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Enhancing Prudential Standards in Financial Regulations

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Abstract

The financial crisis has generated fundamental reforms in the financial regulatory system in the U.S. and internationally. Much of this reform was in direct response to the weaknesses revealed in the pre-crisis system. The new “macroprudential” approach to financial regulations focuses on risks arising in financial markets broadly as well as the potential impact on the financial system that may arise from financial distress at systemically important financial institutions. Systemic risk is the key factor in financial stability, but our current understanding of systemic risk is rather limited. While the goal of using regulation to maintain financial stability is clear, it is not obvious how to design an effective regulatory framework that achieves the financial stability objective while also promoting financial innovations. This article discusses academic research and expert opinions on this vital subject of financial stability and regulatory reforms. Specifically, among other issues, it discusses the impact of increasing public disclosure of supervisory information, effectiveness of bank stress testing as a tool to enhance financial stability, whether the financial crisis was caused by TBTF, and whether the DFA resolution regime would be effective in achieving financial stability and ending TBTF.

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Notes

  1. Governor Daniel Tarullo (February 25, 2014) also pointed out that the recent financial crisis had prompted increased attention on the relationship between monetary policy and financial stability. Similarly, then-Governor Jeremy C. Stein (March 21, 2014) supported the idea of explicitly incorporating financial stability considerations into a monetary policy framework. Moreover, Federal Reserve Chair Janet Yellen (July 2, 2014) noted that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment.

  2. See, for example, Stern and Feldman (2004, 2009).

  3. For more details of his discussion, see Kaufman (2014).

  4. The following is a quick summary of the FDIC resolution process: 1) Receivership—Transfer assets to newly created bridge financial company, replace officers, appoint new board of directors. 2) Funding well-capitalized bridge company—with funding from private market—if market funding not immediately obtained, the FDIC could utilize Orderly Liquidity Fund (OLF), which is a LOC that the FDIC has from the Treasury, on a short-term transitional basis. Taxpayer losses are prohibited. 3) Claims—SHS’s equity, sub debt, and substantial portion of unsecured debt of HC are left in receivership—loss in this order. 4) Termination of Bridge Co.—terminated upon FDIC approval of enforceable restructuring plan—will then be owned by outside creditors. 5) International coordination plays an important role in the resolution process—the FDIC has been working closely with the U.K. regulators and the European Union.

  5. The SPOE strategy is intended to minimize market disruption by isolating the failure and associated losses in a SIFI to the top-tier holding company while maintaining operations at the subsidiary level so that the resolution would be confined to one legal entity (the holding company) and would not trigger the need for resolution or bankruptcy across the operating subsidiaries, multiple business lines, or various sovereign jurisdictions. The FDIC is still in the process of determining the required (optimal) amount of debt holding to ensure sufficient funding for the operations of the critical functions and a successful recapitalization.

  6. Lawson (2014) finds that the chance of well-capitalized banks’ tier 1 capital falling below 4 % was once in 41 years during the pre-crisis period, but is now once every 56 years.

  7. “Comprehensive Capital Analysis and Review 2014: Assessment Framework and Results,” Federal Reserve Board 2014.

  8. See Bulow and Klemperer (2013) and Bond et al. (2010) for more on the role of market-based measure (rather than accounting-based) for capital requirements.

  9. Kapinos and Mitnik (2016, in this special issue) show how informative a top-down (rather than the current bottom-up approach) stress testing could be. Their paper was originally circulated in 2014 under the title “Can Top-Down Banking Stress Tests Be Informative?”

  10. There were no TBTF banks in the 1920s and 1930s, and yet, systemic risk prevailed, resulting in the Great Depression. There are also many kinds of systemic risks, such as those caused by panics, falling asset prices (such as the bursting of real estate bubbles or other asset price bubbles), contagion, or rising interest rates.

  11. See also Acharya et al. (2012).

  12. See, for example, Herring and Wachter (1999).

  13. See Freixas et al. (2000).

  14. A list of SIFIs has been created by the Basel Committee and is updated in November each year based on the institution’s size, complexity, and interconnectedness. Under the DFA, SIFIs are subject to enhanced capital standards, such as countercyclical capital buffers, liquidity requirements, increased capital charges for exposures to large financial institutions, large exposure rules, etc.

  15. See Pozsar et al. (2013) for a comprehensive discussion and review of this topic.

  16. At the time of the conference, Charles Plosser was President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia (August 2006 to February 2015). Plosser’s speech is consistent with the views expressed by Haldane (2012a, b). The full speech is available online at http://www.philadelphiafed.org/publications/speeches/plosser/2014/04-08-14-frbp.cfm.

  17. See Calomiris and Herring (2013) for a discussion on how to design contingent convertible debt requirements.

  18. Ben Bernanke (2010) said, “The release of detailed information enhanced the credibility of the exercise by giving outside analysts the ability to assess the findings, which helped restore investor confidence in the banking system. In a demonstration of greater confidence, nearly all of the SCAP firms that were judged to need additional capital were able to raise the capital in the public markets through new issues or by voluntary conversions of preferred to common shares.”

  19. For more details of the proposed approach, see Dudley (2014) and Mosser et al. (2013).

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Author notes

  1. William W. Lang

    Present address: Promontory Financial Group, New York, NY, USA

Authors and Affiliations

  1. Imperial College London, London, UK

    Franklin Allen

  2. The Wharton School of the University of Pennsylvania, Philadelphia, PA, USA

    Franklin Allen & Itay Goldstein

  3. Federal Reserve Bank of Philadelphia, Philadelphia, PA, USA

    Julapa Jagtiani & William W. Lang

Authors
  1. Franklin Allen
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  2. Itay Goldstein
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  3. Julapa Jagtiani
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  4. William W. Lang
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Corresponding author

Correspondence to Julapa Jagtiani.

Additional information

This paper is an introduction to the regulatory issues discussed at the conference held at the Federal Reserve Bank of Philadelphia on April 8–9, 2014. The conference was jointly organized by the Federal Reserve Bank of Philadelphia, the Wharton Financial Institutions Center, and the Journal of Financial Services Research. Please direct correspondence to Julapa Jagtiani, Federal Reserve Bank of Philadelphia, Supervision, Regulation & Credit Department, Ten Independence Mall, Philadelphia, PA 19106; 215-574-7284; e-mail: julapa.jagtiani@phil.frb.org. The views in this paper are the authors’ and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

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Allen, F., Goldstein, I., Jagtiani, J. et al. Enhancing Prudential Standards in Financial Regulations. J Financ Serv Res 49, 133–149 (2016). https://doi.org/10.1007/s10693-016-0253-2

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