WORD ON THE STREET: A key challenge for community banks in the years ahead will be to adapt to the changing regulatory environment, particularly the regulatory reforms contained in the Dodd-Frank Act, as well as the changes that will be associated with the Basel III reforms. We are certainly aware of and appreciate the concerns that community banks have about these regulatory changes, and we have stepped up our efforts to understand those concerns and to respond to them as appropriate.
I think it is worth emphasizing that the changes we will be seeing in the financial regulatory architecture are principally directed at our largest and most complex financial firms, including nonbanks. Consequently, one benefit of the reforms should be the creation of a more level playing field for financial institutions of all sizes.
Focusing reform on our largest, most complex financial firms makes sense. The recent financial crisis highlighted the fact that some financial firms had grown so large, leveraged and interconnected that their failure could pose a threat to overall financial stability. The sudden collapses of major financial firms were among the most destabilizing events of the crisis. The crisis also demonstrated the inadequacy of the existing framework for supervising, regulating and otherwise constraining the risks of major financial firms, as well as of the toolkit the government had at the time to manage their failure.
A major thrust of the Dodd-Frank Act is addressing the too-big-to-fail problem and mitigating the threat to financial stability posed by systemically important financial firms. The too-big-to-fail problem is a pernicious one that has a number of substantial harmful effects. Critically, it reduces the incentives of shareholders, creditors and counterparties of such firms to discipline excessive risk-taking. And it produces competitive distortions by enabling firms with large systemic footprints to fund themselves more cheaply than other firms because of the implicit subsidy of too-big-to-fail status.
This competitive distortion is not only unfair to smaller firms and damaging to competition today, but it also spurs further growth by the largest firms and more consolidation and concentration in the financial industry. A financial system dominated by too-big-to-fail firms cannot be a healthy financial system.
The act addresses the too-big-to-fail problem with a multi-pronged approach. Under it, we are developing more-stringent prudential standards for banking firms with assets greater than $50 billion and all nonbank financial firms designated as systemically important by the Financial Stability Oversight Council. These more-stringent standards will include stronger capital and leverage requirements, liquidity requirements, and single-counterparty credit limits, as well as requirements to periodically produce resolution plans and conduct stress tests.
Our goal is to produce a well-integrated set of rules that meaningfully reduces the probability of failure of our largest, most complex financial firms and that minimizes the losses to the financial system and the economy if such a firm should fail. In doing so, we aim to force these firms to take into account the costs that they impose on the broader financial system, soak up the implicit subsidy these firms enjoy due to market perceptions of their systemic importance, and give the firms regulatory incentives to shrink their systemic footprint.
Complementing these efforts, the Federal Reserve has been working for some time with other regulatory agencies and central banks around the world to design and implement a stronger set of prudential requirements for large, internationally active banking firms. These efforts include the agreements reached in December on the major elements of the new Basel III prudential framework for large, globally active banks. Basel III should make the financial system more stable and reduce the likelihood of future financial crises by requiring large banks to hold more and better-quality capital and more robust liquidity buffers. A more stable financial system will benefit all banking institutions and, of course, our economy as a whole. We are working to adopt the Basel III framework in the U.S. in a timely manner.
A central issue that we and the other banking agencies face in implementing Basel III in the U.S. is deciding how these capital rules will be applied for banks that are not systemic or internationally active. We recognize the importance of striking the right balance between promoting safety and soundness throughout the banking system and keeping the compliance costs for smaller banking firms as low as possible. Also, to minimize the impact of the new capital rules on credit availability while the global economy is still recovering, we and our international colleagues have agreed to allow long transition periods for the implementation of the new standards.
In addition to stricter regulation and supervision of large financial firms, the Dodd-Frank Act places new checks on the growth by acquisition of our major financial firms. It expands current restraints on acquisitions by bank holding companies to include a broader range of acquired firms (not just banks) and a broader range of liabilities (not just deposits). This expansion reflects a financial system that has changed in important ways since 1994, when the Congress first adopted concentration limits for banks and bank holding companies.
The act also imposes new restrictions on the capital markets activities of banking firms – restrictions that will disproportionately affect the structure and profitability of the largest banking firms. For example, the so-called Volcker rule will restrict the ability of banking firms to engage in proprietary trading of securities and derivatives and to invest in or sponsor private investment funds.
Among the most important aspects of the act are the measures that it authorizes to reduce the financial and economic effects of the failure of large firms. A clear lesson of the past few years is that the government must not be forced to choose between bailing out a systemically important firm and having it fail in a disorderly and disruptive manner.
Instead, we need the tools to resolve a failing firm in a manner that preserves market discipline – by ensuring that shareholders and creditors incur losses and that culpable managers are replaced – and that at the same time cushions the broader financial system from the possibly destabilizing effects of the firm's collapse. Of course, such a framework has been in place for banks for several decades now, as you know.
The Dodd-Frank Act creates an analogous framework for systemically important nonbank financial firms, including bank holding companies. Resolving a large, multinational financial firm safely will likely always be a difficult challenge, and a great deal of work remains to be done to make these new authorities fully effective. Ultimately, though, these changes will mitigate moral hazard in our financial system by reducing expectations of government support by the creditors and counterparties of large firms. Taken together, the measures I have described should give us a financial system that is safer, more efficient and more equitable.
In short, two key objectives of financial regulatory reform are, first, addressing the problems that emerged in the largest, most complex financial firms during the crisis and, second, creating a better balance with respect to regulation and oversight between banks and nonbank financial firms. The Federal Reserve believes that these are the right goals for reform. We are committed to working with the other U.S. financial regulatory agencies to implement the act and related reforms in a manner that both achieves the law's key objectives and appropriately takes into account the risk profiles and business models of smaller banking firms, including community banks.
Ben Bernanke is chairman of the Federal Reserve. This article was adapted from a speech Bernanke gave March 23 during the Independent Community Bankers of America National Convention in San Diego. To read the speech in its entirety, click here.
