The Road to a More Effective Regulatory Environment

The global financial regulatory environment has changed dramatically in many ways since the onset of the financial crisis. The events of the fall of 2008 were a watershed in how market participants, regulators, politicians, media, and the public viewed the financial system. For me, along with many others, it was certainly a sobering—and instructive—event as the existing crisis plans either fell short or simply became irrelevant. While the U.S. government, and bankers, took decisive action to prevent the worst consequences of the market disarray, many of the lessons from the crisis remain under debate. In many ways, this debate is a prism for broader questions about the future role and framework of the financial system.

In the wake of the 2008-2009 financial crisis, very few challenged the idea that we needed regulatory reform to make our financial system, and its participants, more resilient, accountable, and resolvable.1 However, even with this general consensus, little effort has gone into assessing whether these broad goals have been translated into the specific regulatory reforms now underway. Indeed, many of the debates today around resolution authority and the desire of some to “break up the banks” revolve around disagreements about the nature of the financial system we are trying to achieve through regulatory reform. That is unfortunate since, to paraphrase the Cheshire Cat, “if you don’t know where you’re going, any road will get you there.”2

The 2009 Treasury blueprint, “Financial Regulatory Reform: A New Foundation”, embodied a mixed bag of reformist ideas. However, it did focus on improving the resiliency of financial companies and markets, enhancing regulatory coordination, and creating a new resolution process for non-bank financial companies. 3 The final Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) transformed—in many ways for the better—the original Treasury proposal, but the road to final enactment also led to new requirements that were not part of the original concepts, including the Volcker Rule and the Lincoln Amendment requiring the push-out of certain swaps activities. These latter reforms seemed mostly unrelated to the causes of the financial crisis and, while in principle intended to improve resiliency, may have instead impaired the ability of financial companies to weather future market dislocations.

The debate about the lessons from the crisis continues to affect the ongoing regulatory reform process in the United States and around the globe. Perhaps one of the clearest lessons from the financial crisis was that the U.S., and every other country, needed better tools so that all failing financial companies could be resolved without destabilizing the financial system and without imposing the burden on taxpayers.

This edition of Banking Perspective addresses critical issues involved in meeting this goal. The implementation of effective resolution tools must, as Greg Baer in particular notes, be integrated into a supporting regulatory framework of enhanced capital and liquidity. Other articles discuss how different strategies may be best suited for different types of companies, and describe how the development of thinking on effective resolution strategies over the past two years has brought us much closer to our goal. As observed in other articles, we still have much work to do, including by enhancing cross-border coordination and promoting greater market understanding of preferred resolution strategies. Nonetheless, there has been enormous progress. Combined with the extensive work undertaken by the banks to develop effective resolution plans—under Title I of Dodd-Frank—we have already laid the foundation for the essential capabilities to respond to any future crisis.

Where is Regulatory Reform Headed?

Our banks weathered a financial cataclysm of unexpected severity. Though government intervention played a critical role in responding to that upheaval, banks themselves took key steps to strengthen their financial and operational resiliency during the crisis. Their ability to raise capital and liquidity reserves during a trying economic period—as part of supervisory stress tests and close regulatory coordination to be sure—contributed substantially to calming the financial markets and preventing a long-term recession. Since 2009, banks have continued to strengthen their balance sheets with much larger cushions of capital, long-term debt, and liquidity reserves, both to meet regulatory requirements and to restore confidence in their ability to serve businesses and consumers. While government played a key role, banks have received too little credit for their responses.

Over the past six years, many new regulatory reforms have been adopted. Many are only now coming into effect and others, including Volcker and more stringent capital and liquidity standards, are still not fully implemented. However, banks already have made important strides toward more streamlined corporate and operational structures with increased flexibility and efficiency.

Nonetheless, some argue that final implementation of the existing reform frameworks will be insufficient. These critics fundamentally question the value of improvements in resolution capabilities because, they have concluded, these banks are too large, too complex, and too global to be resolved. From their perspective, the only regulatory reform requires global banks to shrink and restructure.

These criticisms, in my view, fail to acknowledge the role of finance and banks in our global system, and the negative consequences that can flow from too narrowly defining permissible banking activities in a dynamic financial system. Initially, in a globalized financial marketplace, it will be difficult, if not impossible, to meet the needs of global businesses with banks that cannot draw on global resources. Forced subsidiarization and further significant restrictions on banks’ activities will have direct consequences on their ability to meet the needs of global businesses.

We no longer live in a world where banks are the only sources for financial resources and services. Restrictions on banks will only drive those activities to other market participants who may, or may not, conduct them in a way that could give rise to new systemic risks. It has long been clear that other financial market participants can trigger instability in our financial markets. As history teaches, governments will respond to systemic risks no matter whether they originate within or outside the formal governmental safety net. Therefore, a solution to the risk of “too big to fail” must be focused on ensuring that all market participants can be resolved.

Finally, we are only now implementing many of the financial reforms adopted in the wake of the financial crisis. The effect of some of those reforms remains undetermined. While some critics point to purported lower funding costs for global banks to demonstrate a persistence of TBTF, the studies to date are based principally on historical data from the immediate post-crisis period or earlier. However, it would have been surprising indeed if data from just after the crisis had not shown an expectation of governmental support given the massive government intervention. More recent data tend to show that the difference in funding costs has been reduced if not eliminated. Clearly, it is too early to fully assess the impact of the current reforms. To make a reasoned assessment, we need to complete the current reforms.

The financial crisis demonstrated the need for significant regulatory reform. While some regulatory initiatives may relate only tangentially to crisis lessons, the need for effective resolution frameworks for all banks is clear. As this issue of Banking Perspective shows, we have made great progress on the road to accomplishing this goal. If some other goals of regulatory reform remain disputed, no one disputes that creation of an effective resolution framework is essential. While more work remains, our progress so far shows that we are on track to this clear goal. •