Despite the forceful policy responses by the Treasury, the Congress, the FDIC, and the Federal Reserve as well as authorities abroad, the crisis continued to intensify: The vulnerabilities in the US and global economies had grown too large, and the subsequent damage was enormous. From the beginning of 2008 to early 2010, nearly 9 million jobs, on net, were lost in the United States. Millions of Americans lost their homes. And distress was not limited to the U.S. economy: Global trade and economic activity contracted to a degree that had not been seen since the 1930s. The economic recovery that followed, despite extraordinary policy actions, was painfully slow.
These painful events renewed efforts to guard against financial instability. The Congress, the Administration, and regulatory agencies implemented new laws, regulations, and supervisory practices to limit the risk of another crisis, in coordination with policymakers around the world.
The vulnerabilities within the financial system in the mid-2000s were numerous and, in hindsight, familiar from past financial panics. Financial institutions had assumed too much risk, especially related to the housing market, through mortgage lending standards that were far too lax and contributed to substantial overborrowing. Repeating a familiar pattern, the "madness of crowds" had contributed to a bubble, in which investors and households expected rapid appreciation in house prices. The long period of economic stability beginning in the 1980s had led to complacency about potential risks, and the buildup of risk was not widely recognized.8 As a result, market and supervisory discipline was lacking, and financial institutions were allowed to take on high levels of leverage. This leverage was facilitated by short-term wholesale borrowing, owing in part to market-based vehicles, such as money market mutual funds and asset-backed commercial paper programs that allowed the rapid expansion of liquidity transformation outside of the regulated depository sector. Finally, a self-reinforcing loop developed, in which all of the factors I have just cited intensified as investors sought ways to gain exposure to the rising prices of assets linked to housing and the financial sector. As a result, securitization and the development of complex derivatives products distributed risk across institutions in ways that were opaque and ultimately destabilizing.
In response, policymakers around the world have put in place measures to limit a future buildup of similar vulnerabilities. The United States, through coordinated regulatory action and legislation, moved very rapidly to begin reforming our financial system, and the speed with which our banking system returned to health provides evidence of the effectiveness of that strategy. Moreover, U.S. leadership of global efforts through bodies such as the Basel Committee on Banking Supervision, the Financial Stability Board (FSB), and the Group of Twenty has contributed to the development of standards that promote financial stability around the world, thereby supporting global growth while protecting the U.S. financial system from adverse developments abroad. Preeminent among these domestic and global efforts have been steps to increase the loss-absorbing capacity of banks, regulations to limit both maturity transformation in short-term funding markets and liquidity mismatches within banks, and new authorities to facilitate the resolution of large financial institutions and to subject systemically important firms to more stringent prudential regulation.
Several important reforms have increased the loss-absorbing capacity of global banks. First, the quantity and quality of capital required relative to risk-weighted assets have been increased substantially.9 In addition, a simple leverage ratio provides a backstop, reflecting the lesson imparted by past crises that risk weights are imperfect and a minimum amount of equity capital should fund a firm's total assets. Moreover, both the risk-weighted and simple leverage requirements are higher for the largest, most systemic firms, which lowers the risk of distress at such firms and encourages them to limit activities that could threaten financial stability.10 Finally, the largest US banks participate in the annual Comprehensive Capital Analysis and Review (CCAR)‑‑the stress tests. In addition to contributing to greater loss-absorbing capacity, the CCAR improves public understanding of risks at large banking firms, provides a forward-looking examination of firms' potential losses during severely adverse economic conditions, and has contributed to significant improvements in risk management.
Reforms have also addressed the risks associated with maturity transformation. The fragility created by deposit-like liabilities outside the traditional banking sector has been mitigated by regulations promulgated by the Securities and Exchange Commission affecting prime institutional money market funds. These rules require these prime funds to use a floating net asset value, among other changes, a shift that has made these funds less attractive as cash-management vehicles. The changes at money funds have also helped reduce banks' reliance on unsecured short-term wholesale funding, since prime institutional funds were significant investors in those bank liabilities. Liquidity risk at large banks has been further mitigated by a new liquidity coverage ratio and a capital surcharge for global systemically important banks (G-SIBs). The liquidity coverage ratio requires that banks hold liquid assets to cover potential net cash outflows over a 30-day stress period. The capital surcharge for US G-SIBs links the required level of capital for the largest banks to their reliance on short-term wholesale funding.11
While improvements in capital and liquidity regulation will limit the reemergence of the risks that grew substantially in the mid-2000s, the failure of Lehman Brothers demonstrated how the absence of an adequate resolution process for dealing with a failing systemic firm left policymakers with only the terrible choices of a bailout or allowing a destabilizing collapse. In recognition of this shortcoming, the Congress adopted the orderly liquidation authority in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to provide an alternative resolution mechanism for systemically important firms to be used instead of bankruptcy proceedings when necessary to preserve financial stability. The orderly liquidation authority contains a number of tools, including liquidity resources and temporary stays on the termination of financial contracts, that would help protect the financial system and economy from the severe adverse spillovers that could occur if a systemic firm failed. Importantly, any losses incurred by the government in an Orderly Liquidation Authority resolution would not be at the expense of taxpayers, since the statute provides that all such losses must be borne by other large financial firms through subsequent assessments. In addition, the Congress required that the largest banks submit living wills that describe how they could be resolved under bankruptcy.12 And the Federal Reserve has mandated that systemically important banks meet total loss-absorbing capacity requirements, which require these firms to maintain long-term debt adequate to absorb losses and recapitalize the firm in resolution. These enhancements in resolvability protect financial stability and help ensure that the shareholders and creditors of failing firms bear losses. Moreover, these steps promote market discipline, as creditors — knowing full well that they will bear losses in the event of distress — demand prudent risk-taking, thereby limiting the problem of too-big-to-fail.
Financial stability risks can also grow large outside the regulated banking sector, as amply demonstrated by the events of 2007 and 2008. In response, a number of regulatory changes affecting what is commonly referred to as the shadow banking sector have been instituted. A specific example of such risks, illustrative of broader developments, was the buildup of large counterparty exposures through derivatives between market participants and AIG that were both inappropriately risk-managed and opaque. To mitigate the potential for such risks to arise again, new standards require central clearing of standardized over-the-counter derivatives, enhanced reporting requirements for all derivatives, and higher capital as well as margin requirements for noncentrally cleared derivatives transactions.13
Another important step was the Congress's creation of the Financial Stability Oversight Council (FSOC). The council is responsible for identifying risks to financial stability and for designating those financial institutions that are systemically important and thus subject to prudential regulation by the Federal Reserve. Both of these responsibilities are important to help guard against the risk that vulnerabilities outside the existing regulatory perimeter grow to levels that jeopardize financial stability.14
The evidence shows that reforms since the crisis have made the financial system substantially safer. Loss-absorbing capacity among the largest banks is significantly higher, with Tier 1 common equity capital more than doubling from early 2009 to now.15 The annual stress-testing exercises in recent years have led to improvements in the capital positions and risk-management processes among participating banks. Large banks have cut their reliance on short-term wholesale funding essentially in half and hold significantly more high-quality, liquid assets. Assets under management at prime institutional money market funds that proved susceptible to runs in the crisis have decreased substantially. And the ability of regulators to resolve a large institution has improved, reflecting both new authorities and tangible steps taken by institutions to adjust their organizational and capital structure in a manner that enhances their resolvability and significantly reduces the problem of too-big-to-fail.
The progress evident in regulatory and supervisory metrics has been accompanied by shifts in private-sector assessments that also suggest enhanced financial stability. Investors have recognized the progress achieved toward ending too-big-to-fail, and several rating agencies have removed the government support rating uplift that they once accorded to the largest banks. Credit default swaps for the large banks also suggest that market participants assign a low probability to the distress of a large U.S. banking firm. Market-based assessments of the loss-absorbing capacity of large US banks have moved up in recent years, and market-based measures of equity now lie in the range of book estimates of equity. To be sure, market-based measures may not reflect true risks — they certainly did not in the mid-2000s — and hence the observed improvements should not be overemphasized.16 But supervisory metrics are not perfect, either, and policymakers and investors should continue to monitor a range of supervisory and market-based indicators of financial system resilience.
Economic research provides further support for the notion that reforms have made the system safer. Studies have demonstrated that higher levels of bank capital mitigate the risk and adverse effects of financial crises.17 Moreover, researchers have highlighted how liquidity regulation supports financial stability by complementing capital regulation.18 Economic models of the resilience of the financial sector — so called top-down stress-testing models — reinforce the message from supervisory stress tests that the riskiness of large banks has diminished over the past decade.19 Similarly, model-based analyses indicate that the risk of adverse fire sale spillovers across banks or broker-dealers have been substantially mitigated.20
I suspect many in this audience would agree with the narrative of my remarks so far: The events of the crisis demanded action, needed reforms were implemented, and these reforms have made the system safer. Now — a decade from the onset of the crisis and nearly seven years since the passage of the Dodd-Frank Act and international agreement on the key banking reforms — a new question is being asked: Have reforms gone too far, resulting in a financial system that is too burdened to support prudent risk-taking and economic growth?
The Federal Reserve is committed individually, and in coordination with other US government agencies through forums such as the FSOC and internationally through bodies such as the Basel Committee on Banking Supervision and the FSB, to evaluating the effects of financial market regulations and considering appropriate adjustments. Furthermore, the Federal Reserve has independently taken steps to evaluate potential adjustments to its regulatory and supervisory practices. For example, the Federal Reserve initiated a review of its stress tests following the 2015 cycle, and this review suggested changes to reduce the burden on participating institutions, especially smaller institutions, and to better align the supervisory stress tests with regulatory capital requirements.21 In addition, a broader set of changes to the new financial regulatory framework may deserve consideration. Such changes include adjustments that may simplify regulations applying to small and medium-sized banks and enhance resolution planning.22
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