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 Remarks by Assistant Secretary Marisa Lago at a Georgetown University and PwC Conference on "Financial Institutions in the New Regulatory Environment: Opportunities, Constraints and Global Challenges"


9/22/2011
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As Prepared for Delivery

It is a pleasure to join you.  This conference is so very timely because it tackles some of the same financial regulatory reform issues that the Group of 20 financial leaders will be discussing this weekend as they meet in Washington.

Today, I’ll preview those meetings by taking stock of the G-20’s financial regulatory reform agenda, and I’ll address some of the remaining policy priorities. We have come a long way since the first meetings of the G-20 during the height of the financial crisis, when the need for urgent and collective action to repair the financial sector, stimulate growth, and establish a financial reform agenda were paramount. 

The leaders of the G-20 nations established a robust financial regulatory reform agenda with the intent of preventing future crises of this magnitude.  The United States quickly went to work, crafting the most far-reaching and historic financial reform legislation since the Great Depression:  The Dodd-Frank Wall Street Reform and Consumer Protection Act.  In addition to protecting consumers and taxpayers, and strengthening our financial sector, Dodd-Frank put down an international marker, since the United States was one of the first nations to implement a domestic reform agenda that met, and in many cases exceeded, the G-20 agenda.

As the topics covered in today’s conference demonstrate, our efforts are far from over.  We must now make sure that any global rules are robust enough to deal with the interconnection and integration of our global economy.  And, we must act promptly to minimize opportunities for regulatory arbitrage and ensure a level playing field. 

Let me now highlight a few of the critical financial regulatory reform issues that remain works in progress: capital; OTC derivatives; large, interconnected firms; resolution; and a legal entity identifier (LEI). 

1) First, we have focused on strengthening capital, liquidity, and leverage requirements because these elements can make the difference between the success or failure of firms, and the jobs and livelihoods their lending supports.  Capital, liquidity, and leverage also make the difference between confidence or contagion in the markets, and between protection or exposure of taxpayer dollars. 

In July 2009, as a direct result of lessons learned in the crisis, the Basel Committee issued updates to the market risk framework, known informally as “Basel 2.5”.  These revisions strengthen standards for measuring market risk and holding capital against those risks, and improve transparency, especially with respect to securitization activities.  Basel 2.5 will help banks to better withstand market turmoil such as that experienced during the crisis.

More recently, in November 2010, the G-20 Leaders endorsed a new framework for bank capital, known as Basel III.  This will help to ensure that banks hold significantly more capital, and that the capital will truly be able to absorb losses of a magnitude associated with a major crisis without recourse to taxpayer support.  Basel III will also help to ensure that the level and definition of capital will be uniform across borders. 

In addition to specifying the quantity and quality of capital, Basel III outlines new mandatory leverage and liquidity ratios, which are designed specifically to allow financial institutions to withstand significant balance-sheet losses in times of stress, while still being able to provide credit to households and business, and without exceptional government support. 

Let me give you an example: Basel III includes a simple check – called a mandatory leverage ratio – to protect against the possibility of weak international implementation of these new capital rules.  This simple leverage ratio will require banks to hold a minimum level of capital against total assets, similar to the leverage ratio that has long been in force in the United States, to prevent firms from gaming the system.

Full international convergence will be achieved only if supervisors in all major financial jurisdictions ensure that banks across the world measure risk-weighted assets similarly.  This is essential to maintain a level playing field, and to ensure that markets and investors can be confident that capital adequacy ratios stated by banks are consistent across borders.  We are pursuing comparability by urging greater visibility into supervisors’ scrutiny of how banks measure risk-weighted assets.  We are pleased that the Basel Committee has added this important work to its agenda. 

Already, there is evidence of progress across the globe.  For example, among the 50 largest global banks, tier one capital adequacy ratios have climbed from 8.1 percent in 2007 to 11.3 percent at the end of 2010, making the global financial system markedly more resilient.  Since the end of 2008, the 19 largest financial institutions in the U.S. – the ones that were subjected to stress tests – have together increased common equity by more than $300 billion.  And, European banks have raised $121 billion in capital since Europe’s June 2010 stress test exercise.

In wrapping up this topic, I’ll note that the timeline for Basel III includes a multi-year phase-in period, which allows a staged implementation that minimizes risks to economic recovery. 

2)The second area that I will address is OTC derivatives and the need for international convergence.  In the run-up to the crisis, derivatives were traded over the counter on a bilateral basis, and without transparency, few understood the magnitude of aggregate derivatives exposures in the system.  Firms themselves, as well as their supervisors, had no basis to measure the risks embedded in their derivatives exposure.

This lack of transparency was an important source of unidentified risk to the global financial system.  As we learned from the crisis, we must require greater transparency for the OTC derivatives markets, move their trading onto exchanges, and require them to be centrally cleared. Central clearing will greatly reduce risk by requiring a central clearinghouse to stand in the middle and guarantee the transaction, as well as helping market participants better monitor their risk.  Mandatory trading on exchanges or trading platforms will improve price discovery and greatly enhance transparency.  And reporting to trade repositories will shed light on what was once an opaque market. 

If we do not have international alignment in these rules, firms will move activities to jurisdictions with lower standards, and we will suffer from a “race to the bottom,” increasing risks to the global financial system.  For this reason, G-20 Leaders set forth sound new principles to govern derivatives frameworks.  And I will note that Dodd-Frank fully aligns with these principles which require that swaps be centrally cleared and traded on a regulated platform. 

At the international level, work is proceeding in numerous standard setting and regulatory bodies to promote international convergence, and develop supervisory cooperation arrangements.  In addition, the U.S. is actively engaged with our counterparts in Europe and Asia to encourage them to adopt equally robust standards that live up to our G-20 commitments.  It will come as no surprise that, because of the size of our respective markets, we coordinate especially closely with Europe. 

Both the U.S. and the European Commission are now developing margin requirements for OTC derivatives that are not centrally cleared.  The posting of margin is an important risk management tool that helps counterparties cover current and future exposures to OTC derivative contracts.  More broadly, margin reduces risk to the global financial system.  Secretary Geithner recently proposed achieving global agreement on specific minimum standards for margins on un-cleared derivatives in order to prevent regulatory arbitrage.  These standards would be analogous to the standards for banks that have been developed through the Basel Committee.  We are pleased that international work on this topic is now underway.

3) A third vital issue is reducing the systemic risk from large, interconnected financial firms.   Prior to the crisis, many large, interconnected firms held too little capital relative to their risk-weighted assets, posing risk to the global financial system, and in the end necessitating significant government intervention when their balance sheets deteriorated rapidly.  

To guard against a recurrence and to protect our taxpayers, Dodd-Frank created the Financial Stability Oversight Council to coordinate across agencies and instill joint accountability for the stability of the financial system.  The Act provides the Council with a leading role in several important regulatory decisions, including designating the largest, most interconnected firms for heightened prudential standards. 

 G-20 Leaders also committed to developing additional capital requirements for Globally-interconnected Systemically Important Financial Institutions, G-SIFIs.  We are now at an advanced stage in identifying global systemically important banks.  Work is at earlier stages in identifying global systemically important insurers and other institutions. 

The U.S. welcomes the FSB and the Basel Committee proposal for a capital surcharge for G-SIFIs, especially its focus on raising common equity.  We have been clear about our priorities:

First, it is critical that additional capital consists first and foremost of high quality and loss absorbing common equity. Common equity is the strongest defense against financial stress. Lower quality alternative instruments just cannot absorb losses as readily in a crisis. 

Second, it is equally important that the capital surcharge be well calibrated to balance the imperatives of the financial sector and of macroeconomic stability.

And third, the G-SIFI capital surcharge must apply to a wide range of the large, interconnected financial institutions across the globe to promote a level playing field.  And it must be both mandatory and comparable across jurisdictions.

4) The fourth topic that I will touch upon is resolution regimes. The recent financial crisis demonstrated the economic damage to our financial system and the global economy when large, complex financial institutions failed in a disorderly manner. The crisis exposed the fact that many countries lacked comprehensive national resolution tools and cross-border arrangements for winding down systemically important firms. 

Dodd-Frank established a special robust resolution regime that provides federal regulators with strong authorities to resolve financial institutions that pose a systemic threat to the broader financial system.  These new authorities extend the resolution powers beyond traditional bankruptcy laws.  They permit the federal regulators to wind down a firm in an orderly manner, and in a manner that takes account of the impact on the broad financial system.

But, when addressing firms that operate in multiple countries, the best national resolution regime in the world will not be sufficient if other countries do not have complementary authorities. 

That is why the United States successfully urged the G-20 Leaders to endorse a set of principles for developing an effective cross-border resolution system.  We recognize that achieving a truly international cross-border resolution regime is complex, and it is going to take time.  We are currently working, through the FSB, on a three-pronged international framework.  First, ensuring that regulators and G-SIFIs develop recover and resolution plans (these are the so-called living wills), which provide for advanced planning before a crisis.  Second, developing criteria to improve the “resolvability” of G-SIFIs.   Third, negotiating institution-specific cross-border resolution cooperation arrangements with foreign regulators. 

The U.K. and Germany have already passed resolution legislation, and the European Commission is considering proposals.  For our part, we will continue working to encourage other jurisdictions to adopt national resolution powers and implement the legal reforms that will allow them to achieve orderly resolution. 

5) The final topic that I want to touch upon briefly is LEI – legal entity identifiers.  Secretary Geithner called for the establishing of one global system for uniquely identifying parties to financial transactions.  A legal entity identifier system would be an efficient way to help regulators –and firms themselves – better understand—and ultimately reduce—systemic risk.   If such a system had been in place during the financial crisis, policy makers and the private sector would have had a much better understanding of the true exposures and interconnectedness among and across financial systems.

So, these are just some of the critical issues that we face on the global financial regulatory landscape.  We know that the steps we have taken in the U.S. and globally have helped. Banks have more capital. Leverage has been reduced.  We also know that we need to do more.  We must continue to pursue the highest standards if we want to secure our financial system against future crises, cultivate financial markets that efficiently allocate capital and support growth, and maintain the competitiveness of our markets and financial firms.  Recent history has underscored that the risk is not in being too bold, too strong or too secure, but rather in being too lax and too vulnerable.  Together with our partners in the G-20, the U.S. seeks to establish high standards that allow competition and innovation to thrive, while protecting consumers and taxpayers from future crises.

Thank you.

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