WORD ON THE STREET: President Obama inherited an economic and financial crisis more severe than any president since Franklin Roosevelt. The president responded forcefully with a historic job creation package, with a multi-prong effort to stabilize our financial and housing sectors, and with reforms to make the financial system more stable, more resilient, and safer for consumers and investors.
The need to reform our financial system is nowhere more clearly illustrated than the great recession from which we are just beginning to emerge. The cost of the old financial order can be measured in the trillions of dollars of savings lost, in Americans who can't find work, and in small businesses that still struggle to find funding.Â
There were many causes of the crisis, but I want to begin today by talking about the role that innovative financial products seemed to play and the importance nonetheless of fostering innovation as we implement financial reform.
Those markets with the most innovation and the fastest growth seemed to be at the center of the current crisis. There is no doubt that, taking the long historical view, at many turns we have seen a pattern of tremendous growth that has been supported by financial innovation.Â
But in this cycle, as in many times in the past, this growth often hid key underlying risks, and innovation often outpaced the capacity of risk managers, boards of directors, regulators and the market as a whole to understand and respond. For instance, securitization helped banks move credit risk off of their books and supply more capital to housing markets. But it also widened the wedge between principals and agents – lowering underwriting standards and the incentives for due diligence.Â
Tranching of asset-back securities and the assignment of ratings to tranches of structured products by credit rating agencies seemed to give investors more control of the precise risk profile they were taking, but risk managers, corporate directors and regulators did not account for the tail-risk that this crisis so painfully exposed. Rapidly expanding markets for hedging and risk protection allowed for better management of corporate balance sheets and freed businesses to focus on their core missions. Credit protection allowed financial institutions to provide capital to businesses and families that needed it.Â
But a lack of transparency hid the movement of exposures. When the downturn suddenly exposed liquidity vulnerabilities and important counter-party risks, uncertainty froze even the most deeply liquid and highly collateralized markets at the center of our financial system.
It may be useful to think about our response to this crisis in terms of cycles of innovation. New products develop slowly while market participants are unsure of their value or their risks. As they grow, however, the excitement and enthusiasm can overwhelm normal risk management systems. Participants assume too soon that they really know how they work, and more extreme versions, applied widely without thought to the differing contexts, and often carrying more risk, flood the market. The cycle turns, as this one did, with a vengeance when that lack of understanding and that excess is exposed. But past experience shows that innovation survives and, after a time, renews once again.Â
Innovation creates products that serve the needs of consumers, and growth brings new players into the system. Businesses and financial institutions have an important and ongoing need to manage their risks. Our financial system must maintain its role as an efficient way to allocate capital.
But innovation demands a system of regulation that protects our financial system from catastrophic failure, protects consumers from widespread harm and ensures that consumers have the information they need to make appropriate choices. Rather than focus on the old ‘more regulation versus less regulation’ debate, the questions we have asked are why certain types of innovation contributed in certain contexts to outsize risks, and why our system was ill equipped to monitor, mitigate and respond to those risks.Â Â
Our system failed to require transparency in key markets, especially fast-developing ones. Rapid growth hid misaligned incentives that people didn't recognize. Throughout our system we had inadequate buffers – as both market participants and regulators failed to account for new risks appropriately. The apparent short-term rewards in new 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.Â Â
With our reforms, we will now have a financial system that is safer and fairer, more stable and more resilient. And one that continues to foster innovation.
With the enactment of the Dodd-Frank Act, we have made a critical structural change in our approach to consumer protection. We all aspire to the same objectives for consumer protection regulation: independence, accountability, effectiveness and balance – a system that promotes financial inclusion and preserves choice. The question is how to achieve that. A successful regulatory structure for consumer protection requires mission focus, market-wide coverage and consolidated authority.
Today's system has none of these qualities. It fragments jurisdiction and authority for consumer protection over many federal regulators, most of which have higher priorities than protecting consumers. Nonbanks avoid federal supervision; no federal consumer compliance examiner lands at their doorsteps. Banks can choose the least restrictive supervisor among several different banking agencies. Fragmentation of rule writing, supervision and enforcement leads to finger-pointing in place of action and makes actions taken less effective.
The Dodd-Frank Act now creates one agency for one marketplace with one mission – protecting consumers. The Consumer Financial Protection Bureau will create a level playing field for all providers, regardless of their charter or corporate form. It will ensure high and uniform standards across the market. It will focus on ensuring financial literacy for all Americans. It will end profits based on misleading sales pitches and hidden traps, but there will be profits made on a level playing field where banks and nonbanks can compete on the basis of price and quality.
Once we streamline authority, we will be able to leave behind regulatory arbitrage. And we will be assured of accountability.
The Dodd-Frank Act ensures – not limits – consumer choice; preserves, not stifles, innovation; strengthens, not weakens, depository institutions; reduces, not increases, regulatory costs; empowers, not ignores, consumers; and increases, not reduces, national regulatory uniformity.
To rebuild trust in our markets, there is no need to wait for the implementation of these reforms. Today, the financial industry can begin to find new ways to improve disclosure for consumers, end hidden fees and create a culture of sound underwriting that puts people into loans they can afford.
Much of the discussion of reform over the past two years has focused on the nature of and proper response to systemic risk.Â
To address these risks, the Act focuses on three major tasks: 1) providing an effective system for monitoring risks as they arise and coordinating response; 2) creating a single point of accountability for tougher and more consistent supervision of the largest and most interconnected institutions; and 3) tailoring the system of regulation to cover the full range of risks and actors in the financial system so that risks can no longer build up outside of supervision and monitoring.
The critical role of monitoring for emerging risks and coordinating policy is vested in a Financial Stability Oversight Council. At the same time, the Act provides for consolidated supervision and regulation of any financial firm whose combination of size, leverage and interconnectedness could pose a threat to financial stability if it failed.
This crisis has clearly demonstrated that risks to the system can emerge from all corners of the financial markets and from any of our financial institutions. Our approach is to bring these institutions and markets into a comprehensive system, where risks are disclosed and can be monitored by regulators as necessary. That's why the Act brings all over-the-counter derivatives markets into a comprehensive regulatory framework and provides regulatory authority for clearing, payment, and settlement systems; strengthening the regulation of markets for securitization; and registration of all hedge funds and other private pools of capital over a minimum threshold in size.
We need a system that's flexible enough to adapt to the emergence of other institutions that could pose a risk to the system. And we need a system that lets regulators see risks as they emerge across the financial system. The reforms we've enacted achieve these aims.
As Treasury Secretary Timothy Geithner has said, the three most important things to lower risk in the financial system are ‘capital, capital, capital.’ We need to make our financial system safer for failure. We cannot rely on perfect foresight – whether of regulators or firms. Higher capital charges can insulate the system from the buildup of risk.Â
That's why we have proposed raising capital standards across the board. Making the system safe for innovation means raising the buffers for financial firms against loss. It also means creating a more uniform system of regulation so that risks cannot build up without adequate regulatory oversight.
Financial activity involves risk, and no one will be able to identify all risks or prevent all future crises. We learned through painful experience that when the financial system is fragile, the failure of a large, interconnected institution can threaten the stability of the financial system. While we have a tested and effective system for banks, there was no effective legal mechanism to resolve a non-bank financial institution or bank holding company. The Act fills this gap in our legal framework with a mechanism modeled on our existing system under the Federal Deposit Insurance Corp.
Finally, 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 framework, improving oversight of global financial markets, coordinating supervision of internationally active firms, and enhancing crisis-management tools. We will not wait for the international community to act before we reform at home, but nor will we be satisfied with an international race to the bottom on regulatory standards.
The path forward
I want to turn to the task ahead and describe the principles Secretary Geithner laid out that will guide us in the implementation of this reform and for which you should hold us accountable. First, we have an obligation of speed. We will move as quickly as possible to bring clarity to the new rules of finance.Â
Second, we will provide full transparency and disclosure. The regulatory agencies will consult broadly as they write new rules. Draft rules will be published, and the public will have a chance to comment. And those comments will be available for everyone to see.
Third, we will not simply layer new rules on top of old, outdated ones. Alongside our efforts to strengthen and improve protections for the economy, we will eliminate rules that did not work. Wherever possible, we will streamline and simplify.
Fourth, we will not risk killing the freedom for innovation that is necessary for economic growth. Our rules must protect the innovation that serves customers and increases efficiency, but must end the laxity that allowed for recklessness and abuse.
Fifth, we will make sure we have a more level playing field – not just between banks and nonbanks here in the U.S. – but also between our financial institutions and those in Europe, Japan, China, and emerging markets who are all competing to finance global growth and development. We will do this by setting high global standards and blocking a race to the bottom from taking place outside the U.S.
Finally, we will bring more order to the regulatory process, so that the agencies responsible for building these reforms are working together, not against each other.Â
As we go about the task of implementing these reforms, we will be criticized by some for going too far and by some for not going far enough. This distinction is stuck in a debate that presumes that regulation – and efficient and innovative markets – are at odds.
In fact, the opposite is true. Markets rely on faith and trust. Markets require clear rules of the road. Consumers rely on the trust and fair dealing of financial institutions. And for all our sakes and that of our economy, we must restore honesty and integrity to our financial system. The president's financial reforms lay a new foundation for financial regulation that will once again help to make our markets vital and strong.
Michael Barr is the assistant secretary of the Department of the Treasury. This article is adapted from an Aug. 4 speech delivered before the Charlotte, N.C., Chamber of Commerce.