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 Remarks by Assistant Secretary for Financial Institutions Michael Barr at the Financial Times Global Finance Forum on "Reforming the Global Financial System"


12/2/2010
New York, NY
As Prepared for Delivery
 
Over two years ago, our country faced the worst economic crisis since the Great Depression. A crisis rooted in years of unconstrained excess on Wall Street; and prolonged complacency in Washington and in major financial capitals around the world.
 
A crisis that has made painfully clear what we should have always known--that finance cannot be left to regulate itself; 
 
That consumer markets permitted to profit on the basis of tricks and traps rather than price, quality, and competition will, ultimately, put us all at risk; and
 
That financial markets function best where there are clear rules, transparency and accountability; and that markets break down, sometimes catastrophically, where there are not.
 
For many years, a core strength of the U.S. financial system had been a regulatory structure that sought a careful balance between incentives for innovation and competition, on the one hand, and protections from abuse, predation and excessive risk-taking, on the other.
 
When that balance was properly struck, our system worked at its best. 
 
And for the better half of the last century, the American financial system surpassed other major developed economies in innovation and productivity growth. It was consistently better at directing investment towards the companies and industries where the returns would be the highest. Its regulatory checks and balances helped create a remarkably long period of relative economic stability which, in turn, gave rise to extraordinary national wealth. It endured crises--and recessions--but they were shorter and less damaging.
 
And it did so while providing investors and consumers with strong protections.     
 
Over time those great strengths of our system were undermined.  The careful mix of protections we created eventually eroded with the development of new products and markets for which those protections had not been designed.   And our regulatory system found itself outdated, outgrown and outmaneuvered by the very institutions, markets and instruments it was responsible for regulating and constraining.
 
In the years leading up to the recent crisis, we saw significant growth of large, short-funded, and substantially interconnected financial firms.    Huge amounts of risk moved outside the regulated parts of the banking system to where it was easier to increase leverage.   Creditors and investors hardened in their belief that large firms could grow larger, take on more leverage, engage in riskier activity – and avoid paying the consequences should those risks turn bad.
 
Legal loopholes and regulatory gaps allowed large parts of the financial industry to operate without oversight, transparency, or restraint; allowed unchecked predatory and abusive lending; and failed to require sufficient responsibility from those who, for example, made loans, sold loans, or packaged loans into complex instruments to be sold to investors.
 
Derivatives were traded in the shadows, and entities performing the same market functions as banks escaped meaningful regulation on the basis of their corporate form.  The financial sector, under the guise of innovation, piled ill-considered risk upon risk. The lack of transparency hid the growing wedge in incentives facing different players in the system.
 
And then, in the fall of 2008, credit markets froze.  And the over-reliance on short-term financing, opaque markets and excessive-risk taking that had been the source of significant profit on Wall Street and in financial capitals globally, fed a panic that nearly collapsed the global financial system.
 
When President Obama came into office our financial markets were in a state of crisis.   Our economy was shrinking.  Our nation was losing over 750,000 jobs a month. Small businesses were closing their doors. And home prices were in free fall.  President Obama moved quickly and forcefully.  His actions stabilized the financial markets, reduced the widespread harm brought on by the failed policies of the past, and restarted economic growth.  Had he not taken such decisive action undoubtedly the recession--as brutal as it has been--would have been far, far worse.
 
Yet stabilizing the economy did not address the failures that led to the crisis.
 
Our system failed to require real transparency in key markets, especially fast developing ones.  Rapid growth hid misaligned incentives and underlying risk.  Financial innovation often outpaced the capacity of managers, regulators and markets to understand new risks and adjust.  Throughout our system we had inadequate capital buffers – as both market participants and regulators failed to account for new risks appropriately.  The apparent short-term rewards in new financial products and rapidly growing markets overwhelmed private sector gatekeepers, and swamped those parts of the system that were supposed to mitigate risk.  And households took on risks that they did not fully understand and could ill-afford.   
 
Further action was necessary to restore discipline to our financial markets, adequate protections to consumers and investors, and the market's long-term ability to generate innovation, efficiency and economic growth for future generations of Americans. 
 
The test of whether a financial system works is whether it does a reasonable job of channeling savings to finance future innovation and growth.  The test is whether it protects consumers and investors.  And the test is also whether it can do so while supporting, not harming the economy.  Financial intermediation, capital formation and reasonable risk-taking are essential to well functioning markets and innovation that leads to long-term growth.  But innovation demands a system of regulation that protects our financial system from catastrophic failure, protects consumers and investors from widespread harm and ensures that they have the information they need to make appropriate choices.   
 
In the lead up to 2008, our system failed that test.
 
That is why President Obama called for comprehensive Wall Street reform.  And last summer, he signed into law the Dodd-Frank Act--the most sweeping reform of financial regulation since the New Deal.
 
These reforms require the largest financial firms to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on the riskiest financial activities. They increase regulatory accountability, bring transparency to the shadow banking system and comprehensively regulate our derivatives markets.  In addition, these reforms filled a regulatory gap by creating a much needed mechanism for the government to orderly liquidate failing financial firms without putting taxpayers at risk.
 
The Act modernizes the fundamental architecture of U.S. financial regulation and provides a strong foundation on which we must now carefully build a more stable and balanced regulatory system--a system that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in financial markets. 
 
Restoring Balance to the Financial Regulatory System.
 
I have to admit, that what I continue to find most curious about the voices of opposition to these reforms is that the logic often rests on the presumption that regulation is somehow at odds with efficient and innovative markets.
 
In fact, the opposite is true.  Markets rely on good faith and on trust and fair dealing.  Markets require transparency that reflects economic reality rather than distortions caused by misleading sales pitches and hidden traps.  And discipline of the market requires accountability and clear rules that are fairly and consistently applied.
 
In each of these, before Dodd-Frank, our financial system fell significantly short. 
 
Let's just take a step back and remember why reform was necessary and what the financial landscape will look like going forward.
 
Before Dodd-Frank, major financial firms were essentially regulated by what they called themselves rather than what they did.   The supervisory boundaries of our regulatory system--which were largely drawn to address the banking system of the 1930s--had remained relatively stagnant while huge amounts of risk was moved outside of the regulated banking system into non-bank entities offering weaker consumer protection and subject to less oversight, lower capital requirements, and more favorable accounting treatment.
 
For example, if an entity were a bank, then it had tougher regulation, more stringent capital requirements, and robust supervision.  But if an entity were an investment bank engaged in the same activities--then, it had to abide by different rules.  It had become a "voluntary" system with little oversight.  A system that allowed large financial institutions to choose the regulator that would offer the least restrictive supervision. 
The Federal Reserve did not have any authority to set and enforce capital requirements on the major institutions that operated businesses outside of bank holding companies. That meant it had no supervision over investment banks, diversified financial institutions like AIG or the nonbank financial companies competing with banks in the mortgage, consumer credit and business lending markets.
 
Today, Dodd-Frank has provided authority for clear, strong and consolidated supervision and regulation by the Federal Reserve of any financial firm--regardless of legal form--whose failure could pose a threat to financial stability.  And Act provides clear authority for regulators to restrict excessively risky activity, including a statutory prohibition of proprietary trading, by banking firms.
 
We will have a single point of accountability for tougher and more consistent supervision of the largest and most interconnected financial firms.
 
Before Dodd-Frank, the government did not have the authority to unwind large, highly leveraged, and substantially interconnected financial firms that failed – such as Bear Stearns, Lehman Brothers, and AIG – without disrupting the broader financial system.
 
Firms benefited from the perception that they were "too-big-to-fail"-- a presumption that they would receive government assistance in the event of failure.  Such a presumption reduced market discipline and encouraged excessive risk-taking by firms. It provided an artificial incentive for firms to grow.  And it created an unlevel playing field with smaller firms.
 
Today, we have ended "too big to fail".   Major financial firms will now be subject to heightened prudential standards, including higher capital requirements. Major financial firms will be required to by these standards to internalize the costs that they impose on the system, which will give them incentives to shrink and reduce their complexity, leverage, and interconnections.   And should such a firm fail, there will be a bigger buffer to cushion losses.  Moreover, we no longer have to make the untenable choice between taxpayer bailouts and market chaos. Instead, the Dodd-Frank reforms provide the FDIC with the authority to wind down any firm whose failure would pose substantial risks to our financial system, in a way that will protect the economy while ensuring that large financial firms – not taxpayers – bear any costs.
 
Before Dodd-Frank, no regulator or supervisor had the legal authority or responsibility to look across the full sweep of the financial system and take action when there was a threat.   Our financial markets have suffered for the lack of an effective system for monitoring and responding to systemic risks or threats to financial stability as they arise. 
Today, the Financial Stability Oversight Council (FSOC) has clear responsibility for examining emerging threats to our financial system regardless of whence they come. The FSOC is accountable to identify threats to financial stability and to address them.
 
Before Dodd-Frank, the OTC derivatives market--with a notional amount of $700 trillion at its peak--grew up in the shadows, with little oversight.  Enormous risks built up in these markets – without effective constraints or any robust monitoring by regulators. 
 
In the recent crisis, because of a lack of transparency in these markets, the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms.  So, when the crisis began, regulators, financial firms, and investors had an insufficient understanding of the degree to which trouble at one firm spelled trouble for another.  This lack of information magnified contagion as the crisis intensified, causing a damaging wave of margin increases, deleveraging, and credit market breakdowns.
 
Lack of transparency--combined with insufficient regulatory power to police these markets and bets placed without capital--left our financial system vulnerable to imprudent concentrations of risk and abuse.
 
Today, regulators are putting in place the tools to comprehensively regulate the OTC derivatives market for the first time.  The Act provides for regulation and transparency for transactions in this market. It provides for strong prudential, capital, and business conduct regulation of all dealers and other major participants in the derivatives markets. And it provides for regulatory and enforcement tools to go after manipulation, fraud, and other abuses in these markets.
 
These reforms will cover the full range of risks and actors in the financial system and help to prevent risks from building up without oversight or the ability to monitor them.  Ultimately, these reforms will help create a more stable financial system by enabling managers to better manage enterprise-level risk, and regulators to better identify and constrain excessive risk throughout the system.
 
Before Dodd-Frank, consumer protection regulation was fragmented over seven federal regulators, most of which chose to focus their energies in areas other than protecting consumers. Regulators lacked mission focus, market-wide coverage, and consolidated authority. Nonbanks could avoid federal supervision. Banks could choose the least restrictive consumer approach among several different banking agencies. Federal regulators preempted state consumer protections laws without adequately replacing these important safeguards.  Fragmentation of rule writing, supervision and enforcement led to finger-pointing in place of action and made actions taken less effective.
 
Today, there is one agency for one marketplace with one mission – protecting consumers. The Consumer Financial Protection Bureau will focus on  more effective regulation and supervision.  Regulation that is designed and implemented with an understanding--and respect--of neoclassical models, but is not blind to the compelling insights into consumer decisions derived from behavioral economics. Regulation that helps consumers by giving them the tools to make their own choices to find the most suitable financial products even when a provider may have incentives to hide true costs.
 
The CFPB will set  high and uniform standards across the market. It will focus on improving financial literacy for all Americans.  And it will help to end profits based on misleading sales pitches and hidden traps; rather, banks and nonbanks can compete vigorously for consumers on the basis of price and quality.
 
And despite the voices of opposition to the contrary, these reforms are, and have always been, about restoring the necessary balance between the incentives for innovation and competition, on the one hand, and adequate protections for consumers and investors, on the other. 
 
So that is where we were before the Dodd-Frank Act; that is why reform was necessary. And those are the key changes the Act will bring.  Now we are hard at work implementing these reforms. 
 
Last week the Financial Stability Oversight Council held its second meeting. We all are bringing clarity to the public and the markets. We have to write new rules in some of the most complex areas of finance; consolidate authority spread across multiple agencies; set up new institutions for consumer protection, insurance  and for addressing systemic risks.  This will take time.
 
Pressing for Progress in the International Community
 
While we are reforming our markets at home, we have also been hard at work on global reforms.
 
On the international front, the United States will continue to press for progress on raising the quality and quantity of capital; reducing the moral hazard of systemically important financial institutions; and improving the transparency and oversight of the OTC derivatives market. 
 
We are working to raise capital requirements so that financial firms can withstand future crises as severe as the one we have just gone through, and do so without government support.  In the Basel III negotiations, we pushed hard to set minimum capital ratios at a level that will represent a significant increase in firms' requirements.  These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock.  Such restrictions will help shore up a firm's capital base before it reaches a point of no return. 
 
Not only are we raising the ratios, but just as importantly, we are raising the standards on the quality of capital that underlie them.  The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis. There will be strict limits in the capital calculation on counting minority interests, as well as on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.
 
In addition to increasing the quantity and quality of the capital that firms hold, we are increasing the capital required for banks' riskiest activities, such as their trading positions and their counterparty credit exposures.  Capital calculations for trading exposures will now have to be based on stressed market conditions, and the charges for securitization exposures will be increased substantially.  In both derivatives and secured lending transactions, firms will now also be subject to a capital charge for losses associated with a deterioration in the credit worthiness of their counterparties.
 
Under Basel III we will also be introducing a new, internationally applied, leverage ratio requirement that, for the first time, includes firms' off balance sheet commitments and exposures. 
 
The combination of these changes – higher capital ratios, new capital requirements, tougher and more extensive measurement standards – will help ensure that firms have sufficient capital to weather the next crisis.
 
Furthermore, in addition to new capital requirements, we will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains.  Under the new rules that we are helping to craft, firms will have to hold enough highly liquid assets to meet potential net cash outflows over a 30 day stress scenario. Through the Basel Committee we are also working on developing a liquidity requirement that will require a minimum amount of stable funding over a one year time period, relative to a firm's assets, commitments and obligations.  These liquidity requirements will be crucial in helping to mitigate severe strains like those that we saw on the financial sector at the time of the collapse of Bear Stearns and Lehman Brothers during 2008.
 
In addition, we believe it vital that countries implement the resolution recommendations agreed by G-20 Leaders in Toronto, which are a necessary prerequisite for an effective cross-border resolutions framework for systemically important financial institutions.  These firms must also be subject to enhanced supervision. These measures are necessary to end the perception in the international community that some firms are too big to fail.
 
Finally, we will encourage our counterparts to continue the solid international efforts to put in place common global standards for transparency, oversight and the prevention of manipulation and abuse of derivatives markets.  U.S. regulators will continue to lead international efforts focused on advancing international standards for clearing and settlement, and development of cooperative supervisory arrangements for critical OTC derivatives market infrastructure.
 
Both our financial system and this crisis have been global in scope. So our solutions have been and must continue to be global.  International reforms must support our efforts at home, including strengthening the capital and liquidity frameworks; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.  We have not waited for the international community to act before building a new foundation in the Dodd-Frank Act, and we will not accept an international race to the bottom on regulatory standards.
 
Conclusion
 
The passage of the Dodd-Frank Act was a historic achievement.
 
From the outset, we knew that achieving serious reform would be a hard fight.  And it has been.  We knew that the forces for the status quo would outnumber the forces for reform.  And they did. But we also knew that reform could not wait.
 
We had an urgent obligation to fix the failures that threatened our financial system and helped trigger the worst global economic crisis since the Great Depression, and a recession that has cost American families and American businesses so dearly.
During the past two years, I have been honored to serve President Obama and Secretary Geithner in rebuilding our financial regulatory system on a stronger foundation.
 
An effort that eschewed the misguided debate of "more regulation" vs. "less regulation"; that resisted pitting "innovation" against "consumer protection"; that never mistook slogans for real reform; that  instead focused on creating a smarter, more effective, and more agile regulatory system. 
 
A system with safeguards that can keep pace with market evolution, without stifling innovation, capital formation or growth. 
 
A system that will restore that careful balance--between efficient markets and necessary protections--that has been a core strength of our financial system.
 
Thank you very much.
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