness in serving as backstops to support market functioning and the flow of credit in times of stress.8 When appropriately calibrated, these programs can help promote market functioning but limit the Federal Reserve's overall footprint in financial markets in the longer term. It is also important to clearly distinguish any temporary central bank asset purchase programs to promote core financial market functioning from monetary policy actions.9
In the banking system, it is also important that tools to support bank liquidity and payments—including discount window operations and Fedwire® within the Federal Reserve—are available for extended operating hours and are prepared to provide support during times of stress. We should also consider what further steps are needed to ensure that banks have access to liquidity support. In addition, we should encourage, but not mandate, the exercise of contingency funding plans and testing capabilities, requiring bank management to ensure adequate plans are in place.
In the Treasury markets, the Federal Reserve should ensure that tools like the standing repurchase agreement (repo) facility are available to serve as backstops in money markets to support the effective implementation of monetary policy and smooth market functioning. Well-calibrated international swap lines and repo facilities can also be helpful in promoting both Treasury market and dollar market functioning. Of course, all central bank lending tools should serve as temporary backstops. Central banks and other agencies should ensure that regulations and market oversight foster prudent financial institution behavior and resiliency in core financial markets. Doing so can increase the ability of private markets and institutions to function during times of stress and reduce the likelihood of future market interventions by the central bank.
Conclusion
Many central banks are facing challenging and uncertain times as they strive to restore price stability and promote financial stability. A stable and resilient financial system is essential for the effective transmission of monetary policy and for a healthy economy. Healthy economies foster financial stability and financial stability fosters healthy economies. It is essential that central banks facing high inflation bring inflation back to target. A failure to do so would only lead to greater financial stability risks through less certain and unstable economic conditions and through reduced central bank credibility.
It is, therefore, necessary that central banks, in collaboration with other financial regulators as appropriate, develop and use supervisory and prudential regulatory tools to promote financial stability. Effective supervision and regulation, in turn, will support the effective conduct of monetary policy in achieving central banks' macroeconomic objectives. As these issues transcend national borders, central banks and regulatory authorities must also aim to build an international perspective that is complementary to or informed by global collaboration. This perspective has never been more important.
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