FRBank-NY’s Dudley Discusses Global Regulatory Reform

By John M. Pachkowski, J.D., Editor, CCH Federal Banking Law Reporter and Bank Digest Author, Anti-Money Laundering and Bank Secrecy: Compliance and the USA PATRIOT Act; co-Author CCH Financial Privacy Law Guide and Dodd-Frank Wall Street Reform and Consumer Protection Act—Law, Explanation and Analysis, April 11, 2011.

In a speech before the Institute of Regulation & Risk North Asia in Hong Kong, William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York discussed regulatory reform and the global financial system. His remarks covered: the actions underway in the United States and internationally to make the financial system more resilient and robust; the logic behind the reform efforts; progress to date; and areas where there still is considerable work.

At the outset, Dudley noted that the financial crisis exposed significant vulnerabilities in the financial system, but added, “[t]ruly effective reform would generate sizable and widespread benefits.” However, he cautioned that there are “significant challenges to achieving this.”

The Reserve Bank president then discussed a number of the initiatives underway to address the issues exacerbated by the financial crisis, noting that most of these initiatives can be grouped into three major categories:

1. Actions to significantly reduce the probability of failure of large systemically important financial institutions.
2. Measures to broaden the oversight of the financial system to include activities that occur outside of the core banking system.
3. Steps to strengthen the resolution regime and the core financial market infrastructure to ensure that when a large complex financial firm fails, the failure doesn’t threaten to bring down the entire financial system.

Reducing SIFI Failures

The tougher capital and liquidity regimes that the Basel Committee has devised “are probably the most important elements” to reducing the probability of failures of large, systemically important financial institutions (SIFIs). Dudley noted that Basel III’s 2.5 percent capital conservation buffer should act as a form of “automatic stabilizer” to a financial institution’s capital resources and change the incentives banks face during periods of stress. Moreover, the Basel Committee’s proposed liquidity coverage ratio requirement for globally active financial institutions would create a pool of liquid assets that would “buy time” for a financial institution to explore options to restore market confidence.

Shadow Banking

In regards to regulation of the shadow banking system, Dudley noted that this “is still in its early days. But work is underway.” He cited work by the Financial Stability Board to identify potential sources of vulnerability caused by the activities in the shadow banking and that in the United States, the Financial Stability Oversight Council (FSOC) views its mandate broadly with respect to identifying systemic risks and proposing remedies. For example, on an ongoing basis, the FSOC will monitor and assess which non-bank financial intermediaries in the United States are systemically important and, thus, require greater regulatory oversight.

Resolution Authority

The final major strand of regulatory reform is to strengthen the core of the financial system and make the system as a whole robust to the failure of a large bank or non-bank financial institution. In this realm, there are several notable initiatives.

First, there is the creation of robust resolution regimes that allow large systemically important financial institutions to be wound down smoothly so as to minimize contagion and the risk of a broader panic or that causes damage to other parts of the financial system. A second effort is a evaluation by global regulators as to provide “bail-in” forms of capital to help recapitalize firms when they would otherwise lose their viability, or, alternatively, to help facilitate the orderly wind-down of a firm. Another effort is the reduction of counterparty risk exposures by requiring that over-the-counter (OTC) interest rate swaps, credit default swaps, and equity and commodity derivative trades be standardized where feasible—and that all standardized trades be cleared through central counterparties (CCPs). A final effort, related to reducing counterparty risk exposure, is to strengthen financial market infrastructures.

Challenges to Reform Implementation

Dudley then noted that there were broad challenges in designing and implementing effective reform:

• The resolution of large financial firms that operate in multiple jurisdictions remains largely out of reach—at least in the near- to medium-term due legal rules that are not harmonized across the different regulatory regimes.
• The uneven progress of reform across different jurisdictions shifts the tenor of the discussion away from what is the proper macroprudential framework and set of capital and liquidity requirements to one that focuses too much on issues of relative competitiveness.
• The sequencing of reforms is another challenge and that “the regulatory oversight effort has to be broadly applied “so we just don’t trade one problem—for example, undercapitalized large banks—for another—a shrunken regulated banking sector and an enlarged, unregulated non-banking sector.”

The Road Ahead

Finally, Dudley discussed “what needs to be done?” and provided “In short, plenty.” He focused on:

• The need to adopt an additional capital requirement on large global systemically important financial institutions so as to reduce the risk of failure of such institutions to very low levels since all the necessary resolution tools are not in place.
• Discourage regulatory arbitrage and “beggar-thy-neighbor” policies that might benefit narrow national constituencies at the expense of global financial stability.
• Closer cooperation among regulators.
• Greater clarity concerning the responsibilities of the home versus the host country, especially when a bank encounters problems.
• How emergency liquidity should be provided on a cross-border basis.
• The need to be persistent and avoid the natural reflex will be to relax and grow complacent.

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